Entrepreneurship University
College of Entrepreneurial Studies (CES)

The VC Process

VCs consider the following characteristics of a prospective enterprise, in approximate order of importance, in assessing the probability of a firm’s success.

    The Team. Of prime importance is

  • The success with which the enterprise team can articulate the business plan to the potential investors, that is, beyond the three minute read.
  • They assume the team is made up of the technical experts as well as the marketing and overall management and, if there are gaps in team, the founders must be able to convince their audience that they can fill them.
  • Previous entrepreneurial success by former investor/managers who have “cashed out” and discharged their obligations to the new owners so they can return to being entrepreneurs.

According to Bob Fulk, principal of Robert Fulk, Inc, private investment counselors since 1953, “What you look at first and last are the people. You try to assess if they will be able to face the difficulties that always face a new firm and will survive.” One way to look at the team is what experience they have as individuals in operating a similar enterprise.

The Outside Team.

The perceived quality and reputation of the outside advisors who have been assembled by the entrepreneurs can be the difference in serious consideration. These include legal counsel, accounting and audit services, risk analysis and insurance advice, intellectual property and patent attorneys, media relations counsel and marketing counsel.

    The Marketing Plan.

  • Have they thought out and budgeted how they are going to bring the product or service to the potential buyers?
  • Does the marketing plan support the revenue model presented in the overall business plan?

“So many business plans with which we have recently been confronted simply base their marketing on mounting the new product or service on the Internet, period,” observed Pat Anderson of ITQ LATA, B2B Web development and marketing firm. “There is no further consideration or budget of getting the right customers to the Web site with checkbook in hand.”

The Technology.

Sometimes entrepreneurs are loath to explain the technological basis of the enterprise because of some misplaced paranoia that someone is going to compromise it. Using the expertise of their advisors, the founders can protect themselves and, yet be able to explain their proprietary position in such a way that the analysts can determine if it is sound and unique.

    How investors and venture capitalists read a business plan:

  • Determine the characteristics of the company and the industry from reading the Summary (many never read beyond the Summary). It is important to match your deal to the investor. Most investors have a preferred area for investment, e.g., high-tech, real estate. It is easier to impress them if other similar companies are used as successful examples.
  • Determine the terms of the deal from the Financial Plan. How much of the company is being sold? How is the financing split between debt and equity? How are shares priced? What is the total valuation of the company? What is the exit policy?
  • Read the balance sheet. Determine liquidity (asset to liability ratio), evaluate debt/equity structure, assess net worth.
  • Examine the people in the deal. Who are the founders, directors, other investors? Are there letters of reference? What is the “track record,” background, balance and experience of the management team? How good are their financial advisors?
  • What is different about this deal? Is there some unusual feature of the product or service. Is there some particularly innovative approach, market strategy, or production technique? Does the company have patents, unusual technology or a significant lead over competition? Is there a distinctive competence or other competitive advantage?

Questions investors will ask:
1. How much can I make?
Investors usually have a target of Return On Investment of 35% to 50% per annum over 3 to 5 years. For riskier start-ups it can be as high as 50%. For later stage investment 35% is not unusual.

Investors will usually look at third year projected earnings. Using third year earnings, investor will multiply by the Profit to Earnings ratio of similar companies. Usually a P/E ratio is 10 to 12.

Next, they will multiply the amount invested by 4 or 5 which is usually the expected turn on their money in a three year period. Then they divide to determine what percentage of ownership it should yield.

EXAMPLE:

Investor expects 5 Turns On Initial Investment Over 3 Years on a
$150,000 Investment; typical P/E Ratio for similar companies is 12.
3rd Year Net Profit After Taxes projected to be $250,000.

What share of the company should this buy?

5 turns on initial investment = 5 x 150,000= $750,000.
Company valuation= Earnings (250,000) x P/E (12)= $3,000,000.
Investor share= Turn (750,000) / Valuation (3,000,000)= 25%

Remember that these are only projections! The credibility of revenue projections cannot be assumed. They must be realistic, and based on research on the documented size of the market, and penetration by similar companies.

2. How much can I lose?

Two factors apply: riskiness of the deal, and financing structure.

There are three major inherent risks in early stage company: can the product/service be produced by the company; can it be sold; and, can it be produced and sold at a profit? For a going concern, operating at a profit, these three risks are minimized. For a startup, management risk is the most serious – people invest in people, not ideas.

A key element of the financing structure is “Exit Policy,” i.e. how investors get their money out of the company. The business plan should outline exit policy. Options include: go public; sell the company; liquidate; or allow for management to repurchase shares at a predetermined P/E ratio.

3. Who says it’s a good deal?

Investors like to see endorsements and testimonials: references, both personal and trade; customers’, suppliers’, and bankers’ opinions of the company. The business plan should include, where applicable and available: letters from customers; customer response to demonstrations; focus group results; and trade show responses. Another important issue is who else is in the deal.

Wishing you success,

John B. Vinturella, Ph.D.

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