CHAPTER SIX
Choosing Investors and the Board of Directors
The greatest value investors and board members provide is their knowledge, experience, and support—not just their money. If you’re choosing investors for their money or deal terms alone, you’re at great risk.
ENTREPRENEURS SEEK VENTURE OR PRIVATE EQUITY capital investment in order to accelerate business growth. In fact, 91 percent of the companies listed on the NASDAQ were backed by one or more of nine hundred venture capital firms.1
But venture capital investment isn’t only about the money. The best firms provide resources that are far more valuable than their financial investment. Their investment serves as an immediate signal to the world, marking the venture as important and valuable—something to pay attention to. And they help recruit top talent for your team. By having seen hundreds of ventures in their chosen market domain, they are usually experts in the ecosystem—how it works, what has succeeded, and what has failed. They take a role on the board of the company and make crucial decisions about its continued leadership and investment strategy. They introduce the company to potential customers and partners. They help the company navigate the constant threats and opportunities that unfold during its life. In short, they provide the expert guidance, support, and mentoring that every venture needs.
The best teams understand the value of the experienced venture capitalist and seek investment not based on the largest offer or the least dilution, but on these other, less tangible—but more important—attributes.
While we focus in this chapter on attracting investments from professional firms that manage capital, it is important to mention the availability of capital for start-ups from individual angel investors who are prepared to risk money in early-stage companies. These individuals can be a valuable source of funds and advice in the early years of a venture, but there may be risks in the conditions set by such investors and care is therefore needed in seeking such sources.
The Basics: Venture Capital Firms and What They Look For
Although there are venture capital funds in many countries, the majority are US-based, managing funds with assets ranging from a few million to a billion dollars or more. Most venture capital funds are managed by partners and are independent partnerships. Others are part of corporations and invest corporate funds. For example, the investing organization of Intel is best known for funding technology start-ups consistent with Intel’s own corporate strategic interests. Intel was an early investor in Covad Communications because of its strategic interest in fostering broadband communications technology—a potential market for Intel chips.
The partners who manage venture capital funds have a wide variety of backgrounds, which influence their investment interests. Some come from industry and have experience in management and technology development or marketing. Others have worked in investment banks such as Goldman Sachs or J.P. Morgan. Still others were successful company founders who decided to become professional investors after leaving company management. The investing partnerships primarily raise capital for their funds from wealthy individuals, retirement funds, and endowment funds of institutions such as universities. The institutions that provide the capital for the fund are called the limited partners of the fund. The members of the venture capital firm that have responsibility for the management of the limited partners’ investments are often called the general partners.
The investors are basically committed to a long investing period, with the anticipation that the profit on their invested capital will exceed that of other asset classes, such as the public stock market. The fact that the funds have a finite life (usually ten or twelve years) means that investments must be liquidated within the anticipated life of the fund and the capital returned to the investors. Hence, investors measure financial performance within a rather short time frame in the context of building businesses that may require several years.
Historically, venture capital returns have varied widely. Venture capital partnerships that manage funds that underperform their peers likely will be unable to find investors for new funds. This means the end of the investment firm, and hence the intense focus of partners on venture profitability. The most reliable information concerning venture capital in the United States is found listed in the Yearbook of the National Venture Capital Association.2
The success or failure of venture capitalists depends on their ability to generate a high return for their limited partners. Countless new investment presentations offer product features that are cool or compelling or remarkable in their technology or their insightful ideas. But if there isn’t a clear understanding of how a high return will be achieved, they’ll almost certainly pass on the opportunity. This is why the value proposition part of the business plan is critical.
Normally, venture capitalists invest in companies that are potential home runs and can return ten times or more of the investment, at least if they’re investing in the earliest stages. This kind of financial success may happen only once in ten or twenty of their investments, but that is often enough to make their entire fund successful. Three or four in ten investments will be lost or return only the capital invested. And the rest of their investments will return from twice to a few times the investment.
