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SOURCING STRATEGIC INVESTORS

Monopoly Investor MS Office clipart TPart I – Funding your Business with Strategic Corporate Investors

by Laurence Hayward

It’s common to think of strategic investors, or strategics, as large established corporations that make equity investments in entrepreneurial ventures (and that is precisely how the Kauffman Foundation defines it). However, the reasons they make these investments vary and are more subtle than the definition implies.

The obvious reason is to gain a strategic or operational advantage by investing in emerging technologies. But let’s give it a bit more color.

  • To serve as a single contact point for emerging technologies, which historically can get lost in the organization.
  • To fill the gap in the capital markets where meaningful innovation needs to occur.
  • To align interests between several technology companies, which bring value to the corporate enterprise.

Corporations also create open innovation programs and becoming limited partners in independently managed venture capital funds. A corporation need not have a dedicated fund division to be actively involved in the world of venture-backed companies.

Monopoly Investor MS Office clipart

 

Corporate VCs

A strategic, in many cases, wants just the opposite of the typical venture capital operation. A VC fund is operated by a team of professional asset managers backed by limited partners as part of a financial return strategy. Much like the average investor in stocks and bonds, one doesn’t tell his mutual fund manager what to do. Like the average investor, limited partners often want little or no connection to the assets managed. They seek capital gains, not strategic or operational benefits.

This distinction was not always so clear. In the heat of the late 90s, corporations caught the private equity bug and many large companies entered the venture game—with or without venture experience. Companies often targeted companies not strategically aligned in product or service. It didn’t end well and many of these initiatives terminated. Today, I see corporate investors making significant efforts to ensure business unit alignment—seeking an operational benefit in addition to a financial one.

Today, corporate venture capital is experiencing a renaissance, but one more circumspect than in the past. This marks the strongest year since the crash of 2000. According to National Venture Capital Association, corporate venture groups invested $5.4B in 2014 accounting for 11% of all venture dollars invested.

Large corporations are playing an increasingly critical role in financing important technologies. There is a distinct lack of non-strategic investment in vital sectors such as Cleantech, Agriculture, Material Science and Advanced Manufacturing. (Cleantech investors themselves want more competition.) Because companies in these sectors tend to be capital intensive, with extended sales cycles, financial venture firms are straying back to traditional areas of focus such as Infotech.

Fortunately, strategic investors have stepped in where financial investors have exited. This is important. Many of these companies are commercializing breakthrough innovations that benefit mankind. Government research dollars alone cannot bring them all to market. I’m reminded of a cover of MIT Technology Review featuring Buzz Aldrin saying, “You promised me Mars Colonies. Instead, I got Facebook.”

 

Types of Strategics

Many entrepreneurs in underfunded sectors ask how to work with strategics. Just like other types of investors (angels, family offices, venture capital firms, etc.) there is a wide spectrum. They don’t all approach deals the same way.

Many strategic investors begin by making investments from their balance sheets through operating divisions within the company. This important activity may not be captured in the industry statistics, which represent more formalized venture funding.

Other firms set up a separate venture capital unit, in some instances as a separate corporate entity or business unit. This is done for a variety of reasons including internal organizational considerations for the strategic, but it is also done to address a key concern of the entrepreneurs, such as, “Will the strategic attempt to tie me up in some way?” Separate venture capital units are designed to avoid these concerns.

In most of strategic transactions, the investor seeks some special rights in addition to the purchase of equity. These can come in the form of distribution and supply agreements, license agreements, exclusive rights to product/technology, right of first refusals (ROFRs) for sale of the acquired company, preferred pricing arrangements and so on. It is critical for the entrepreneur and any co-investing financial investor to understand the implications of the agreement before beginning discussions with a strategic. These terms can make a significant impact on a company’s ability to pivot, its opportunity to exit, and ultimately its valuation.

For example, most venture capital funds will advise their entrepreneurs that ROFRs are a non-starter—and with good reason. A right of first refusal in the sale of the company can make a competitive bid or auction process entirely impractical. Why would a competitive buyer delve deep into diligence if they know the company holding the ROFR can sweep the deal away from them at the last minute? The potential buyer will also wonder how deeply entrenched the company is with the strategic owner and be concerned with competitive disclosure issues. The ROFR can restrict an entrepreneur’s ability to maximize value in an exit and inhibit a true auction-like environment.

Remember the objective of most venture-backed companies is extraordinary returns, not average returns. From the perspective of the entrepreneur and the non-strategic investors, it is not about seeking a fair price in an exit, it is about getting the best price possible.

 

Separating Equity from Everything Else

Many strategic investors in formally run venture capital units do not necessarily seek to become eventual acquirers of the companies in which they invest. And they often avoid conflicts such as ROFRs. Strategic and operational gains can be found in other ways.

