Inside the Real World of Venture Capitalists

By: Cheryl Smith

Cheryl Smith has been the chief executive officer of the start-up company utility.net since April 2006. Previously, she spent more than 25 years as an information technology professional and as a senior executive at McKesson, KeySpan, and Verizon, three of America's largest corporations in health care, energy, and telecommunications.

Two years ago a good, trusted friend, a lawyer, came to me with a technology patent that his firm had become involved with. The patented technology provides high-speed Internet access (broadband) to homes and businesses over electric power lines. Some 50 percent of American homes and small businesses, mostly in rural areas, do NOT have high-speed, low-cost Internet access, but nearly all are wired for electricity.

The basic idea looked like a win-win situation for everyone: underserved consumers; the utility companies whose lines we would pay to use; and, not least, the entrepreneurs and venture capital investors whom the financial model suggested would reap great returns within three years. My friend asked if I would consider being the chief executive officer of the start-up company that would take this technology worldwide.

I was then the chief information officer of McKesson, a San Francisco-based health care services company that is one of the 20 largest corporations in the United States. I managed an annual budget of $500 million. Thousands of people reported to me. I had led two successful start-up subsidiaries within companies where I'd been a senior executive. I'd been a "techie" for 25 years and considered myself very, very good at it. But should I take the risk of leaving McKesson to head a completely independent start-up?

The first step was to do the appropriate "due diligence" research for the project. This meant:

. Verifying the technology (making sure that it would work as advertised),

. Verifying the patent (making sure that nobody else had patented the technology),

. Verifying the market (making sure there was a niche and need that would allow the technology to make money),

. And finally, looking into whether we could put the right people in place to bring this to fruition.

I concluded that the risks were low and the potential upside huge. How difficult could it be? I decided to leave the world of large corporations for that of the fledgling start-up.

What I have learned over the past two years of pursuing venture capital for this project could fill a book. I've kept a journal along the way, listing dozens of major things that I wish I had known but somehow had to learn the hard way. In the paragraphs that follow, I share my "Top Five."

It Takes Money

A start-up requires more than technology that works, a need in the marketplace, solid patents or patentable ideas, excellent partners, the absolute right team, strong management experience, commitment, passion, and lots of hard work. It takes money. Make sure that you have enough before, or shortly after, you begin. The excitement at the beginning of a new venture is palpable. All involved are eager to get to work bringing their vision to reality. But money is essential, and getting it requires well thought out and properly drafted documents. This means ownership agreements with the original funders, corporate operating agreements, and employment agreements. Sweat the details here - or they will come back to haunt you. Do not allow anyone but the chief executive officer and the chief financial officer - not even an initial venture capital (VC) company that might provide seed money while you approach major investors - to have access to company bank accounts. This is not the time to be a nice, trusting person. This is the time to make sure that you are aware of every dollar in those accounts and how each dollar is being spent. Make sure that you have at least one year of funding in hand when you begin. If you don't have it, you, first, will not be able to attract a good team, and, second, shouldn't quit your "real" job to take on the venture.

Choose Your Investment Banker Carefully

Your investment banking firm (IB) is the crucial connection to the venture capitalists who can supply the major funding your project requires. Begin looking for a qualified IB as soon as your operations begin.

Once you have one, give the firm a month to help you prepare the presentation you'll make to the venture capitalists, and then 90 days to work its network in search of money. Your investment banker's job is to get a venture capital firm's written "term sheet" spelling out the terms on which the VC will fund your project. The goal is to obtain funds to develop the business sufficiently to make an initial public offering (IPO) of stock to the public, also known as going public. A venture capital firm will typically demand at least 51 percent ownership of the company that results, and your IB will ask for 8 percent of the VC's investment and an option for 3 percent of the company. Of course these terms are highly negotiable, so negotiate them!

If it takes your investment banker longer than 90 days to get a term sheet, find a new IB - or think seriously about whether your project should go forward. By this time you will be about six months into your (typical) one year of initial funding. You will have time to work with one or, at best, two more IBs. Even though the excitement is still likely high and the commitment strong, do not invest your own money - or that of friends and family - as interim funding until you have a signed commitment for sufficient venture capital funding.

While an investment banking firm may tell you that the venture capitalists are looking for "skin in the game" (cash from you), your time and intellect already represent a tremendous personal investment. If you don't have a written term sheet by this time, remember that business is business. The market simply may not share your assessment of your project's prospects for success. This is not the time to increase your personal financial commitment.