Therefore, you have a high bar to convince top venture capitalists to invest. Mike Moritz of Sequoia Partners told us how he thinks of home run companies:
Sequoia always thinks about the long-term opportunity when we’re considering a venture, as opposed to what most people believe venture capitalists think about. We don’t think only of the liquidity event as the end. Instead, we have a great desire to be a participant for a very long time—five, ten, fifteen years, way beyond the liquidity event. We look for ventures that in the long term will be a permanent part of the landscape.3
In fact, many venture capitalists are so committed to a company that they will continue to serve on boards, even after liquidity events have occurred.
Choosing the Right Investors
Before seeking investment, astute entrepreneurs begin discussing the opportunity with potential investors, seeking their advice and ideas. It’s always valuable for the entrepreneur to be introduced to the investor by a respected entrepreneur or investor already known to them. Professional investors are focused on the character and reputation of the entrepreneurs they fund. Such introductions can greatly ease your ability to get a meeting with the right partners in a high-quality venture capital firm.
Venture capitalists usually have only six to eight investments that they personally participate in at any one time. Most of those last for years, so the decision to invest in a new company and add one more company to their investment portfolio is not a frequent event. They may look at hundreds of companies before investing in a single one. It’s not unusual for a venture capitalist to invest in only one new company a year. They may be happy to look at many companies, though, both because they’re always looking for a great new opportunity and because it helps them learn as much as they can to help their existing portfolio companies.
The discussion between the entrepreneur and the investor is a way for the investor not only to evaluate the venture concept, but also to judge the team and the team’s skill in articulating the opportunity. It gives the investor the chance to assess the intangible elements of the team: passion, commitment, ability to listen, integrity, and more. It’s important that, during this time, you ask for advice and not investment. It is a time of joint collaboration and development.
Teams that go on “road shows” (when a team seeks funding from multiple investors during a short period of time) and ask for funding without having started these earlier conversations are likely to have a much more difficult path. It’s a funny truism: if you ask for advice, you’ll be much more likely to get funding; if you ask for funding, you’ll be much more likely to get advice.
Professional investors can be expected to do a great deal of work prior to writing a check—an obligation that they have as fiduciaries for the funds they manage. What will be important for you is to select the right investors based on their background, industry knowledge, acceptance of your vision, and ability and interest in working with the management of your company over a time frame needed to build a great business. When you seek funding you must be highly selective; providing capital is, of course, essential, but the future relationships between lead investors and the company will last for years. The lead investor will have great influence on the company, particularly during its formative years.
Think of this as a marriage, where divorce is almost impossible until the company is either self-funding or goes public. This means that entrepreneurs and investors must be comfortable entering into a long-term relationship on the basis of shared goals. First, venture capital firms with specific interest in the entrepreneur’s industrial sectors must be identified. Second, it’s important to know where the funds are in their life cycle. For example, if a ten-year fund is in its ninth year, and no new fund is opening, it’s a waste of time to solicit investing interest when you cannot count on the fund for follow-up investments.
In the Siri venture, Norman and CEO Dag Kittlaus established a relationship with Shawn Carolan of Menlo Ventures and with Gary Morgenthaler of Morgenthaler Ventures months before asking for funding. Norman had the additional advantage of having known and worked with Morgenthaler for years.
Carolan and Morgenthaler are both successful venture capitalists who are deeply knowledgeable about the consumer and enterprise market spaces and about mobile, speech, and artificial intelligence software and systems. They were the perfect investors for Siri, because they clearly understood both the market and the technology. Morgenthaler had also invested in Nuance, a highly successful previous venture launched by SRI.
In the course of the Siri venture, the team and the investors successfully navigated the many unpredictable issues that emerged. Here are examples.
- A critical metric for success of the product was the latency (slowness) in getting a response from Siri. Should we release Siri for the next generation of iPhones (giving us time to address the latency issue), or release it with the current generation?
- A few of our corporate partners who provided some of our services were also competitors and were even beginning to build their own versions. How could we avoid being too dependent on them?
- Acquisition offers occurred before we were ready to entertain the idea. How should we handle them?
- When we launched the product, it became an immediate success, with ten times the download rate we expected. Were we prepared?
The deep experience and knowledge of the venture capital board members helped us answer these questions, and hundreds more.
Here are some parameters for you to consider in choosing lead investors:
- Knowledge of your industrial sector.
