<Thoughts on Taking Venture MoneySaturday, December 5th, 2009
by Roger Ehrenberg

My (highly intelligent and experienced) friend Chris Dixon just posted on the importance of VC brands. He makes many good points and you should read his perspective. But the issue Chris raises begs a more fundamental question: whether or not to take venture money, and if so, from whom?

There are many variables that come into play. Are you a seasoned and successful entrepreneur? Do you have a functioning product with demonstrable traction? Does your team include a strong founder-technologist with a strong reputation? Taking venture money early is simply not an option for many, if not most, start-ups. If you are a guy like Chris who has already made top institutional investors money (Bessemer, General Catalyst) from a prior start-up (SiteAdvisor, sold to McAfee after 14 months), getting venture backing for your next company (Hunch) is not much of a struggle. But this is the exception and not the rule. And while raising money as a seasoned and successful serial entrepreneur from legacy backers isn’t difficult, it is generally a wasteful time-suck pursuing venture money early in the game. This is not the same as “Don’t talk to VCs.” Absolutely not! VCs are invaluable sources of input, contacts, and pitching experience for the new entrepreneur. These are opportunities not to be missed. But to spend enormous amounts of time trying to raise first-round money from venture investors is almost always a mistake.

So where to go? Strategic angels. Small venture firms and “super angels.” Entities, be they firms or individuals, whose charter is to take pre-revenue risk at a fair price and help these nascent companies succeed. At the seed stage it is critical, absolutely critical, to build the right investment syndicate. Getting money from mom, dad and friends is ok, but is not going to deliver the value-added of a strong seed-stage syndicate of professionals who may be tough on valuation, but bring a discipline and culture of support to the venture. Angels and small firms, just like brand-name VCs, can be due diligenced fairly easily. There are a finite number of these people and firms, and they can be tracked down through either VCs, online research or smart networking quite easily. But as is the same with venture firms, warm introductions are critical to getting the right meetings and being taken seriously. Fair or not, reality is that the best of these investors get bombarded with deals, and need to impose filters to effectively manage inbound traffic. And the most powerful filter is receiving a deal from a trusted source. So if you are a start-up seeking seed funding, I’d create my target list of angels and small firms/super angels and work my rolodex like hell to get the right introductions. Otherwise, you are fighting an uphill battle.

Let’s say that you’ve gotten that seed funding, something in the $250K-$1.5MM range, that has helped you prove out the business model, win early customers and generate some revenue traction. And let’s say that you are in a capital-efficient business, where you don’t need $20MM to ramp growth, but something in the $2-$5MM range. While it may make sense to take more money down the line, this amount is likely sufficient to build a very valuable business at scale (but perhaps not the $100MM+ business that we all dream of). Where should you get this Series A money? The “big brand” firms with huge pools of capital? Medium-sized firms? Small firms? Not an easy question, with virtually countless permutations. That said, t I do think there are three factors all entrepreneurs should keep in mind when making this decision.

  1. Size of fund
  2. Deal partner
  3. Domain expertise

Size of fund: In general, the larger the fund, the larger the required exit in order for an investment to be worthwhile. A fund with assets north of $500MM is going to be hard-pressed to invest $3-$5MM in a company and be ok with an exit less than $100MM, assuming they own 20% of the company. The payoff simply doesn’t move the meter. They want to “lean hard” (e.g., put more money into and shoot for a mega-exit) on winners, because nominal dollar returns to pay back the fund are critical. This is where alignment of motives breaks down. ROI is not the measure, it’s dollars returned. This creates a problem for entrepreneurs who may want to accept the $60-$70MM exit (which, incidentally, is many times more likely to occur than the multi-hundred million dollar exit), but where the VCs have a blocking position and can force such a deal to be turned down. So it’s important to understand that taking money from large, “brand name” firms (and the two generally go hand-in-hand) often means that you are “going for it” – no sub-$100MM exit for you. It will either be a home run or you’ll be stuck for a long, long time. As long as you go in eyes wide open, then ok. But this is a material barrier to those running capital efficient businesses who want to preserve the optionality of exiting across an array of scenarios.

Deal partner: As mentioned above, having the right deal partner is critical, regardless of whether you are talking about the seed round, the A round, B round or beyond. A strong deal partner can help materially de-risk a business through sound mentoring, prudent board leadership and valuable connections. The brand of the deal partner is far more important than the brand of the firm. While having a brand name firm might help in future fund-raisings (unless they choose not to invest – then you’re screwed), it pales in importance to a great deal partner. Deal partners become great because of what they do, not who they work for, so raising the next round with a great partner, even if they’re not at one of the “elite” firms, does not in my experience represent a barrier to fund raising. And if the deal partner has good chemistry and a positive attitude towards working with the first-money in seed investors, so much the better. Then everyone can be pulling in the same direction. It is a powerful combination.

Domain expertise: An extension of the deal partner concept. Certain firms have experience at certain things. Those firms most active in your space and close to the end-users you want to sell to should be the highest on your hit list. They have the benefit of “pattern recognition,” having lots of data about firms like yours, how they might stumble and ways in which the growth plan can be better executed. They are also likely to have great contacts on the recruiting front, absolutely essential to building a Series A company in rapid growth mode. And while your deal partner is the one you work with most closely, having others in their firm able to help out with introductions, occasionally sit in on strategic Board sessions and to identify key recruits will prove invaluable over time.

While there are always exceptions, these are the factors I’ve found most important in helping entrepreneurs achieve their business and strategic goals. Good luck, and be careful out there.

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