Equity Financing: Understanding Venture Capital
By Julie King | July 31, 2000
If you are a typical dot.com entrepreneur looking to develop a great but unproven business idea, financing your start-up will be one of your biggest challenges.
With expected losses for several years, traditional debt financing won't likely be a viable option. Which leaves equity financing as your main alternative to the banks. With equity financing, the business owners sell shares in their company for an agreed amount of cash.
One of the most common sources of equity financing is venture capital (VC).
The basics of venture capital financing
Typically, VC investments are done in a series of rounds. After the initial deal is signed, the job of the entrepreneurs is to meet specific milestones that enable them to move on to the next round of financing. The ultimate goal of this process is a liquidity event, where everyone realizes the return on their investment, either through an initial public offering (IPO) or the sale of the company.
As the company progresses and the validity of the model is demonstrated, two things happen. The value of the company increases, and the company will attempt to raise additional capital, based on their performance to date combined with current marketplace conditions.
We recently spoke to David Lawee, a managing director at Mosaic Venture Partners based in downtown Toronto, to find out more about venture capital, such as how the rounds of financing are structured, typical investment levels in each round, and what venture capital firms are looking for when they invest in a business plan.
In the coming months we will look at the different rounds of financing. To get things started we have looked at what happens in the very first round: financing the unproven start-up, known in VC lingo as the 'SEED round'.
Getting Started: The SEED Round
The money: Up to $1 million, maybe $5 million maximum, with the average deal falling in the $1-3 million range.
The business: Usually at this stage there are just a few people with an idea, but the idea must be thoughtful.
The players: While most VCs will invest in fantastic SEED opportunities, many focus the majority of their investments on later rounds. Some VCs, however, specialize in early stage investment opportunities.
Timeline to Round 1 (dot.com companies): Six months.
Valuations: Putting a Price on the Deal
Lawee explains that SEED stage financing has seen some fluctuations recently.
A few years ago, the standard of a million dollars for a third of the company used to apply. While there was a range, this would have been a good seed stage financing at that time. But today SEED stage investments have gone up.
"There was a point where it had gone up substantially, like $2 million for a third, or $3 million for a third," says Lawee. "We've done deals, seed stage deals, where we've done $7 million for 40%, 30%. It's been all over the range because companies have needed money very quickly and the time-to-market thing has just been so critical to your success that you end up going higher on the valuation."
It can be hard to do an objective valuation at the SEED stage, which is why Lawee focuses valuation discussions on partnership basics. As Lawee explains, he is going to put in some capital and some time, and you are going to put in a lot of time. Viewed from this perspective, the question shifts away from a specific valuation figure to the question of what is a fair distribution on that equation. "Because you are really just putting a partnership together," says Lawee.
"My dad used to do deals, finance companies, and it would be 50-50 notes; it didn't really matter how much capital he was putting in," says Lawee. "There are a lot of VCs that are just like, first round just take a third. Whatever the company needs, take a third. That's why I say there's not really a lot of science to it."
Valuation Tip: In a round of financing, equity distribution is based on the post-valuation value. For example, if an investor puts $1 million into a company valued at $2 million, he/she then receives 33.3% of the equity, based on $1 million divided by the final valuation figure of $3 million.
Businesses at the SEED round usually consists of just a few people with an idea, explains Lawee. The idea should be pretty thoughtful in terms of the research that they have done, and often the idea stems from experience coming out of the entrepreneurs' own backgrounds.
"Usually people will generate ideas from their own background, so they will have worked in a specific area and they will see opportunities there, so they can be thoughtful and authoritative on a particular area of business. That's where you get the best SEED plans from," says Lawee.
For dot.com companies at the SEED stage, Lawee doesn't expect to see extensive website mock-ups and technology developed. But technology expertise is a big plus.
"It is really hard to attract senior technology people, and it's great if they've already got that," says Lawee. "It makes a big difference."
Key Investment Factors: "It's all about the people."
Lawee explains that at the SEED stage, a deal really depends on the people and the 'relevancy' of the target market.