- Experience in working with early-stage companies.
- Available references of past activities, particularly bearing on relationships with management teams and other investors.
- Industry relationships that can help your venture.
- Current activities in competitive companies. How confidential will your information be kept? Venture capitalists are rarely willing to sign a nondisclosure agreement.
- Size and age of the fund. Will follow-up investments be possible?
- Historical pattern of the venture capital firm regarding follow-up investments.
- Other commitments of the venture capital partner who will be responsible for the investment. Will this person have the time needed to devote to your venture?
How to Approach Investors
When experienced entrepreneurs seek funding, they wisely begin their road show with only a few investors—and only add new potential investors as others pass. As we mentioned earlier in this chapter, investors are making a real commitment to the entrepreneur and company, and they want to know that you highly value them for their knowledge and experience. Shopping the venture broadly undermines that impression.
It’s also important to recognize that once the entrepreneurs begin seeking funding (rather than advice), they’ve started a clock ticking. About three or four months after a company begins seeking funding without success in reaching a term sheet with a lead investor, the investor community (which is highly networked) will be aware that the company is still shopping for an investor and will eventually see it as stale. They respect each other’s opinions, and if other firms passed on the opportunity, they probably had a good reason. Their interest will drop precipitously. If this should happen to you, it would be best to regroup at this point and decide on a new plan, seeking investment again at a later time.
The Five Meetings Needed to Gain Funding
There are five types of meetings when entrepreneurs seek venture capital investment. (If you’re following our advice, you will usually iterate with investors, gaining their advice and support. So don’t take the number as literal.)
Meeting 1: The Beginning
When you meet venture investors for your first discussion, you need to convince them that the answer is yes to these three questions:
- Do you have a compelling vision and value proposition?
- Are you and your team passionate and unrelenting in your commitment to the vision?
- Are you and your team capable of executing?
If you achieve these three goals, you’ve succeeded in this meeting. Don’t try to do more.
Woody Allen is famous for saying “Eighty percent of life is showing up.” We can add, “Twenty percent of life is knowing when to leave.”
How do you achieve these goals? The presentation should be brief, compelling, and interactive, and should last no more than thirty to forty-five minutes unless there are questions and discussion. There is also an unspoken “five-minute rule” when you give the first presentation: if you haven’t told the story in such a way that you’ve begun to generate interest in your venture in the first five minutes, you’ve likely lost their attention for the rest of your presentation.
This presentation should focus on the team, the mission and business vision, key points of the value proposition, and the amount of funding requested.
We cannot overemphasize the importance of preparation. Entrepreneurs should not waste time in their presentation giving well-known industry background information instead of concentrating on their value proposition.
Venture capitalists test everything you say or do to determine whether you’re capable of executing—actually running a business. Teams that come in with an unfocused, disjointed presentation are not credible. Teams that don’t know competitors that the investor asks about are not credible. Teams that don’t show energy, drive, and enthusiasm are not credible. Teams with team members who jump into a discussion to answer questions, rather than leave the presentation to the CEO, are not credible.
The purpose of this first presentation is to educate a potential investor to the point where a level of interest is generated—or not. If there is a next meeting, it will focus on addressing specific issues and questions raised during the first meeting. And the level of interest will be determined by the perceptions of the risk–reward equation of this investment. An acceptable risk-reward is the key factor that leads to an investment decision, and that is very much a personal decision factor for the investor—hence the importance of researching the investment history of the decision makers prior to your meeting. The investors will also be highly aware of competitive companies, likely having seen dozens or hundreds of related ventures, and will challenge you with questions about competitors, their differentiation, their business models, and more.
Also in this presentation should be references to potential or actual customers. If the venture capitalist is interested, her next step is to start calling these customers as well as market and technology experts to begin to validate your value proposition. This will be done only with your approval.
The venture capitalist will almost certainly ask how much funding is being requested. This is both a question and a test. The entrepreneur should have a plan with the overall goals, schedule, and milestones he wants the company to achieve. The funding level will then be the investment required to achieve the plan. Asking for money without having a clear explanation for how it will be used is an immediate reason for the investor to end the discussion. More about this in meeting 3.
