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What Makes Venture Capitalists Tick

Venture capitalists are far less visible these days, but with the right approach, you can still woo them — and win their support.

By Edward O’Connor August 01, 2006

There comes a time in every technology company’s lifecycle when its owner wonders whether, when and how to land venture-capital investment.

Not too long ago, this was a sure-fire way to fund growth even with very little prospect of actually making money. Those days are gone.

Seeking venture capital is harder these days: You have to prepare to go about it in the right way while trying to avoid all that can go wrong. But first it’s important to understand what you’re getting into in the venture capital world.

Investment Lingo and Concepts

There are two types of equity investors in privately held companies:

• Venture-capital investors, who place money into high-risk, seed- or early-stage firms usually in exchange for a substantial or majority ownership stake
• Private-equity investors, who take an equity stake in later-stage firms with a proven track record and often seek less than a majority stake

In common parlance, all such equity investors are categorized as venture capitalists (VCs). But in reality, all of them are private-equity investors — they invest in private firms in exchange for equity, as opposed to investing in public firms or buying corporate debt — and VCs are a subset of these. We’ll use the term equity investors to refer to all such investors, whether they’re in seed-, early- or later-stage firms.

Equity investors are seasoned middlemen. They invest other people’s money in their portfolio companies in exchange for an ownership stake. And they do what they can to make the firms in which they invest profitable and to drive them toward lucrative exits, whether through initial public offerings (IPOs) of stock or by selling them to other companies within a certain timeframe. At some pre-defined point, the equity-investment firm returns to its investors their share of any profits.

Candidates for Equity Investment

Because equity investors aim to make high returns on their investments, they seek companies with proven business models, high revenue potential in large addressable markets (often $1 billion or more), high profit margins (25 percent to 50 percent) and a scalable, repeatable, go-to-market and product- or service-delivery capability that will lead to profitability.

These factors are most important to equity investors. But the biggest criterion is an experienced management team, which had better be a group of smart people with whom the equity investor is comfortable working and building the business.

Generally, systems integrators and value-added resellers — together called service providers (SPs) — are excluded from consideration by most equity investors. Unless they’re riding hot trends or playing in booming markets without much competition, SPs tend to suffer from several flaws. They have relatively low revenue potential, their profit margins are diluted by competitors, and they lack scalable, repeatable, efficient service delivery.

Critical factors in assessing an SP’s viability as a prospective investment include the scope and market-desirability of services, depth of talented executives beyond the CEO, utilization rates, profit margins, and ability to expand — in terms of services or markets served — without cost constraints that eat into margins.

On the other hand, independent software vendors (ISVs) tend to be more favorable investment targets because the software business generally enjoys high revenue and margins, and a higher scale of product delivery whether through channel partners, with resellers or Internet delivery.

In 2005, there were 622 venture-capital fundings (totaling nearly $6 billion) in the U.S. information technology market, representing 47 percent of all VC investments for the year, according to the VCDeal.com section of The Deal LLC. which reports on and analyzes business and financial news in the deal economy. Of those deals, 264 involved software firms, while 350 others were in the networking, Internet and semiconductors and wireless industries. Only eight were in services firms.

Dealing with the Hybrid Organization

What about hybrid companies — that is, those offering a software product with services wrapped around it? The ordinary objection from equity investors is that the product and services business models are quite different, so how do such companies intend to succeed?

The hybrid company is likely to choose one business model over the other, preferably the one in which it has had the most success, and it should be able to justify that transition while sustaining and growing revenue and profits. (Note: if you’re making the transition to a services company, it’s better to go elsewhere for capital; if becoming a product company, it’s better to demonstrate a track record as a pure-play software shop before going for equity investment.)

Alternatively, the hybrid company can spin off its product business into a separate, stand-alone organization while retaining its services business.

Basics of the Equity Business

Every business has a balancing act. For equity investors, the balance is on two pivot points. First, they must negotiate the interests of their own firms, their portfolio companies and capital investors; additionally, they must balance time and capital. The balancing part involves how much time they spend on their portfolios, how long it takes to find new funding opportunities and how much time passes until they can exit the investment at a substantial profit. By achieving and maintaining balance, the equity investor stays in business and can raise more funds to invest in order to make still more money.