Relevance is a term commonly used by equity investors, meaning that the scope of your business plan and your marketplace are significant enough to warrant investments in the million dollar range. Like all investors, VCs are looking for substantial returns on their investment. On the venture capital landscape, a relevant plan has the potential to generate a multi-million dollar return on the initial investment.
"Most of the time there is a correlation," says Lawee. "People who are real shooters are going to aim their resources at big markets, and so normally you can just do it [the deal assessment] around the people."
Once a deal is signed, you are going to be in business with each other for many years. Which makes liking each other another important factor.
"The human element cannot be lost here," says Lawee. "If you are going to get into business with someone for six or seven years, you want to like them. You want to go to their kids parties .. otherwise you'll work on something else where you can have those relationships."
Seeking SEED Financing: Making the Connection
One of the first hurdles in getting venture capital is getting the attention of a VC. As Lawee explained, a firm cannot possibly look at all the plans it receives.
One key to connecting with a possible investor is to get a referral from someone that the VC knows and trusts. Lawee offers these tips for getting in the door:
- It dramatically improves your chances to come in through a trusted reference.
- You have to be savvy about who those people [are] .. not to listen to everybody and say 'oh that guy's a trusted referral'. If you're associating with someone who is not considered to be credible then you get tainted by that.
- There is so much available on the Internet. Go out, read up, learn about the market. Figure out how you're going to get to the influencers. We do that all the time for our companies. You need to do that .. it's just a normal business skill.
"Some entrepreneurs that we've really been really impressed with and have ultimately invested in have been the ones who have really figured out the landscape and have been extremely thoughtful about who to associate themselves with and who not to associate themselves with," says Lawee. "They come in here and they know all our portfolio companies, and they may have talked to a few of our CEOs already, and they've just been prepared. That's just basic homework."
Lawee appreciates the value of good networking skills in the entrepreneurs that contact him.
"When you see someone who is actually a very good networker, that's a very good business skill. The way they get to us is indicative of that part [of their] business acumen. Not everybody is going to be sophisticated on everything, so you don't go, 'if they haven't come in from referral you're not going to consider it'. But it just shows another level of sophistication."
Where to Look for Capital: Local or Global?
For Canadian entrepreneurs that have 'relevance' – or a business plan large enough in scope – and have something to show their capabilities, Lawee believes that there is no reason to expect better acceptance in the US rather than in Canada. In fact, he thinks there is an advantage to being financed in Canada.
"When you [an investor] are in a market, you know all the stories, because you've read them in the paper .. people have histories," says Lawee. "When you're new to a market [like a US investor], people don't have histories. So I think typical VC investors try and get local investors involved, because they can add value to the businesses."
Another advantage: being involved with local investors gives you local recruiting assistance. And as Lawee explains, recruiting is everything.
"People give us their resumes all the time. We have thousands of their resumes on file. Some people I keep up ... [I] try and find an opportunity for them. And they are looking for an entrepreneurial adventure so it could work out the other way. They're just good people. And then sometimes it works out, like Jim McGill who is now the CFO of Grocery Gateway. He was the CFO of Purolator. The fit was perfect."
"That's how you build businesses. Through your own networks you ask everybody who's the best person that you met this week, and you try and meet them, and you try and build your own networks."
Investment Focus: Mosaic Venture Partners
Lawee explains that his firm stays away from broad investment themes, such as 'we hate B2C, and love B2B, we hate this, we love that.' Instead, at Mosaic they gravitate towards specific businesses.
"There are probably B2C things that we would do, but they're not going to be like eToys Canada. We don't think of that as relevant, relevant enough," says Lawee.
Unable to look at all investment areas, Lawee instead focuses his time becoming much more knowledgeable about a number of things that interest him personally, which enables him to be much more proactive in these areas. He is currently watching the B2B infrastructure and application space, looking for the new SAPs. [SAP was an enterprise application that became one of the dominant enterprise applications.]
"I think the web software, B2B software space is going to consolidate quite quickly, and there will be a few major package providers that will link up everybody," says Lawee. "So that's obviously an area that we're very excited about."
"Personally, I'm very passionate about broadband space .. particularly given Canada's relative advancement in that area, having a broad number of @home users," says Lawee, who is also following eHealth, both in Canada & the US.