For example, the gain can be a customer, distributor, supplier, etc. It can be first to market with a new technology. A distribution or supply agreement can be of great benefit. For example, imagine a small company that quickly gains access to global distribution of a large corporate enterprise. Therefore, a key consideration is the value of any arrangement outside of or in addition to the exchange of equity.

It’s important to account for any exchange of value above-and-beyond the equity. For example, a license provides value via access to technology. Such agreements often include upfront payments and royalties for the value of the technology to the strategic. A company will want to clearly capture and specify this value.

 

Too Many Cooks

An entrepreneurial venture will require multiple types of investors over time. If an angel, a venture capital firm, and a strategic invest in the same company, how do you ensure they have equitable value especially if the strategic is getting “extras”? On the one hand, access to the emerging company technology might provide the strategic a major competitive advantage in the marketplace. Then again, the strategic investor might bring added value that the angel investor can’t. What is one to do?

The answer is to account for each unique benefit with a discrete standalone agreement, separated from the equity arrangement. For example, if there is access to technology, then structure a separate license agreement. On the flip side, if the strategic is providing access to new markets, a distribution agreement might help ensure fair compensation for selling the company’s product. In other words, price “extras” separately where possible.

At some point, equity interest and operational interest may diverge. For example, a strategic may at some point elect to exit an equity position, but might still want to have an operational relationship such as a license with the company. If those are intermingled in the original agreement, separating them may become a challenge.

In short, meticulous accounting is required for operational and strategic benefits. They need to be valued separately from the price of equity. After all, the price paid for equity involves a fair exchange in percentage ownership in the company just as provided to any other investor.

 

GO TO PART II

Larry Hayward Photo

Venture Lab Logo

Laurence Hayward | lkh2@theventurelab.com | VentureLab | 2100 Sanders Road | Northbrook, IL 60062

This article is abridged from News From Heartland and TheVentureLab.

Copyright 2015. The VentureLab

Image Credits – Parker Brothers via MS Office, Laurence Hayward

Subscribe to Larry’s articles at http://theventurelab.blogspot.com/

Chicago Venture Magazine is a publication of Nathaniel Press www.ChicagoVentureMagazine.com Comments and re-posts in full or in part are welcomed and encouraged if accompanied by attribution and a web link. This is not investment advice. We do not guarantee accuracy. It’s not our fault if you lose money.

.Copyright © 2016 John Jonelis – All Rights Reserved

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TWENTY QUESTIONS YOU WILL BE ASKED BY VENTURE CAPITALISTS

(If You Get That Far)

Logo Tby Laurence K  Hayward

Most likely you’ve played the game 20 questions. As the contestant, you use your best combination of questions, which can be answered with a simple “yes” or “no,” in order to discover a piece of information held secret by the other player. The objective is to discover the unknown information with the fewest questions (from the 20 you’re allotted), as quickly as possible.

This game shares some common traits with a venture capital interview. As the interviewee, you can expect a barrage of questions. You might also feel like the interviewers are trying to box you in as they narrow the choices, in order to hone in on the “answer” as quickly as possible. Recognizing that venture capitalists reject a far greater number of deals than they accept, the quickest way for this interviewer to finish the game is to find a fatal flaw, a deal-killer, a quick “no.”

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A key difference between the game “20 questions” and the venture capital interview is that you, the interviewee, don’t get to answer the questions with a simple “yes” or “no.” So, in order to help you prepare, outlined below are 20 questions that venture capitalists most frequently ask entrepreneurs. Following each, I’ve included a brief explanation regarding what the venture capitalist (VC) might be trying to uncover. These questions aren’t necessarily in the order you would receive them, though the winnowing process was taken into consideration when creating this list.

 

1 – What is the market potential for your company’s product or service? What is the revenue potential for the industry, and what is its growth rate?

The VC wants to quickly ascertain whether the opportunity is large enough to pursue. What determines if the opportunity is large enough? Typically, it hinges on whether the VC will be able to achieve a target return within the designated timeframe (often three to five years). While all firms have different investment criteria, most VCs target a minimum internal rate of return (IRR) of 25 percent and many seek IRRs higher than 50 percent. To reach these thresholds, VCs look for companies with considerable market potential for their products or services (often $500 million, $1 billion or more). They prefer growing markets to retrenching ones. Also, most VCs focus on specific industries, so they’ll be trying to ascertain whether this deal is within their bailiwick.

 

2 – How did you calculate market potential? How do you determine industry sales and growth rate?

It is common for entrepreneurs to include very large market potential figures in their business plans and then indicate that they require only a miniscule fraction (e.g. one percent) of the market to achieve their projections. These figures are often suspect and lead to a rolling back of the eyes of the would-be investor. Further, VCs often prefer opportunities that capture a larger fraction of a target market segment otherwise its value may be questionable relative to the competition. Market potential should be verified by independent research as well as bottom-up and top-down calculations.

