Raising Capital in Entrepreneurial Ventures

Raising Capital in Entrepreneurial VenturesBy David Chu & Steve Chin & S. Ramakrishna VelamuriAlthough wealthy individuals and families have provided funding for new ventures since the first half of the twentieth century, private equity investing in seed, early stage and growth ventures has really blossomed only in the last twenty years. It has been particularly exciting to see the growth of private equity activity in emerging markets such as China and India over the last ten years. These relatively new sources of finance are of special interest for high human capital individuals, whose education and work experience place them at the confluence of interesting entrepreneurial opportunities. These opportunities can potentially lead to innovative products and services, and high revenue and employment growth. Private equity investment can both accelerate and increase the likelihood of these favorable outcomes. For example, 90% of Chinese IPOs (initial public offerings) on the NYSE and NASDAQ in 2007 had previously received investment from venture capital and / or private equity firms.1 Many of the founders of these high growth ventures are first generation entrepreneurs whose families have neither the wealth nor the business connections to help them launch their ventures. Thus, there is clearly a win-win potential between these entrepreneurs’ need for capital and the investors’ need to back ventures with high returns.However, we find that entrepreneurs in many promising ventures choose not to seek external funding because they fear a loss of control of the venture to the investor. Even amongst those that do approach private equity investors, there are many that are unable to finally raise capital because of a) the unrealistic expectations which they bring to the negotiating table and b) their poor understanding of the process. This is particularly true of emerging economies such as China, where private equity is a relatively recent phenomenon in the institutional landscape. In this article, we will provide a brief overview of the different categories of private equity investments, outline some common mistakes that we see entrepreneurs making in their interactions with investors, and suggest ways to avoid them.1. Investor categoriesPrivate equity investment can be divided into three broad categories, although many finer distinctions can also be drawn.Angel Investor: An angel investor is typically a high net-worth individual who provides capital for a business in its earliest stage (also referred to as the seed stage). Many angels are successful entrepreneurs who have decided to invest a part of their wealth in seed and early stage ventures. In recent times, senior managers who have built up significant levels of net worth have also been practicing angel investing. In China, these investments can be as small as US$25,000 and typically go up to US$200,000. Some angels gather together to form angel groups and networks to share deal flow and the due diligence involved to research a particular investment opportunity.Venture Capital Funds: Generally, VCs are pooled investment funds managed by professional investors that invest cash for equity in businesses with exceptional growth potential. VCs typically invest at a later stage than angels; during a business’ growth cy cle, when the business has begun to show meaningful traction in revenues or has achieved significant milestones (i.e. prototype product is complete, or a certain number of unique visitors are regularly visiting a website). VC investments range usually between US$1 million andUS$10 million, but can be much larger depending on the stage and type of business. In terms of return on investment, VCs often target annual net returns of 30% to 50% with a liquidity event (Initial Public Offer, or sale to a strategic acquirer) in three to seven years.Buyout Funds: Buyout funds are similar in structure to VCs, but that’s where the similarities end. Buyout funds look to take “controlling” stakes in larger, more mature companies with steady cash flows, by either acquiring the entire company or a controlling stake in the company’s shares. However, in China, obtaining controlling stakes is often more difficult given regulatory restrictions and / or an entrepreneur’s reluctance to relinquish control. Buyout funds are typically much larger than VCs, with many greater than US$1 billion and some approaching US$20 billion in size. These funds also typically use financial leverage in consummating these transactions, which is why these transactions are often called leveraged buy outs (“LBOs”). Investment sizes typically range from US$50 million to US$1 billion with target net annual returns of 20% to 30% with a liquidity event in three to five years. In China however, and with larger funds to invest from, VCs are now targeting much larger and more mature companies once reserved only for the buyout funds.2. Understanding the benefits of external fundingWe find that many entrepreneurs are reluctant to consider bringing in external capital into their companies because they fear a loss of control. It is true that accepting capital from angel investors, VCs or buy-out funds involves a significant change in how the business is run. Financial investors have their own procedures for monitoring their portfolio companies, and they will certainly limit the margin for maneuver of entrepreneurs. However, their entry also makes it possible for the company to grow faster that it would otherwise have grown. Moreover, the expertise that they can contribute on governance and operational issues can be of great value for entrepreneurs. Our recommendation is for entrepreneurs to focus on working with competent individuals, be they investors, managers, or strategic partners to grow the business. Sharing ownership with competent stakeholders makes it easier for the company