A venture capitalist’s thoughts on preparing for your pitch to an investor.

The following notes summarize a conference call with venture capitalist Bill Lyman (Partner, LMG Corp, Atlanta GA). After evaluating a term sheet offered to a client, the VC offered some general tips on pitching to an investor. These notes are conversational, not to be taken as an official plan or advice.
The Pitch
Separate the customer from the investor. Pitch to the investor, not the customer. Show the company, not the product when selling to the investor. Have a one or two sentence elevator pitch ready for the investor. Where are you at in the business cycle, this is important to the investor. Tell the investor why you need money, how much you need, and how long it will last.  Mention three key customers which represent  $x per year.
If you are sending the value proposition as an email, make it a paragraph with a few bullet points. Explain the profitability of the company, the sales, and the need. What are you looking for?

Valuation

Get a beta customer to help determine the value of the company. Get them on board, choose someone who wants to be a leader. Work with this customer to help create a two page case study on the value it brings to the customer. That customer should be given the right pricing to ensure that it is worthwhile with them.

• Think about ongoing revenue opportunities. Once you get a customer, what is your account penetration strategy?
• Departmental license?
• Enterprise wide?
• Maintenance fees?
• Single users?

Investor’s Value

What does the investor bring to the table other than dollars? Is there some inherent value? Remember, what a VC says is great, but bottom line, they are investing a dollar to make profit. Don’t put a price on “other value” the investor brings. If they insist on a lower valuation because of their inherent value, put some milestones in place for the investor just like they would put milestones in place for you.
The value add from the investor is also of benefit to the investor because they should have a better chance of a good investment. Valuation should be done on what the company is worth, not what the investor is worth.
How much is It Worth?

You don’t want to release your valuation first. Let the investor play their cards first!

Valuation as a multiple on today’s sales would be a bargain in a high growth company because it wouldn’t account for future growth. If the company is growing faster than the market, this isn’t a good deal for the entrepreneur.

How much money do you need, that is where to start. You should ask for about 12-18 months of cash; consider all expenses, fixed and variable. Rule of thumb for a Round A financing run is that you can be expected to get a 20% to 50% dilution of your company. The goal is to go from growth company to a commercialized company.

What value can you create above and beyond where you are today, that will make your profile look so much more attractive that you can then issue another round of financing at a higher company value than your post-money value after Round A?

Explain this to the investor; what will you do? What milestones will you hit?
Look at a categorical sales forecast of the next two years
Look high level, how many A, B, and C size deals will you win?
Assign a multiplier to each sale to account for additional revenue from current clients etc.
Don’t get hung up on the details, use a rough order of magnitude
You need to translate your company’s growth / excitement into value.

One strategy to reduce the risk to the investor is to tranche the investment, or split it into manageable chunks with associated milestones. Articulate the financing needs with traction in the marketplace. The advantage to the investor by splitting the investment is that the later stage investment is valued at present day, but the risk is mitigated by the second/third injection of funds. Set reasonable, achievable milestones that trigger part of the financing. IE $250k up front, $250k upon sales of X dollars, $250k upon achievement of development of product Y.

When you are cash flow positive, you control your own destiny. This gives you the ability to go out and create more value rather than take a bad deal. The bottom line is, start with YOUR number. You need to know what amount of capital you need.

Do You Really Need Investor Funding? Problem: growth is hampered now because of the need to have staff to support the growth. Try non-recurring engineering revenue (NRE’s). When you make a sale, ask the customer to pay some upfront to allow you to pay for staff. Front load the contract to give you the cash to support your growth. Talk to friends and family. The bank. Maybe your capital needs are actually very short term. If you can bootstrap some $ together and pay them back upon sales, you could avoid ownership dilution.

It is important to quantify the milestones when you get investment dollars. What does the investor expect for the investment? How is the investor motivated?

Get educated. Head to venture sites. Look for other deals/companies who were purchased in your industry. How were they valued? How did they survive? Check out http://www.sec.gov/edgar.shtml to see records of other public company filings.

Create a bona fide Board of Directors prior to the investment. This will help comfort the investor. Keep everything at a high level, don’t get in to the nitty gritty legal jargon until you agree on the high level terms.

Purchase Order Financing

This is another risk reducing strategy. You could propose that financing would be distributed upon reception of a signed purchase order. It is similar to staged tranching using equity financing. An investor might give a loan after you get a PO because the risk to the investor is far reduced. With a PO in hand, it may be possible to achieve financing from a bank, or friend. A VC may still ask for ownership with this financing model, but a bank or friend may not. You may have to provide a relatively high payback on your short term loan, but this might be worth it to keep 100% ownership. You could include some “warrants/options” as a kicker to the investor. More commonly, it is easy to “factor” the accounts receivables yet this is after the delivery of the project.

