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What VCs look for while funding a business
Puneet Bambha and Nupur Hetamsaria | April 11, 2007
"In the world today, there's plenty of technology, plenty of entrepreneurs, plenty of money, plenty of venture capital. What's in short supply are great teams." -- John Doerr, Partner, KPCB.
Early investors in amazon.com, Apple Computers and the Body Shop got returns of 260, 1,692 and 10,500 times their initial investments, respectively. That's mind boggling. Now let's look at some other numbers.
According to www.1000ventures.com, only six out of 1,000 business plans get funded on an average. Only about 5 per cent of the business plans are read beyond the executive summary and 10 per cent of proposals pass initial screening. Only and only 10 per cent of these screened proposals pass due diligence and receive funding.
The investor, at whichever stage of the venture he might be investing, as per a report by Lehman Brothers, makes detailed evaluation of the quality of people, quality of business and the quality of investment involved. A decision to invest is reached after several rounds of presentations and negotiations.
The most difficult to assess is however the quality of people. As John Doerr rightly put it, 'What's in short supply are great teams.'
So given a great idea, a great business plan, and plenty of money, will the people involved be able to pull the project through to make great returns possible for the investors?
Before deciding to invest in a project, venture capitalists (for the purpose of ease, we are using venture capitalists as the term representative of incubators, angel investors, private equity investors and mezzanine financiers) undertake a series of steps to evaluate the project.
The following paragraphs broadly explain the various steps of the evaluation process.
Initial Screening: VCs are in the business of making more than the average returns and only the proposals which can match or exceed the VCs expectation will get an attention from them. Thus initial screening is a step in which the venture capitalist reaches an initial decision to investigate further the investment (or not).
The initial screen is a cursory glance at the business plan to determine whether or not the proposal fits within the investor's areas of expertise. VCs carry out initial screening of all projects on the basis of some broad criteria.
For example, the screening process may limit projects to areas with which the venture capitalist is familiar in terms of product, technology or market scope. The size of investment, stage of financing and geographical location could also be used as the broad screening criteria.
Detailed Business Plan: If the plan manages to clear the initial screening round then the VCs call for the detailed business plan from the entrepreneur. The business plan is the main tool with the help of which VC would make up his mind. Thus the entrepreneur should present clarity of thinking about the business in the plan as the "Surprises can be great for parties, but potentially could be fatal for businesses."
Due Diligence: In the next and the most important phase, due diligence is conducted by the VC to verify the accuracy of the statements made by the entrepreneur. The two main types of due diligence conducted are Business and Legal.
The legal due diligence involves verification of the documents by the lawyers of the VC. These documents include Memorandum and Articles of the Association, important contracts, patents, copyrights, et cetera.
Business due diligence involves looking at the quality of people, quality of business and the quality of investment. Quality of people is one of the most important criteria. There is unanimity among theorists that venture capitalists prefer a Grade A team with a Grade B idea to a Grade B team with a Grade A idea. However, how the quality of team is evaluated is a source of controversy.
Many feel that the integrity of the team members is the most important criterion. Past research shows that trustworthiness, enthusiasm and expertise of the entrepreneur are the most important factors considered by the VCs. It has also been seen that about 50-60 per cent of the projects which are seriously considered for financing but are ultimately rejected is due to the factors related to the entrepreneur.
The other major consideration is quality of business. Some VCs, especially the early stage ones, may not give a lot of importance to details; however, the idea must necessarily and clearly signify a distinct and unique competitive advantage.
Generally, market potential and attractiveness are an integral part of a marketing plan.
Though visibility and transparency in a business may not necessarily increase its attractiveness, it is more of a necessity. One of the most important considerations for VCs while judging an investment proposal is clarity of the exit mode and the expected return from the project, which is quality of the investment. This is because the VC is ultimately a fund and they (like mutual fund managers) need to manage their portfolio to get maximum return.
Dr A K Mishra of IIM Lucknow, conducted a detailed study in the year 2001 on the investment evaluation criteria used by the Indian venture capitalists. Even though the study was conducted six years back, its findings are still relevant and confirm the findings of researchers globally.
Mishra found the entrepreneurs' personality (integrity, attention to detail, long term vision, etc.) to be the most important criteria for the VC, followed by growth prospects of the business.
Finally, if the VC is positive after the due diligence, he will issue a term sheet which is an indication that he is seriously looking at the proposal. It is pertinent to note that the term sheet is not the final document, but only a basis for further negotiations.
So, behind those mind boggling returns lies serious evaluation. Apart from luck and being in the right business at the right time, venture capitalists must also be given due credit for the detailed evaluation that they carry out before deciding to invest.
Puneet Bambha is an MBA from ICFAI Business School, Hyderabad. Dr Nupur Hetamsaria is Member of ACCA, UK; and a faculty member at ICFAI Business School, Hyderabad.