Venturing forth

The global financial crisis has affected more than just the existing business market. It has affected the emerging one as well. The ongoing deteriorating market conditions mean that many venture capital and private equity firms have had to rein in their enthusiasm for funding new ventures and as a result, both VCs and new companies are facing some pretty serious issues – and some pretty tough times. The drop in VC activity is all part of the flow-on from the rapid collapse in the health of major global economies over the last six to 12 months, but it makes the challenge of getting funded just that more complicated.

So what are the key factors that are now affecting the private capital industry? The first is that the paths to exit are now closed. I mean, imagine trying to IPO a business in the current market? Debt is becoming tough to get, particularly now that banks are being conservative. Trade sales are failing or going off at very low valuations. In short, the traditional markets for an exit by a VC are hostile at the moment and are likely to remain so for 2009 at least.

Then there are the difficulties in raising capital. For VCs, the limited partners that are the fuel for their funds now often require existing investments to be sold before any fresh investment into the VC is offered. With the markets closed, you can see the issues for the VC.

Then there are the general problems associated with the current environment. Despite the brave faces, there are many problems out there in private capital firms, which are often the result of high-debt gearing or astronomical valuations struck at the top of the market – or both. The well is dry for many investees. They have used their capital and can’t raise more. As a result, many businesses are dying on the vine.

Which leads into another matter. Many of the pc firms have used their investment capital and simply don’t have more money to invest. Together, these factors mean that the cost of money is going up, and that only the best business stories are being supported.

How do I access capital?

The good news is that it is not all doom and gloom. Deals are still getting done. But there is no luck in it. A successful investment close in the current market is a combination of a solid and conservative business plan, a credible management team that convinces it can deliver, favourable deal terms, and valuations – which tend to be in favour of the VC. Let’s visit a number of these points.

• Business Plan A business plan must always be tight, detailed and realistic. With a slowing economy there needs to be a clear understanding of how the management team will be able to steer the company through the rough 12 to 24 months ahead.

• Defending the Model With investment committees in a conservative frame of mind, expect a barrage of questions in the due diligence period. You will need to defend the assumptions, beliefs and representations that you have made. Be prepared.

• Focus On Cash Flows How will the business get to a positive cash flow state? There needs to be deep analysis on this, establishing why assumptions are conservative.

• Mile Stoning Capital Many VCs have fallen foul of letting too much capital flow into the investee’s hands too quickly – and it has been therefore squandered. Be prepared to negotiate a deal structure that has capital released against operational milestones – that is; progressively.

• Valuations Don’t expect anyone to buy into an aggressive valuation. If you are pushing for a strong valuation then consider linking value to milestones. That is if you miss your milestone the VC will be issued more shares for free, which effectively lowers the valuation for the capital injection. If you hit your numbers and business plan then no problem – the strong valuation stands. But if you won’t
back yourself then don’t expect your valuation to be believed.

• Cash Invested To Date Don’t try and convince anyone that your time is worth a high ‘carry’. Today, most pc firms want to understand how much cash investment has already been made by the promoter. Injecting cash is much more sticky than sweat equity. And I’m talking from experience here. Those ventures that have proven to me they’ve already put cash up have tended to be the ones that have been successful in raising capital. Those that have commended free equity for sweat have typically been poor performers and the first to drop the ball when things get tough (lots of excuses, few results).

What questions should I ask a VC?

In the current tough market it is important that you are not wasting too much time on VCs who might be fighting internal fires – and hence are not actually open to make fresh investments. Additionally, be aware that the individual you are dealing with will not be the decision maker. All VCs have an Investment Committee that sits independently and considers each opportunity on its merits. So don’t be fooled that the nice cup of tea you had with the friendly VC will go anywhere. If you want to get funded you need to work harder than ever before. Do your homework. Check the following: 

1. What investments does the VC have at the moment, and how are those investments travelling? If there is an investment in a similar space to your business plan, and it is struggling (for whatever reason) you will likely not get funded.

2. Which older funds are around with money? If you can locate a fund that has survived the 2001 tech wreck they might be a good experienced player to have on
your side.

3. What deals have they done in the last six months? Why ?

4. What deals have they rejected in the last six months? Why ?

5. What would need to be present in a deal for them to support it today?

6. What are repeating discussion points with the VC’s Investment Committee?

In many ways venturers and VCs are in the same boat – in the current market conditions a factual and professional approach is needed from both sides. You need to find the person in the VC who will ‘back your plan’ internally – the individual who will be the deal champion so to speak. To create this relationship you need to work hard at building credibility and establishing that you will be a great business partner going forward. I often quote the great golfer Gary Player who once, in response to a journalist’s question, said “the more I practice, the luckier I get”. No one is interested in big statements and promises. It will be simply the best-prepared management teams that will attract funding through 2009. There is no luck to it. Just hard work, long hours and a single-minded focus to deliver a successful outcome for all.

The checklist

In order to catch the attention of the VC you will need to demonstrate that you are exceptionally organised and ready to go.
The point is you will not waste the VC’s time. The following are some of the documents you need to prepare ahead of time. It’s also a good idea to detail, in your covering letter, the fact that this documentation has indeed been prepared.

1. Information Flyer Basically a two-page executive summary of the opportunity. Given this is the first contact the VC will have with your opportunity it needs to be exceptionally well-crafted.

2. Information Memorandum This is the stripped-out business plan presented as a fundraising document. You should also ensure that you are using experienced legal, accounting and corporate advisors to steer you through this exercise. VCs gain comfort when they realise that the potential investee is being professionally supported.

3. Market Research Prepare as thorough a market research outline as possible, with a summary being included in the Information Memorandum. This will simply cut down on the time that the VC will need to dedicate to this task.

4. Terms Sheet This is a summary of the key terms of the transaction. It is likely the VC will give you their own, but it helps to establish credibility that you are presenting your own. It also shows you know the game. This is a critical document and ends up being central to commercial and legal negotiations.

5. Capital Expenditure Timetable This is a summary of the financial model’s capital expenditure (not operating) assumptions presented in a clearly explained simple document. You may find that this document, as opposed to the model, becomes a primary discussion point if you present it well.

6. Financial Model This needs to be well built and presented.

7. Due Diligence Data Room Index When the pc firm commences work they will want to see all information on your opportunity presented in a logical and professional fashion. A Data Room Index is an overview of each document you will make available during the Due Diligence Period.

You will note I have not included a Confidentiality Agreement in the above.
My experience is that fewer and fewer pc firms are executing them, simply because it is fairly unlikely that yours will be the first deal of its type they will have seen – and just as unlikely that it will be the last. Prepare one if you want, but don’t be surprised if you hit a roadblock with it. And to this day I have not seen a professional pc firm pinch an idea. They simply don’t have the time.