The Key

How much money do you need for 15 months and what are you going to do with it to increase the value of the company for the next round of financing.
The real hallmark of an entrepreneur is bootstrapping. Use customer financing to pay for your growth. Don’t sell the farm for a bad deal. Be creative. Figure out what you need before agreeing to a financing deal.

A venture capitalist’s thoughts on raising capital for “Round A” Investment.

The following notes are a summary of an educational conference call with venture capitalist Bill Lyman (Partner, LMG Corp, Atlanta GA) about “Round A”, or first round, of venture capital funding. The notes are broken out in two sections, the Entrepreneur’s Perspective, and the Investor’s Perspective. These notes are conversational, not to be taken as an official plan or advice.

The Environment: Venture capitalists (VC) have an asymmetrical advantage when it comes to the term sheet. VC’s invest day in day out and see companies make countless pitches for money. Most entrepreneurs only get to a fundraising table one or two times in their life. Silicon Valley is well known for is investment community, and similarly well known by the investors for seeing good “pitches.” Deals are packaged properly in the Valley and if they aren’t, they have a hard time raising funds. Quite often, these deals don’t have their elevator pitch & executive summary done properly.

Entrepreneur’s Perspective

The entrepreneur really needs to focus on a solid business plan to pitch to the investor. The plan should focus on the business, not on the product or service being offered by the business. As the lecturer noted, “The financials mean nothing, the economics mean everything.” The plan must focus on the business model.
The plan should be approximately 12-15 slides, plus backup slides if the discussion warrants further information. Focus on selling the company, not the product. A template could include:

• 2 slides product/service
• 2 slides market opportunity
• 2 slides competition
• 2 slides marketing plan
• 2 slides sales plan
• 2 slides financials – cash flow at each stage, gross margins, operating margins
• FOCUS on the company, not the product

It is important to outline the basics of your business model. Is it a manufacturing model, software model, e-commerce model, or social media model? Understand the successful elements of the model and ensure that you explain how your business will also succeed with this model. The economics of your business will be driven by your business segment.

The sales forecast needs to be quite granular. Show the ramp up as your business grows; this should be monthly for the first 12-18 months, then quarterly. A quarterly summary should be used for the pitch, but ensure that you have monthly forecasts prepared and available. Internally, it may be beneficial to work on weekly sales numbers, but presentation can be made monthly & quarterly.
Demonstrate the sales cycle. Be sure to explain the customer acquisition cost. How many calls have to be made to acquire a customer/how long is a typical sales cycle? Who is the target customer? Are there certain groups who are the early adopters? What happens when you actually make a sale? What is your advertising model or plan? Is there a volume of business that has to happen before you are profitable? Answers to these questions provide a VC with a picture of the stability of your business model; they drive a picture of success much better than a five year profit/loss spreadsheet.

Comparable business models should be demonstrated in your pitch. Find a similar business and look at their S1 Registration Statement filings with the Securities and Exchange Commission (http://www.sec.gov/edgar.shtml). The S1 statements will show you revenue generation, head count, cash flow, venture rounds, profitability, growth rates, etc. This will help you determine a valuation for your company. The S1 statement helps you, and the VC’s, see a pattern for how business operating under your model were launched in the past. You can start to recognize a pattern of how other companies have launched.

There are some criteria which venture capital investors are typically looking for which need to be addressed in the pitch. The criteria are:

• Disruptive innovation or “leapfrog technology”
• High growth
• High profit
• Scalable – people intensive models are often not scalable

Your target audience is determined by meeting these four criteria. For instance, if your innovation is only incremental, as opposed to disruptive, it might be better to pitch to a corporate R&D department. VC’s want high growth, not incremental growth; disruptive innovation is often an indicator of high growth potential. A typical growth rate could be:

• $1M Year 1
• $5M Year 2
• $10M Year 3
• $20M Year 4

The internal rate of return (IRR) should be about 35% per year, so expect to be questioned on this point. If your business model doesn’t meet all four of the above criteria, it might not be appropriate for a VC pitch and you should carefully consider licensing or selling your technology.

If the pitch is better suited to corporate investment, find the right partners to target. VC’s expect to make see three to five times return on their investment within three to five years.

