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The New Rules of Venture Capital

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Now that they have the new economy out of their system, VCs everywhere are changing the way they do business. Anyone looking for an investment--and boy, do VCs want to invest right now--better know how the game is being played.

On the surface, it all seemed very 1999. Adeo Ressi, a video game entrepreneur and the CEO of a new company called Game Trust, needed money. He was paying crushing monthly fees to a Scandinavian company to develop a key piece of technology, and he figured if he didn't purchase the company outright, Game Trust would go broke. The only way he could purchase the company would be with venture capital.
The year wasn't 1999, though. It was 2003, and Ressi spent most of it beating a well-worn path from VC to VC, up and down the East Coast, out to Los Angeles, deep into Silicon Valley. He was the centerpiece of more than 100 introductory sit-downs in which he explained why he and Game Trust were worth a $5.5 million gamble.
Ressi had done this before--he raised $4 million for the Web-development firm Methodfive in 1999. But Ressi soon learned that these days, venture capitalists are no longer throwing millions at untested Internet fancies. Still recovering from the tech bust, they're proceeding with caution, even as the upturning economy makes them increasingly game to dole out money. If they seemed mysterious the first time around, today they are all but impenetrable. For signs of the new caution, just look at Sequoia Capital, one of Silicon Valley's most successful VC operations (its most recent private-to-public superstar is Google). In 2000, according to Fortune, it raised $695 million for investing. Last year, the figure was $395 million--despite access to $3 billion in institutional investor money.

Sequoia is not alone in its desire to play it safe. "We feel no pressure to make investments," says Gill Cogan, general partner with Lightspeed Venture Partners, based in Menlo Park, California, an early backer of companies such as Federal Express, Brocade, and Ciena. "The pressure we feel is to make good investments, and we're perfectly willing to wait for the right ones."
That, as any unflaggingly optimistic start-up entrepreneur worth his Ikea chair will tell you, is the good news: They're waiting for the right ones! The second half of the battle, however, is knowing how to be one of the right ones, how to expertly tune your business plan, your presentation, your pitch, and your request to this exact moment in time. Ressi--who got his money, by the way--learned these new lessons the hard way; we added to his tutelage by talking to a few experts of our own. Below are the new rules of venture capital. Learn them. Live by them. Let them make you rich.

Hurry Up and Wait

Venture capitalists hate to be rushed. During the Internet boom, that's exactly what they were, and they're still not happy about it. "You used to go into a meeting and get a term sheet because they were so afraid that you would go somewhere else," says Ressi. "There was an immediate competition for your interest. These days, the timeline for financing is painfully agonizing. You can't assume someone is following through with due diligence just because he says he is. I was in due diligence with one company for six months, supposedly, and they hadn't asked for a single document. They waited until it was too late. They lost the deal. And I didn't see them crying over it."
Even if you have a white-hot product and a slew of home-run meetings, waiting 12 months before you see any money is normal. For one thing, most VCs actually do spend time on due diligence. Plus, they want to track your company week to week for a while before putting money in. If you're going to tank, they would prefer you tank on your own dime.

Rule 2
Solve an Actual Problem

Two MBAs and a dream of selling pickles over the Internet might have drawn out the checkbooks five years ago. Now investors not only want an idea that can work but one that fulfills a need rather than a desire. A company that has developed a technology to improve eye surgery, for example, stands a better shot than one hawking a celebrity shopping Web site for teens--a potentially lucrative idea that might've been funded a few years ago, but not exactly a social imperative today. "The role of a VC is to say no," says Josh Segal, a principal with Applied Materials Ventures, in Menlo Park, which focuses on funding telecommunications companies. "Come to me with a solution to a problem that currently exists and needs to be solved."