Meeting 2: In-Depth Discussions
The next meeting provides more detail on your planned execution steps and the detailed capital requirements to meet milestones. If the venture is technology based, the firm will also explore more deeply the risks and limitations of the technology, as well as the ownership and rights and restrictions of the intellectual property. The idea here is to provide enough detail for a potential investor to gain confidence that you’ve prepared a thoughtful business plan with all its financial implications. This meeting is also useful in presenting the key management members of your team.
The questions and answers during this meeting serve a dual purpose. The potential investor has the opportunity to dig into details and test the quality of the business plan. For your team, the interaction is valuable in finding out whether the potential investor (and his or her partners) has the interest and ability to understand the risks and opportunities of the venture and whether she has the experience to be useful in the future. Potential investors will make extensive checks on all aspects of the business plan, including consulting experts in the market and technology and making reference checks on the team members.
Meeting 3: Focus on Major Risks and Issues
The next discussions with the venture capital partner might involve one or more meetings to respond to questions and issues relating to the value proposition and business plan. Industry experts and consultants will likely be brought in. Remember—unlike what most people think—the venture capitalists take only calculated risks. They need to be aware of the known risks and understand your plan to deal with them. These meetings continue to be essential in evaluating the chemistry of the relationship and the willingness and ability of the team to engage. At this point the investors will also want to discuss potential deal terms: their investment dollars, pre-money value of the company (its value before they invest), and other contractual terms.
When you propose a level of investment, as we mentioned under meeting 1, you also deliver an important message about the clarity of both your strategic thinking and your execution plan. Is the level of funding consistent with the plan? Have you given yourself a base camp (an early target market) as you’re preparing to climb Mount Everest? Is your plan adequate to achieve the goals and milestones necessary to reach the next funding round—a round that will likely be led by new investors? Are your goals and milestones consistent with what would be the expectations of the next investors? Has the plan left a buffer of time and funds for raising the next round?
Think of each round of funding as a bridge to get to the next round. If you don’t have a good answer to these questions, you’re not walking on a bridge—you’re walking on a plank, and you’re sure to fall. Generally speaking, you should allow at least six months before you begin seeking the next round, because it can take at least three months to identify your next lead investor, and another three months to complete the transaction.
Meeting 4: The Venture Capital Partner Meeting
A venture capital firm is a partnership in which decisions are frequently made by the entire partnership (or a subset of partners that constitutes an investment committee), and not by the individual partner. So even though the venture capital partner who is championing the opportunity may at this point be interested in making the investment, other partners need to be convinced.
Your team will be asked to present to the other partners. The presentation will last about an hour, including questions and discussion. After the presentation, the partnership will decide whether to pursue the investment, and under what terms. Most of the time, if there’s even a single partner against the deal, it won’t go ahead.
Meeting 5: Reaching a Deal
If the venture partnership agrees to pursue the opportunity, the partner who is championing the opportunity will be given authority to negotiate terms for investment. Of course, the terms are very important to the team members and founders. They involve complexities that are best understood by experienced entrepreneurs and an experienced legal team. The terms can have a profound effect on the success of the company and are usually closely related to the industrywide terms that are generally understood to be acceptable both by the venture firm and by other venture investors.
How to negotiate these terms could in itself be a separate book. They include issues such as preferred stock and its rights, liquidation preferences, valuation, and many more. It’s important that the lawyers you choose to represent your company are experienced, are part of the ecosystem, and have done hundreds of these deals. A great lawyer is an essential advocate for you and will help you navigate the complicated maze of deal terms.
Finding a Lead Investor
The extensive process just described is finding what is called the lead investor firm because it has done the diligence necessary to understand and invest in the venture. The lead investor firm is usually the first and often the largest investor in the round. Frequently, additional investors will be solicited to join because investors generally like to share risk, even though they will, of course, be sharing the reward. Therefore, they will work with the team to identify other investors and syndicate with them.