 

3 – What makes your business different or unique?

This question can have two wrong answers. A business can be both too common and too unique for a particular investor. If it’s too common, the VC will be concerned with the competition and the lifecycle of the business. If it’s too unique, the VC might be concerned with the time required to achieve critical mass. Many truly revolutionary products require educating the marketplace, and that can be an uncertain and lengthy undertaking. There is a saying that VCs prefer evolutionary over revolutionary businesses.

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4 – Why would someone be “compelled” to purchase your product or service? What specific needs does it address?

Venture capitalists look for businesses with products or services that address a demonstrable market need or demand. Is your product something the buyer needs? Or is it just something that would be nice to have? If it falls in the latter category, then it is critical to demonstrate how your product will gain traction, that is, how people will come to demand it based on market trends.

 

5 – How do you know that your business has high-growth potential?

Venture capitalists want to know how you “drew down” your revenue estimates from the market potential figures (which hopefully include estimates from external sources). Ultimately, they want to see a large growth opportunity that scales quickly, thereby allowing them to realize the payoff on their investment as soon as possible. Be prepared to explain in detail the process you used to estimate revenues and how/why they scale.

 

6 – What is it about your management team that makes them uniquely capable of executing on this business plan?

You’ve probably heard that the three most important items in private equity investing are management, management and management. More specifically, VCs are typically looking for management with experience in building a business (or comparable), deep expertise with the technology or industry product, and strong character. What comprises the latter? VCs look for managers who demonstrate high energy or passion, resourcefulness, integrity, perseverance, risk-taking ability and pure mental horsepower. A frequently overlooked quality is that of humility – understanding one’s limitations, the need for teammates with complementary skills and the ability to listen.

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Risk

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7 – What are the primary risks facing this opportunity?

Most people tend to think of “the competition” when people ask them about risks facing their business opportunity. However, competition is only one risk. Other risks include changes or shift in technology, governmental and regulatory policies, labor market conditions (availability to find qualified labor at a reasonable cost), business climate changes, product liability, computer crime, etc. And, don’t forget financial risks. For example, what happens if your capitalization doesn’t allow you to reach breakeven or your next financing event? A risk assessment of potential threats to your business can help you prepare for the scrutiny of investors.

 

8 – Who are your competitors?

You’ve heard the warning “never say never.” When answering the above question, the warning might well be “never say none.” There is more to this question than may first be evident. Certainly, VCs are interested in learning about the competition your business will encounter and how you will distinguish your company. But, they also might be assessing your maturity as a businessperson. The answer “none” is typically incorrect because your business almost always has at least two competitors. Potential buyers could simply continue to function without your product (e.g. through the use of a substitute, however less effective) or buyers could “do nothing” (e.g. choose not to utilize the product or service). Furthermore, if the investor is aware of competitors that you have not considered (as many have researched particular segments independently), he or she will lose faith in your business assessment skills – so be prepared.

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competitive advantage

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9 – What gives your company a competitive advantage?

Venture capitalists want to know how you plan to outmaneuver the competition –and this doesn’t just pertain to existing competitors. They want to see that you’ve given thought to future market entrants and how you will stave them off. “First-mover advantage” is rarely a sufficient response to this question. A more effective answer usually depicts intellectual property barriers or the ability to reach the target market in a way that is more effective than the competition. What is unique about your company that gives it an edge?

 

10 – Does the company have proprietary intellectual property in the form of patent, trademarks, copyrights, etc.?

What do you own? What can you protect? These are two important questions on the mind of any VC. In some industries (e.g. biotech), patents play a critical role in protecting the research and development investments of the company and in helping to ensure that there is a window of opportunity (usually before competitor offerings arrive) for the company to realize a significant share of revenues for a particular category. Trademarks and copyrights are critical to protecting the company’s intellectual assets and its “brand.” Also, at some point, VCs will also want to ensure that you’ve taken the proper steps (through non-disclosure agreements, non-competes, and/or employment agreements) to ensure that the company is protecting its intellectual capital.

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patent pending

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11 – When will your company break even in terms of profitability and cash flow?

Remember when you first became financially independent of your parents? Hopefully, you were at a point where your income exceeded your expenses and you no longer required their support. The concept here is similar. Once you’re financially independent, you’re also less of a liability. Of course, the ultimate goal is to reach an exit scenario quickly. Profitable businesses are more attractive to potential buyers or public markets.

 

12 – How do you plan to acquire customers?

A well-developed business plan includes marketing strategies that demonstrate an understanding of market realities and customer behavior. VCs are looking for much more than a list of your marketing initiatives. You can anticipate questions like: What are your company’s customer acquisition costs? Have you calculated average and target revenue per customer? Do you know how many customers are required to break even? Do you know the product sales cycle?