Rule 3
First, Get Some Money On Your Own

Most VCs will be more interested when you can offer tangible results that go beyond financial projections and a head full of ideas, according to Segal. As wonderful as your business plan might be, VCs today lust after operations that are up and running. They don't want to be the ones paying for your first square foot of office space. Virtually every VC Jungle spoke with recommended that entrepreneurs raise seed money by canvassing friends, relatives, and acquaintances. (The exception, according to Donald MacAdam, who has run three companies that have gone public and is the author of the forthcoming book Startup to IPO: How to Build and Finance a Technology Company, is biotechnology. Because start-up costs involve more than a Staples charge account and a Mr. Coffee, VCs are usually willing to fund from the ground up.)

Rule 4
Exaggeration Is Out

If the '90s thrived on hyperbole, 2004 is the year of transparency. VCs are tired of overblown projections. Focus your pitch on what you know to be true, not what you think could maybe happen if everything falls into place. "If you go in there and promise to dominate the world because your software is great and people love you, you will get brutalized," says Ressi. "You will not even finish the meeting. If you go in and show the market size and what you surveyed, there's nothing to argue about. You can't brutalize an entrepreneur over facts. I've done it the other way, and it was hell. I've found that the only way to successfully handle one of these meetings is to do it without superlatives."
Pitch meetings tend to run an hour or so and are brisk, with anywhere from a couple to a dozen VCs firing questions at you like kids flicking Skittles on a school bus. The honesty you show in answering can make the difference between getting money or not. "When somebody asks how many customers are using your system, the common entrepreneur responds, 'We have two, but there are 10 others in the pipeline.' Wrong. The correct answer is two," says Ressi. "And you leave it at that. You don't want to get them fixated on an expectation that might not happen."

Rule 5
Ask For Less Than You Need, And Expect To Receive Less Than You Asked For

Venture capitalists are willing to take risks. They make their living estimating and projecting the exact amount of money that's required to get a return, and not a penny more. Today, most of them have stopped looking for mother-lode paydays. All the better to avoid a mother-lode loss. "Venture capitalists want to give you less than what you need," says MacAdam. "That way they can bail out if things go badly and not lose as much money. Or else, if things go well but the entrepreneurs still need more money, the VC can step in like a shiny white knight and save the company."

Rule 6
Leave Your Business Plan At Home

In part because most VCs are investing primarily in existing businesses these days, carting around a bulky business plan is no longer necessary. In fact, it's discouraged. Foolish, even. A compelling, not overly technical verbal pitch, supplemented by a spreadsheet outlining the basic financials (existing and projected), is all they want. "The necessity of a business plan is a myth--VCs do their own due diligence," says Ressi. "These days they have time to roll up their sleeves and dig into your situation. Then, if they like what they see, they might spend months tracking you."
Segal of Applied Materials Ventures maintains that the most valuable asset a money-seeking company can bring to a pitch meeting is someone who can articulate the product and plan in a concise, easily understood way. He saw it work beautifully for a broadband company called P-Cube, Inc., which creates products and solutions for IP networks: "They raised 40 million bucks in 2002 at a bad economic time because the CEO, Yuval Shahar, can explain stuff to people. There are a lot of entrepreneurs who can't tell you what they do. Yuval can put across a lot of complex information at a third-grade level. It sounds ridiculous to say this, but going above a third-grade level can be a real problem."

Rule 7
Think Globally

Most large companies these days are taking advantage of the low costs and high efficiency of outsourcing information technology responsibilities to foreign countries, notably India. Some have decried the effects of this on the American labor force, but it appears to be more than just a trend. Now start-ups are getting in on the act, and outsourcing has become a common topic of conversation between VCs and the entrepreneurs seeking their money. "People are building their structural strategies in front, helping themselves to save money, be efficient, and get products to the marketplace quickly," says Ash Lilani, South Bay region manager and country head, India, at Silicon Valley Bank in Santa Clara, California. Respected VC firms such as Kleiner, Perkins, Caufield & Byers are hot on the notion of start-ups having outsourcing plans in place. "If a VC asks how you plan on outsourcing and you say that you won't," says Lilani, "he will then ask how you plan on being competitive. It's a necessity in today's market."