to grow and become successful. This requires a change in mindset about managing companies that unfortunately not all entrepreneurs are willing to make.3. Posit ioning your company to attract investmentIn addition to the business, financial, or market opportunity potential of a company, there are a number of company-specific items to implement or conduct, which can increase a company’s attractiveness to investors. In fact, many of the following are often instituted by VCspost-investment. In no particular order, they include:To Moonlight or Not to MoonlightSeveral novice entrepreneurs practice “moonlighting”, i.e., they launch a venture while still being in paid employment. This means that they dedicate only a part of their workin g days to their ventures. Many entrepreneurs claim that moonlighting is the only way they can fund the venture in the early days; they typically pay the rental and staff costs out of their salaries. While this might be a valid reason to moonlight, entrepreneurs must realize that moonlighting could be construed by investors as a lack of commitment. Investors usually do not like entrepreneurs to say ? “I will give up my job if you fund me.” They want the entrepreneurs to be fully committed to the venture when they first approach them for funding.Strong Management TeamA common complaint of investors is the lack of strong management teams in entrepreneurial ventures. Along with business traction, this is probably the most important factor for investors in determining whether to invest. Some Chinese companies have tried to address this deficiency by adding part-time management team members or a host of outsideadvisors. While outside advisors are valued when used appropriately (see Corporate Governance), they do not compensate for a weak management team, and investors know this. Having a strong, full-time team is not only validation of the company’s growth prospects, but it also demonstrates the CEO’s ability to delegate responsibility and attract talent. To att ract top talent, a company must be willing to offer attractive returns, which usually include the issuance of stock options to help compensate a person for the risk of joining an early-stage company by allowing that person a stake in the company’s success. A common mistake entrepreneurs make is to declare that they will build a management team once they have received an injection of capital. However, as stated before, a strong management team should already be in place to improve the entrepreneur’s chances of raising funding.Employee Stock Option Plan (“ESOP”)An ESOP is an employee benefit and retention scheme that aims to motivate employees by giving them a stake in the firm’s success over time through equity participation.ESOP’s are almost always established by incoming institutional investors if one is not in place. Forearly-stage companies, which are often cash strapped, an ESOP can help attract top management talent by providing equity upside in exchange for a lower salary. Moreover, since the equity vests over time, ESOPs also act as a retention tool.Good Corporate Governance (Board of Directors)Similar to an ESOP, a Board of Directors (“Board”) is typically established along with an institutional round of financing if one is not already in place. When properly assembled, good Boards can provide a variety of roles depending on the company’s stage. For example, for early-stage companies, the Board often helps with recruiting top talent and new customer development through the Board members’ person al networks. For more mature companies, Board members skilled in structuring exits can help with a potential sale or IPO of the company. Some qualities of good Boards include having both internal and independent members with diverse backgrounds, regular meetings, and accountability for results.4. Advice On Securing A Term SheetA term sheet is a non-binding letter of intent (“LOI”) from an interested investor which outlines the major terms of a proposed investment. It is non-binding in that either party can typically break the agreement without any legal repercussions. Having said that, it represents a serious commitment by the investor in making an investment in the company and good faith negotiations typically ensue to come to an agreement on terms. Af ter a term sheet is signed, an investor undertakes additional due diligence on the company, and if satisfactory, proceeds to have its lawyers prepare the definitive legal financing agreements. In addition, after a term sheet is signed, and barring any new governmental regulation, the probability of closing the transaction is fairly high. With this in mind, our aim is to share practical advice on how to secure a term sheet and with good terms.Do your research before contacting investorsThis will save entrepreneurs time and energy as different investors not only have different investment criteria (deal size, early vs. later stage, industry, etc.), but also offer different types of value-addition beyond capital. For example, some investors have a reputation for closely working with their portfolio companies while others take a more hands-off approach. Entrepreneurs should try to speak to other entrepreneurs who have concluded deals with investors on their target list to hear what their experiences were to increase their chances of finding an investor that is the right fit.Packaging does matterBy packaging, we mean developing a concise, well-formatted, spelling/grammar checked, and basically professional looking presentation that can be forwarded to potential investors. The investor presentation should address all the main points an investor usually looks for when evaluating an investment opportunity (business model, value proposition, size of market opportunity, competition, etc). Typically for VC deals in China, rather than a detailed business plan, a 15-20 slide PowerPoint Presentation is all that