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13 – How do you plan to keep customers?

The most successful companies seem to have a plan for keeping customers –even before they acquire them. It is said that it costs five times as much to generate business from new customers as it does from existing customers. Customer retention is critical to long-term success.

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14 – What drives customer satisfaction for this industry and for the product? And, how do you know?

Have you conducted research in order to assess what is truly important to your customers? Do you know what product features are critical vs. those that are ancillary? Once you’ve acquired customers, you’ll need processes to ensure their ongoing satisfaction and your understanding of their changing needs. Have you considered how you’re going to support the product and the expenses associated with such support? Will existing customers purchase your product or service again? Will they recommend it to others? Regular and consistent customer feedback is essential in order to obtain the answers to these types of questions.

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15 – Who is the end user of the product or service offering?

Is this a consumer-based business, or will you sell your product or service to other businesses? What do you know about the demand for your product or service in that target market? What do you know about the buying habits of your target market? Do you anticipate any roadblocks? For example, will you have to educate the buyer? Also, give thought to how you can leverage partners or re-sellers to reach your target markets. Knowing the answers to these questions will be critical when you speak to a VC about your opportunity.

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team

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16 – What alliances or partnerships have you entered?

(e.g. joint ventures, marketing alliances, licensing arrangements, selling/distribution agreements, channel partnerships, software agreements, etc.)

It is important to remember that alliances can be assets and liabilities. Venture capitalists will want to know if any of your alliance agreements have compromised your intellectual property claims and if the company has any outstanding obligations to third parties. On the positive side, you’ll want to demonstrate how alliances may have helped your company lock -up certain distribution or sales channels for your products and services. Do any of your alliances give you a competitive advantage? Do they create barriers to entry? Do they help you reach customers more efficiently?

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17 – What is the anticipated lifecycle of your product or service offering? What are your current and future plans for R&D investment?

All great things come to an end. Products mature, competitors offer substitutes and customers demand change. Have you anticipated when the earnings power of your product will run its course –for first-time buyers as well as for follow-on sales to existing customers (e.g. upgrades)? What are your plans for R&D investment, and how will you continue to generate revenues when existing products run their course?

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18 – How do you plan to expand your labor force?

While the precise conditions of labor markets change, it is always a challenge to find the best people. Venture capitalists will not only be interested in the composition of your existing workforce, but also in how you plan to fill key positions now and in the future. Have you used an executive search firm? Do you have qualified candidates currently under review? How will you compensate people, so as to attract, motivate, and retain employees, while keeping labor costs under control?  What does your option program look like?

 

19 – What are the probable exit scenarios?

Venture capitalists need to know how they’re going to monetize their investment, hopefully at an ROI of 50 percent or more. As an entrepreneur, you should spend some time thinking about who could acquire your business down the road. Be both realistic (particularly on timing and valuation) and creative regarding M&A possibilities.

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20 – What is the planned “Use of Proceeds”?

Venture capitalists want to know that their money is being put to good use in order to directly accelerate the business opportunity, so that they will receive their ROI in a timely fashion. One “no-no” is using VC investments to service existing debt obligations. Be prepared to present a timeline of milestones. Include a breakdown of how the money will be spent and what it will allow you to accomplish..

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Adapted from the Journal of the Heartland Angels  news.heartlandangels.com

This article is a summary of a larger article. The full 15-page article may be obtained by contacting VentureLab. ©2014 VentureLab, Inc. All rights reserved.  www.theventurelab.com

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About the Author

Larry Hayward 2Laurence K. Hayward is a founding partner of Independence Equity, an early-stage venture fund launched in 2011.  The fund is actively investing having recently completed its 8th investment.  He is co-founder of Cornerstone Angels, a network of accredited investors that has invested in 40 companies since 2006.  He is also founder/CEO of VentureLab, an organization that has been launching new ventures since 2002.  Previously, he was President of Vcapital.com, an internet start-up that matched entrepreneurs with investors, acquired in 2002.  Hayward has been forming, investing in and advising start-ups since 1999 following 8 years at Arthur Andersen in the Emerging Company Services practice.  He is a graduate of the Joint MBA/BS program at the University of Illinois in Champaign Urbana and hold Series 7 and 63 licenses.

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Image Credits

Wikimedia – 1954 DuMont Television/Rosen Studios, New York, MS Office Clip Art

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Chicago Venture Magazine is a publication of Nathaniel Press www.ChicagoVentureMagazine.com Comments and re-posts in full or in part are welcomed and encouraged if accompanied by attribution and a web link. This is not investment advice. We do not guarantee accuracy. It’s not our fault if you lose money.

.Copyright © 2015 John Jonelis – All Rights Reserved

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