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Tuesday, January 22, 2008

When to Cut Your Losses

Do you really need all the funds you're asking for - or would you take less in exchange for a quick deal? It's the kind of dilemma you might have to square up to when you're seeking VC investment

Imagine the scenario. You're standing in front of a VC you've never dealt with before, you've presented your business plan, and you've concluded with a detailed explanation of why you need ₤2m funding. The VC thanks you, pauses - and asks what you could do with a quarter of that amount if it was with you by the end of the week. Would you take the bait?

It's worth thinking through the answer, because it really could happen. Among other people, it's a technique favoured by Howard Hartenbaum, general partner at San Francisco-based VC firm Draper Richards. And it works. According to Hartenbaum, some entrepreneurs quickly concede that they'd asked for more than they really need and go on to explain just what they could do with a fraction of the funding. If he and his colleagues like the answers, they'll offer a deal on the spot and secure their stake. As he points out with just a hint of exaggeration, entrepreneurs sometimes leave his meetings unsure whether they've been 'blessed or screwed'.

Hartenbaum's story was just one example of the deal-maker's mentality that emerged during a panel discussion at IBF's 18th Annual Venture Capital Investing Conference in San Francisco earlier this month. From the merits of receiving investment in tranches to the steps entrepreneurs need to take to ensure they don't end up losing their shirt, dealing with VCs can get pretty complex. As Vince Occhipinti, managing director of Woodside Fund, wryly pointed out: 'If you could get manna from heaven and not deal with a VC, you probably would choose that option.'

Not surprisingly, trust was a recurrent theme among the panellists - and VCs acknowledged that it works both ways. While most of the focus during fund-raising cycles is on how companies can impress potential investors, entrepreneurs also need to do a little due diligence of their own. Panellists advised companies to check out VCs' references, for example, calling their portfolio companies to see what it's like to work with them and getting the inside view on how they respond when things go wrong. Some VCs, in fact, actively encourage you to find out the worst about them. George Ugras, general partner at Adams Capital Management, tends to work with first time entrepreneurs and is blunt about the difficulties of growing a relationship from scratch: 'How can you build trust with someone who's on a boat with you and never sailed before?' he asked. That's why his firm specifically puts new CEOs in touch with entrepreneurs from previous deals that didn't go well. 'We tell them our mistakes first. We have never lost a deal in ten years where those calls are made - we really expose everything about ourselves,' he said.

VCs also warned that an efficient investment model often depends on them bringing in new senior people. That doesn't necessarily mean a new CEO - although entrepreneurs whose passion is more in the technology than building a business shouldn't be too surprised if their investors want a change of leadership. As Ugras pointed out, part of the VC's role is to reduce the risk of their investment, so if the technology team looks a little shaky or the company's struggling to set up an effective sales channel, that's where talent has to be brought in. 'Upgrading the management team is always something you've got to do,' he argued. Ajit Nazre, general partner at Kleiner Perkins Caufield & Byers, agreed: 'We will find the best person, no matter what it costs, even for Series A [funding] - it doesn't matter.'

Where VCs were split, however, was on the controversial practice of handing over investment in tranches, usually built around milestones. A perennial topic at VC conferences and one that frequently divides panellists, tranching is preferred by some investors as a way of drip-feeding funds to minimise their exposure. Occhipinti at Woodside Fund does it if the right syndicate is in place, where all the partners agree on the business goals and there's no danger of anyone losing patience mid-cycle. 'Having an extra $5m in the bank - believe me, there is a tendency to spend it,' he pointed out. For his part, Nazre argued that if he could, he'd tranche every month. 'It gives the company an internal goal to accomplish something,' he said. 'It's not a question of trust - it's discipline, for the entrepreneur and us.'

But not everyone agrees with that philosophy. Hartenbaum at Draper Richards said the firm rarely takes the tranching route unless there's a disagreement over valuations. 'In my experience, it's generally been a negative for the company - it causes a lot of stress and a lot of angst,' he said. He believes that tranching can actually make it harder for a company to hire new people - if you have less cash in the bank, you offer less security to a new recruit. Just as important, to his mind it's not a good reflection of the VC's role.

'We're a service provider,' he concludes. 'The entrepreneur provides the blood, sweat and tears - and we put in the money.'

By Keith Rodgers, Webster Buchanan Research