The break-even point of your business is an important point for VC’s. Working capital is very important as your grow, so don’t be afraid to show that you will need more than one round of financing. In your pitch, you need to address your sales and expense ratio because this helps you understand your working capital requirements. When you are cash flow positive, that is when you truly control your own business.

You should be looking for financing to cover your business needs for approximately 18 months (VC’s are unlikely to fund you for longer during each Round) or about $1M to $3M. Smaller asks should be made to individual investors like family and friends. Show a reasonable plan, but don’t be too conservative in terms of the financing you will need. It is a lot of work to pitch for investment, ensure you ask for enough, you don’t want to have to return to the investors after only 12 months. Many high growth companies will have to go through multiple rounds of financing. The easy part about raising VC funds is coming up with a realistic forecast; the hard part is coming up with the milestones that will get you to the next round of financing. Some of the milestones include producing a prototype, securing customers, product testing, break-even, clinical trials, etc.

Investor’s Perspective

The Golden Rule – “he or she who has the gold, sets the rules”

There are several different ways to structure a deal, or a term sheet. The tools below are all temporary, and are renegotiated for each round of financing. Keep in mind, tools used in the first round, set a precedent for later rounds. A round of financing usually increases the value of the company by %25-30% and just your ownership is usually diluted by about 25%.

Between each round of financing, investors look for a 2 x valuation step-up or better; if achieved, this is a very positive sign. Round A investors don’t have to be included on Round B, but it is certainly a common courtesy. Round B investors often like to see Round A investors still involved because it is a sign of continued belief in the value of the company. Below are some of the different terms you should be aware of.
Preferred Stock
Startups are almost always interested in equity financing, not debt financing. The preferred weapon of choice is the convertible preferred stock. Convertible shares are preferred shares that can later be converted (1 to 1) to common shares. There are several different rights that can be added to preferred stock.

Dividend rights are used to accrue dividends to the shareholder. When paid out, the shareholder will be given the percentage of the business which they own, plus the dividend value that has accrued. Cumulative dividends are paid upon sale. Non-cumulative dividends don’t continue to add up, they have a one-time payout if the cash for a dividend payout is available from the company; the company controls whether or not the dividend is paid out in this instance. Dividends can step down, or step in after three to five years or even be removed after three to five years. Dividends increase the investor’s upside because they are paid first.

Liquidation preference rights can be used to ensure that investors get paid first upon liquidation of the company. Often the entrepreneur devotes sweat equity, while the investors devote cash; therefore the investors expect to get paid first upon liquidation of the company. A participating preference allows the investor to pull money out of the company and convert to common shares. A non-participating preference allows the investor to either get money out, or convert to common shares. The company and the investors may agree to put a cap on the liquidation preference.

If a VC waives the dividends or agrees to non-participating preference, it may be a sign that the VC likes the price of your company. The greater the value of the company, the more often you will see a request for dividends or liquidation preference; both rights are used as a risk mitigation tool for investors. The National Venture Capital Association (www.nvca.org) has several generic templates for term sheets etc. which can help you at this stage.

Anti-Dilution Rights

Sometimes an early investor can get worried that the second round of investment will be worth less than the first round of investment. If this is the case, there are some tools that investors use.
A full ratchet converts all of the old shares to the new, lower price that is offered in the second round. A weighted average is sometimes used to readjust the shares proportionally to the new price.

Pre-Money vs. Post-Money

Pre-money and post-money refer to the valuation of a company before or after a round of financing. The critical issue in this valuation is whether the value assigned to the company was before or after the investor’s contribution.

Here is an example. If a company was worth $2M “pre-money” and the investor provides $1M, the investor owns 33% of the company. The entrepreneur’s shares are still worth $2M and now the company is valued at $3M.

Investors will always ask the entrepreneur what he/she thinks the company is worth. A good response would be “We have no preconceptions, we are here to find out.” This sort of response protects the entrepreneur from investors taking advantage of a company that could be valued too low or too high. That being said, it is very important for the entrepreneur have a good idea what the company is worth.

Valuation can be affected by the stage of a company IE idea, business plan, proof of concept, beta customers, paying customers.

Founders Stock/Shares

Founders stock is a tool that investors can use to protect their investment. In this case, if an entrepreneur is involved with the company for an agreed period, they will be given the agreed percentage of the ownership shares. If the entrepreneur leaves prior to this period (often four years), their shares are returned to the company. This is a protection mechanism for the investors because if the entrepreneur leaves, the investors need those shares to attract new talent. Often, about 10-20% of the company is set aside for future acquisition of talent as the company grows. This is important to keep in mind in the pre vs. post money discussion.