Taking the pain out of raising venture capital

Jeff Donahue is a good friend and battle-scarred veteran of venture-backed and PE-backed companies. He has raised over $275M of funding for early and later stage startups and has been CFO of 10 emerging growth businesses. He's worked across the table from leading investors like GRP (now Upfront Ventures), Invesco, ComVentures (now Fuse Capital), Allegis Capital, Alta-Berkeley, Invision, Steamboat Ventures and many more. I'm thrilled that he's offered to write a Venture Financing Series. Without further ado, here's episode one. 

Successful entrepreneurship has a rigorous risk management component to it – maximizing the risk of success and minimizing the risk of failure – as the factors below regarding raising venture capital attempt to convey. In managing risk I always recall my three and a half years in Russian telecommunications and what I call “the Russian Rhythm.” By that, I mean doing things so proficiently, including managing risks so thoroughly, that the outcome is predetermined. “Predetermining the outcome” is a mantra for me.

I have never, ever, encountered a startup proposition that satisfies all 23 criteria below.  At the bottom of the list are some separate brief observations about that. In my next guest post, I will enumerate pitfalls to avoid when seeking venture capital.

Things That Make VC Funding Easier…
  • Pre-emptive technology. Your product changes the structure of a market and the way the world works (“disruptive”).
  • Massive market opportunity. You cannot beat a global market opportunity with a well-defined niche of early adopters.
  • Straightforward value proposition. A product that people want and are willing to pay for because it alleviates their pain, solves their problem, enhances their experience, gives them instant gratification, etc.
  • An easily articulated path to revenue and positive cash flow. Your focus as CEO should be revenue and not profitability. Revenue will drive profitability unless you screw up the cost side of the equation. Positive cash flow means you do not need more VC money unless, for example, it is for accelerated commercial expansion such as taking the product international.
  • Something that ramps. Preferably in an uncomplicated manner and a short period of time.
  • Ease of customer adoption, and low customer acquisition, provisioning, support and upsell costs. Barriers to customer adoption and high customer costs are a ball and chain on your business model.    
  • First mover / first to market. Any entity after the first mover requires greater specificity of differentiation, which complicates the dive.
  • Viral product uptake. This typically characterizes network effect plays.
  • Not dependent on sequential capital raises. Sequential capital raises are fine as long as they are expected up front. If not, the founders are going to be in trouble. I’ve been in multiple companies that went beyond Series D or E rounds. In virtually all cases, by that time most of the founders and senior management teams – and sometimes their successors – were long gone and crushed. Extension rounds, or keeping current rounds open for long periods of time, have the same consequences.
  • Tier-1 management team. Ideally including people that have made VCs rich in a prior companies.
    • Deep grasp of the operational and financial metrics, benchmarks and milestones inherent in the business plan, particularly regarding technology, markets, customers and revenues. This often is called “DNA” or “domain expertise.”
    • Strong execution history. A management team that consistently and persistently has hit the numbers in the plan. 
    • Demonstrable knowledge of the competition, their business models, their strengths and weaknesses, their likely responses to what you are doing, and how you are going to spank them.
  • Scalable business model. Unit variable costs go down while revenues increase.
  • Ability to demonstrate pricing power and pricing to value. The hardest thing to do is get prices up. However, you often will encounter intense pressure from VCs to price down in order to land the business. That has consequences.
  • Solid, referenceable customers and partners. Few things are as compelling as great customer testimonials. So much of venture capital these days has turned to growth capital on the back of a product, demo or prototype as opposed to development capital, which is now often the realm of friends and family and of angels.
  • Defendable positioning. You are not going to be pushed aside by competition that can readily replicate/duplicate what you are doing.
  • Virtual or close-to-virtual business model. Tell me that isn’t heaven...
  • A product that addresses the revenue side of your customer’s equation. Cost-side solutions are easy to document in terms of ROI, etc., but they almost always take a back seat to a CEO’s interest in the top line. If you find yourself pitching your product to the CTO of a company, you’ve guaranteed yourself a path of greater resistance.
  • Outsourceable development. It is demonstrably cheaper to develop in India, Croatia, China, Ukraine, Mexico and a lot of other places than in California.
  • Simple distribution models. Heavy reliance on complex distribution channels is a red flag.
  • Simple, facilitative and high-yield partnership opportunities. Think sales, marketing, distribution, technology.  [The value of partnerships tends to be highly firm-specific.]
  • Independent verification. This should validate what you are saying in your business plan, especially around revenue assumptions. That verification can come from potential customers, partners, vendors and other players in your ecosystem, as well as from reputable advisors.  Better yet, it can come from a VC’s other portfolio companies.
  • A bottoms-up customer validation-oriented business plan. This should withstand an arbitrary 50% haircut and still survive the cash burn. Even better, have a business plan that can withstand another arbitrary 50% haircut.
  • Protected intellectual property and/or a strategy for IP protection. The problem is that IP is time consuming and expensive for your team, and also your IP is only as valuable as your ability to litigate its defense. IP in general does not have wide applicability to the early-stage social media space.
  • Expandable technology. You don’t want to be locked into a given application in a defined environment; rather, you want technology that has visible extensions beyond the product or application at hand.
If I encountered a nascent start-up that met all these criteria I would put a second and third mortgage on my home and bet on it. Reality is different from this list of ideal factors. Perhaps the best way to tee up the factors is to delineate those that are most relevant to your technology and product and try to get them “right.” I would note that highest on the list of most VCs I’ve met is the management team.

Your startup doesn’t have to solve all the world’s problems and face a market opportunity in the tens-of-billions of dollars. The landscape is littered with highly successful start-ups with stupendous exits on a small scale.

Notice that I did not say anything about “exit” in the list. I don’t talk to CEOs and VCs about exits. If the CEO executes and the VC adds value, the exit will take care of itself. There is no reason to distract yourself and your team with thinking about how rich an exit will make everyone. I learned that painfully when pitching a company to what is probably the most successful VC firm in history. My CEO blurted out, “Yes, and if we get this right I know Microsoft will buy us in 2-3 years.” The VC partner on the other side of the table proceeded to call several of his senior Microsoft contacts all of who confirmed they knew nothing about the company and were utterly disinterested in the technology. My butt still has the imprint from the door handle hitting it on the way out.