So the entrepreneur seeking investment needs to identify a lead investor having the experience and resources to make a long-term commitment to the new venture. For example, if your team seeks $10 million, the lead investor might provide $5 million, with the rest divided between two or more other investors. The lead investor usually sets the investing terms, such as pre-money valuation (the value they put on the company prior to their investment), and very frequently finds the other investors through relationships with other venture capital firms.
Funding Rounds
The first investment round—sometimes called the seed round (or angel round) if it’s small, such as $250,000 to $2 million, or the A round if it’s larger—is rarely the last. Usually the first funding round finances the company to complete certain milestones, and the valuation placed on that round reflects the risks that the investors are taking. At the seed or angel round, the funds usually enable the company to recruit a core team and build a product demo or prototype. The A round usually brings the company to a product or service in the market, achieving some demonstration of market growth.
A second round of funding usually follows at some time in the future, and the valuation of the company increases if it has met goals that suggest the key risks have been reduced. Further rounds, if the company progresses, are aimed at funding its growth, and the valuations placed on the company will increase. So, if things go well, over a period of years the company will raise increasing amounts of capital at increasing valuations until it becomes cash generative. A public offering (IPO) then becomes possible if public markets are favorable and if the company has reached a sufficient size to warrant the cost of being publicly traded.
The sources of capital that young companies can access expand as it establishes its viability. After its first funding rounds, which have the highest risk, it can access private equity firms (and even funds managed on behalf of wealthy families), which manage much larger pools of money but usually look for lower-risk, later-stage opportunities. As a result, these firms are in a position to finance larger investments, but they do so only when the early-stage risks have been largely eliminated. This may mean that the venture has reached significant revenues and predictable financial results.
The Board of Directors
It’s hard to overestimate the importance of the selection of board members in the development of your venture. As we mentioned above, your lead investor will almost certainly have a board seat. Boards normally meet no less than quarterly, but in early-stage companies monthly meetings are common practice, because the board has many rapidly changing issues to address and discuss. The board is legally charged with protecting the interests of the owners of the company.
The board of directors is responsible for monitoring the financial health of the company, its strategic direction, and the appointment of the CEO, who reports to the board and serves at its will. Board members normally are not involved in daily operations. Usually the CEO is the only active employee of the company who serves on the board. The board is responsible for ensuring that legal and financial matters are handled with appropriate judgment. Its fiduciary responsibilities include approval of financial transactions and capital investments as well as acquisitions, mergers, and anything involving the sale of assets. In short, as a representative of the owners, the board is responsible for all matters that impact the value of the company.
The board’s management tool is the detailed annual operating budget prepared by management, and it constitutes the financial blueprint of the business. This budget includes not only financial results but also planned activities and major operational metrics such as sales and product status. The board compares actual results with planned ones, a process that provides the basis for tracking the progress of the company.
Given the broad scope of the activities that the board is expected to participate in, it is important to pay special attention to its composition. Here are some practices that have proven helpful.
- The membership is limited to five or six people who have the time and interest to serve. Choosing an odd number of members can be valuable in avoiding ties in the event of rare but difficult votes. Board votes on major issues require that a quorum be present, so diligent participation from board members is important.
- The board membership is balanced, with investor representation, independent (noninvestor) industry experts, and the CEO.
- The agendas for meetings include reports on major activities such as marketing, product development, and financial results. These agendas are provided ahead of time to allow board members to digest the information prior to board discussion.
- Combining the CEO and chairman of the board roles used to be common, but it is less frequent now. The selection of one of the board members as chairman has benefits in dealing with difficult situations when management changes need to be implemented.
- There is a compensation scheme in place wherein board members are reimbursed for expenses incurred in conjunction with board activities. In addition, stock options are issued as an incentive for participation in building the equity value of the company.
What Can Make Boards Ineffective
Some board members are appointed because they represent major investors. These members tend to be experienced and reflect opinions shaped by the nature of the venture capital funds they manage. For example, if their funds are ending their life cycle and a new round of investment is needed, investors may well take the view that the company should either forgo growth fueled by such investment or seek an exit path through a sale. Their intent, of course, is to avoid raising more money and to achieve a liquidity event that will make their fund look good. But this may not be in the best long-term interest of the company. It is easy to view such behavior as not being consistent with their responsibilities as board members. But it often happens.