Tell Investors What They Want To Hear

A first-hand understanding of the financial world is mandatory. The only parts of your presentation that the financial community really cares about are your financial models. Make sure that you have personally built them and that you truly understand your numbers. And be prepared to calculate answers to questions on the fly.

I thought my Wall Street experience afforded me a real understanding of the financial services world. But the venture capital world is different. Some VC firms work with companies still in the research and development stage; others like companies that are past R&D but have not yet generated revenue; and still others invest only in revenue-generating companies. In addition, many venture capitalists typically specialize - in energy start-ups or in telecommunications, Internet technology, health care, manufacturing, or retail.

So, first, find an investment banking firm that has a proven track record of raising capital from the appropriate venture capital community. Second, invest most of your time presenting only to VCs with a solid track record of investing in your type of start-up.

When all of these connections come together, you will easily know within 90 days whether you have traction with the right IB and whether VCs are seriously interested in your business. Keep watching your bank account - it tells you how much time you have left.

When presenting to venture capitalists, tell them what they want to hear, not what you want to tell them. That seems obvious, but it's hard to do. Everyone loves to talk about their company, their technology, their business value proposition, their management team, their partners. While these things can be interesting to VCs, many assume that you have "great" everything, that you have done your homework. So the only thing that the VCs want to hear about in any detail is the financial model. How much do you need? What is their return on investment? How long will it take? Why so long to the payoff?

We live in a world where the financial community wants to minimize risk and recoup its investment as quickly as possible. The term "venture capitalist" today is a misnomer. These firms are now publicly owned and must show quarterly results, just like any major corporation. A number of VCs have shared with me their rule of thumb: They double the costs that you present, which typically doubles the return-on-investment time and substantially reduces the return. Even an honest, rock-solid cost model does not help. Unless the venture capitalists know you personally, they will "work" your model themselves. And it won't look nearly as promising.

I have two suggestions for presenting to a venture capitalist "cold" - that is, presenting to a group that you don't know personally:

. Make sure that you have proven all aspects of your model, both cost and revenue, before presenting

- a hint as to how to spend your initial first-year dollars,

. Present a model that is extremely optimistic. This is a bit risky during the due diligence phase, but it may help you to live to fight another day.

Whom Do You Know?

Today's venture capital process is in my view staid and archaic. If you aren't already connected in the VC world, find those investment bankers who will help you think outside the box. Better yet, find someone who is connected and trusts you well enough to get involved. Cold-call presentations are almost always a waste of your team's time and money.

Any credible IB will teach you all about today's venture capital process. My suggestion is to listen carefully, then go with your instincts. Better yet, get advice from someone who has already successfully raised venture capital in your industry. The process - "writing the book," having your IB contact its network, holding preliminary teleconference calls with potential VCs, making personal presentations, and then leaving follow-up contacts to your IB - is fairly standard.

But it really comes down to who knows whom. Or more precisely, who trusts whom. After making 64 official presentations to venture capitalists, I have determined that funding is NOT based on any "book," phone call, presentation, or deeply rational process.

Know Your Competitors

Understand from the very first your key competitors' business value proposition. Think, without passion, about who your competitors actually are, their business approach, and the value they bring to the industry.

Don't believe your competitors' public descriptions of their business value proposition. Know it. One of my favorite expressions today is, "Do you think that or do you know that?" If you compete in an industry business, you will know your competitor's true business strategy.

If that competitor has been in the business longer than you or has already raised funding, learn from him or her. Do not assume that your strategy necessarily is better. You may have to seriously rethink your ideas.

Listen - and learn something new every day. Then incorporate it into your business plans. Focus is good, but business strategy that anticipates the market is better. Follow your intuition and act on it quickly. Every decision that you and your team make is irrevocable and has long-term impact. So make decisions carefully and with everyone's input. College basketball coach John Wooden said it best: "Be quick but don't hurry."

There are few higher highs or lower lows than working in a start-up. No executive position that I've held with major corporations can match the excitement, challenge, or fulfillment that I've experienced in the past two years. But knowing at the beginning a few start-up secrets would have made all the difference in the world!

The opinions expressed in this article do not necessarily reflect the views or policies of the U.S. government.

Editor's Note: As we go to press, the untility.net venture that Cheryl Smith heads is on its third round of funding and is pursuing two new funding opportunities: one with an Asian consortium that is looking to expand into the United States, and the other with a national telecommunications company. Both funding possibilities have required utility.net to modify its original business strategy.

Source: U.S. Department of State

judythpiazza@newsblaze.com

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