is necessary. Additionally, we recommend developing a monthly financial projections model (3 to 5 years) that details the major assumptions and intended uses of funds. While the financial projections model is usually not required for initial investor meetings, it will be required sooner or later as investors show more interest.Target “lead” investorsThese are investors who are willing and able to issue a term sheet. As the lead investor, they are primarily responsible for negotiating the term sheet and managing the negotiation process from the investor side. Some strategic investors are unable to “lead” deals because of how their firms are structured. Other investors like to co-invest alongside other investors for a variety of reasons. A good indicator of whether an investor can “lead” your deal is to look at their past transactions and see whether they “led” those deals.Learn to read between the linesTypically, if an investor is unresponsive to you in either setting up a meeting or follow-up requests, this is a sign that they are not interested. Interested investors almost always are very responsive. Don’t waste your time trying to change their minds. A common response from investors is, “Let us know if you find another investor.”This typically means that they arenot interested but in the event that you do find an investor, they would like the opportunity to reevaluate your business in case they may ha ve overlooked something. Investors who are serious about co-investing in your business typically would help a company find a “lead” investor.Keep the process moving forwardA goal to strive for is to attract term sheets from several investors, which gives the entrepreneur more leverage during negotiations. Therefore, you need to make sure that investors are progressing in their evaluations at a similar speed so when an investor decides to issue a term sheet, the other investors can respond with their own term sheet in a timely manner. Furthermore, a term sheet typically expires after a certain period of time (i.e. two weeks), so managing the process and investors in a timely, but respectful approach is critical.Once a term sheet is received, there are several things to keep in mind.5. Term Sheet AdviceTiming is criticalIn our experience, one of the biggest factors for “failed” term sheets is too much time elapsing between issuance and signing. This is because for most companies, the chances of a “negative” event occurring outweigh “positive” ones. Examples of events that could cause an investor to lose interest include coming across a better opportunity, increasing levels of competition, missed financial forecasts, etc. Additionally, some investors just get fatigued from a drawn out negotiation as they begin to question the company’s sincerity in finalizing a mutually acceptable deal. Lastly, if a first mover advantage is critical to your business, there should be a greater emphasis on getting a term sheet signed so you can move closer to finalizing the transaction.Too much emphasis on valuation vs. term sheet as a wholeA term sheet is comprised of many terms that are interrelated and as such needs to be evaluated holistically. However, we too often see entrepreneurs solely focused on obtaining the highest possible valuation with little regard to other terms. This over emphasis on valuation might be related to some Chinese entrepreneurs’ unwillingness to give up control. Terms such as liquidation preference can have significant economic impact to entrepreneurs that they might not realize. Moreover, higher valuations are typically associated with other terms that are not favorable to the entrepreneurs (such as milestones, which are certain goals the compan y must achieve, failing which it must face a downward adjustment to its valuation, more strict anti-dilution clauses, warrants) in the term sheet to provide investors more downside protection.Do not over-negotiateWhile this is common sense advice, too often we see over-negotiation as another key reason for failed term sheets. Besides investors suffering from deal fatigue, a lengthy negotiation brings into question the company’s ability to execute operationally. Investors may begin to assume that the company has the same protracted negotiation approach with its customersand partners, which raises a big red flag. To avoid over-negotiation, the key is to understand what are the market terms and the relative importance of each term.A term sheet is just a letter of intentAs previously defined, a term sheet is not a legally binding agreement. It may contain certain terms that are legally binding (confidentiality, “no-shop” or no soliciting bids from other investors), but there is nothing that legally prevents either party from walking away. Having said that, executing a term sheet is a serious sign of commitment from both parties. The next steps are typically for the investors to finish company, financial, and legal due diligence and then the execution of the definitive legal financing documents. The key is for the company to be responsive to investor information requests and to keep managing the process forward towards the target close date.6. ConclusionRaising capital from VCs or other professional investors often takes up more time and energy than people expect. As such, it does require a lot of time and commitment from the CEO and other senior executives. Hopefully, the suggestions in this article will help entrepreneurs avoid common pitfalls and increase their chances of success.1Source: JLM Investor Update Newsletter Weekly - 20080123About the authors:David Chu (CEIBS MBA 2004 exchange student) and Steve Chin are co-founders and Managing Directors of Shanghai Venture Partners Ltd. (), an advisory firm that specializes in helping entrepreneurs in China raise capital.Dr. S. Ramakrishna Velamuri is Associate Professor at CEIBS, where he teaches entrepreneurship and negotiation.。