Board inattention is also frequently a problem. There never is enough time at routine board meetings, which last a few hours, to review fully the company’s activities and provide useful feedback to the management team. So items for discussion need to be selected carefully. But if board members are not adequately informed ahead of time, the value of the discussions is questionable. Therefore, it is essential that board members be prepared to spend the time between meetings to understand the company’s activities and have a continuing awareness of the external industry developments that impact the company’s performance. In our experience, it’s difficult to find board members willing and able to do their homework. Often, people are not prepared and expect to be briefed at the meetings—a hopeless task. Finding productive board members is hard. In that quest some caveats are in order.
Let’s start with the idea of asking famous people to join the board just because of their fame: don’t. A common belief is that placing well-known industry and entertainment personalities on boards represents a huge asset for young companies, because it gives them credibility with customers and potential investors. This may be true in rare cases, but often such personalities only show up at board meetings and may offer no value in helping with the issues that really matter in the success of the company. For example, highly visible personalities are reluctant to risk their credibility with customers, because products may fail or they may believe that such endorsements are not befitting their lofty status. Furthermore, they may be active in competitive situations, because serving on boards of directors may well be their only occupation.
Another common practice is to invite the CEOs of companies that are potential customers or business partners. This raises problems. First, such people may be too busy running their own companies to focus on matters relating to your company. A pressing problem in their own business will take all their attention. Second, conflicts may arise from business relationships where sharing all the information could be detrimental in negotiating the best deals.
This leads us to a third category of problematic board members: people with experience from another age or a distant industry. The danger is that they will view current activities in a prism formed when technologies and industrial practices were very different. Such people can hinder board activity by offering opinions that simply do not reflect current realities.
A recent experience comes to mind. The former CEO of a world-leading vehicle company was invited to join the board of a software company. Famous as a great executive, the CEO was extremely inquisitive but uninformed about the software industry. He was excellent at asking questions and taking up time at board meetings, but less able to understand the answers or come up with constructive comments.
Board members may be even less productive if they’ve had experience in big companies and are now faced with questions concerning a young company with a scale far removed from their experience—something that happened with board members who held senior management jobs at the old AT&T or IBM. They had difficulty adjusting to the fact that decisions in smaller companies must often be made with less certainty than in big companies because the time to make decisions is so compressed.
The most productive independent board members tend to be people who have built companies in an industry close to that of your venture. These people understand the stages of development of a business and can provide valuable guidance to the management. Also helpful are people who have specific expertise in growth companies in areas such as product development and marketing. As the company grows, people with financial backgrounds can be very productive if their experience has been in industries with parameters similar to those of your venture.
The Key Role of the Lead Investor and the Board
Given the huge range of issues facing any company, and particularly a new one, your entrepreneurial team cannot expect the board of directors to be involved in the constant give-and-take of a growing company. This is where the lead investor comes in as the essential mentor and coach of the venture. Their role is critical, because the entrepreneurial team may not be skilled in dealing with many issues already experienced by a successful professional investor. Investment firms with a history of success can provide great value to their portfolio companies.
Another important area of support is in raising capital to finance growth in later investment rounds. This can be difficult without the participation of the lead investor, because new investors will look to him or her for clues. If new funds are needed and the lead investor is not prepared to participate, a red flag goes up.
The list of critical responsibilities of the lead investor is long, and topping the list are the daily interactions in moments of crisis or when changes in business direction are mandatory. The board of directors has fiduciary responsibilities, but as a practical matter there is no way that board members as a group can effectively deal with fast-moving issues when sometimes hour-by-hour decisions must be made.
An adversarial relationship between the company management and at least some board members can develop when there is disagreement on fundamental strategic issues. On the other hand, most boards try very hard to help the company. This means that the management team and the lead investors must make a great deal of effort in keeping board members continuously well informed, particularly when adverse circumstances arise.
Remember: bad news travels fast. Smart entrepreneurs keep board members informed and make sure that when action is required, they have the facts to make intelligent decisions. We cannot overemphasize the importance of forthright and timely communications between the team and the board members, and establishing a trusting and strong relationship.