Rule 8
Forget The Old Buddy-Buddy Start-Up Story

Many Internet companies were built on an unconventional management structure in which two or three closer-than-blood friends filled key, complementary roles. Many Internet companies, of course, fell face down in their chalupas. Companies like Google,, and staked their existence on the fraternity-brother model. Two of those companies failed quickly, and they weren't the ones with a proprietary search engine that can scan 7 trillion Web pages per nanosecond.
"There's always the CEO who shows well and the behind-the-scenes person who doesn't show so well," says MacAdam. "Inevitably one person seems more important than the other, and it's usually the behind-the-scenes partner who gets dropped from the board. Once the VCs come in, he's quickly viewed as an employee with shares."
Such was the case at CRS Robotics, a four-partner company that made the machine used to sequence the human genome at the Whitehead Institute for Biomedical Research. The VCs brought in MacAdam as president and CFO. Right away, two of the founders were forced to resign from the board as a condition of the investment. Two and a half years later, when the company went public, only one founder remained on the board--and he left three years later. "In the end the entrepreneurs made money--about $1 million each," says MacAdam. "But they didn't get what they expected, and they probably would have preferred holding on to their company together."

Old School
The new rules of economy didn't change everything. These rules of seeking Venture Capitol still apply.

1 You Will Eventually Lose Control of Your Company.
Regardless of how enthused a VC may be about investing in your start-up, and no matter how bright and innovative and ingenious he says you are, the most important thing for any entrepreneur to understand is that once you bring in a venture capitalist, you have essentially given up control of your company. If the operation is successful, it will, chances are, be merged, sold, or taken public within five to seven years.
"It's no longer your baby, and for better or worse, shots are being called by investors, not by management," says Donald MacAdam, who has run three companies that have gone public and is the author of the forthcoming Startup to IPO.

2 Looking For Money Slows You Down.
A consequence of pitching for VC money, whether you get the dough or not, is that the process will most certainly sap the growth of the business you are running. "The biggest cost associated with seeking venture capitalist financing is the time you take away from building your company," says Elaine Verna, vice president of business development with the Lawrenceville, New Jersey-based Edison Venture Fund. "In a new company you almost always have the CEO and his cofounders doing sales and several other critical jobs at the same time. Then, when they need to raise capital, they're suddenly going out and spending days developing business plans and meeting with VCs."

3 Search For Money Everywhere.
Don't bother sending pitch letters and business plans cold; they rarely get read. As in a job search, personal contacts are worth millions. Ask your CPA, your lawyer, your parents' friends, and your high-flying neighbor for leads and introductions. John Simard, a biotech entrepreneur who launched the biotech company CTL Immunotherapies (it has since been absorbed into MiniMed), once approached the multimillionaire father of a child who attended the same school as his son. The man was flipping burgers at a second-grade fund-raiser when he met Simard, became interested in his company, and put him in touch with his first professional round of financing.

4 Fundamentals Are Key.
Gill Cogan, general partner with Weiss, Peck & Greer Venture Partners, based in Menlo Park, California, looks for three simple things before he signs on: "Good, strong people starting the company; a small market that can grow rapidly but does not yet seem to exist; and proprietary technology." A prime mid-'90s example of this was an enterprise called (now known as Open Wave). "It was the first company that allowed you to receive data on your handheld phone," says Cogan. "We thought it was difficult and the market did not yet exist--so there would be no competitors to move out of the way. This was at a time when nobody had any idea how rapidly the cell phone market would grow, and people thought nobody would use their phones to access the Net."

5 Ignore Logic.
Regardless of what you get or what you think your company is worth, you will wind up giving the venture capitalist exactly the percentage of your business that he needs in order to get a satisfactory return after a sale or IPO. "The math is quite independent of what the business is truly worth," says MacAdam. In other words, what you believe the real valuation is becomes immaterial. Sorry.--M.K.
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