I had coffee with an entrepreneur friend the other day who is in the early stages of putting a company together, and he recounted how his informal conversations with a venture capitalist had quickly escalated into a full partner pitch in just a few weeks. That situation sounds very positive in theory, but the problem is that this founder wasn’t ready for this interest and is trying to play catch up in other capital raising discussions (with both angels and VCs). He lamented that if the meetings with this venture firm soon led to a term sheet, he’ll be faced with a tough problem of a binary decision – take whatever they offer him (which was likely too much money for what the company needs now at not a great price) or risk losing any funding options. A high class problem, certainly, but one in which the entrepreneur could have easily avoided by generated alternative funding options and as a result, a better outcome. I’ve seen this scenario play out often; as VCs are aggressive in pursuing hot new companies and entrepreneur (especially first-timers) are flattered and eager conversations with VCs. Given this situation happening, I’ve even heard some people strictly advise entrepreneurs never ever to talk to VCs unless they absolutely need to… in order to raise money.
All of this led me to think about the question – when is a good time for an entrepreneur to talk to a venture capitalist?
At the recent March Web Innovators Group event, I invited a panel of serial entrepreneurs to talk about their founding stories, during which David Cancel said that “one of the most unproductive things new founders do is talk to investors too early… I test all my ideas on the web.” I completely agree that the best way to test market demand for a business is with customers, and spending too much time with investors early on can be unproductive. Recently Chris Dixon wrote that in developing new startup ideas that founders should be the “opposite of secretive” and talk about startups ideas with “every smart person you can get a meeting with”… including VCs. He continues “VCs are good at telling you about similar companies in the past and present and critiquing your idea in an 'MBA-like' way: will it scale? what are the economics? what is the best marketing strategy? I would listen to them on these topics but pretty much ignore whether they think your idea is good or bad.” Fair enough.
Like most things, knowing who, when, how much, about what, and how often to talk to VCs about your startup is not clear-cut. As a guiding principal, I believe there is a distinction between informal discussions with an individual venture capitalist and formal capital-raising with a venture capital firm. Of course, as an entrepreneur you’re always selling to all of your constituents, including (potential) investors. But I think there’s a bright line between socializing your startup with one person and formally presenting your startup to a firm’s partnership (or a subportion of it).
First, I thought I’d enumerate a quick list few reasons and benefits in talking with venture capitalist before you’re actually ready to raise institutional capital. I am sure there are additional ones. An early conversation with a VC is a great way to:
- Hear another smart person’s gut reaction opinion. Venture capitalists hear numerous startup ideas, benefit from the ability of pattern recognition, and can share that understanding. Of course, it’s important to incorporate knowledge of VCs’ biases into the feedback, but that’s true in any conversation you’re having about your startup.
- Learn a top-level perspective of what’s going on the market and how your idea fits into that space. Many VCs closely follow specific industries and subindustries, and have been for a while. Especially if it’s an entrepreneur is exploring in a somewhat unfamiliar territory, a VC conversation can help add to an entrepreneurs understanding of the market.
- Make connections to people who will be able to improve your business in some way. VCs spend a good portion of their time networking and interacting with a variety of people within the startup ecosystem. Chatting with a venture capitalist could lead to warm introductions to advisors, industry connections, other entrepreneurs who have worked on similar endeavors in the past, potential partners, etc. If a VC thinks an early-stage company has promise, he’ll want to help out in some way to prove his “value add” worth, and providing introductions is a easy one.
- Receive feedback on when or even if the company will be ready for institutional capital versus private angel investment. Many entrepreneurs I speak with who are starting a company don’t fully understand some of the differences between the capital sources, the ramifications of raising from either, and when (or even if) in a company’s life-cycle it is appropriate for venture capital. Having one or two early discussions with VCs can help clarify those scenarios.
- Obtain important value-creation milestones from an investor point of view. Similarly, an experienced venture investor can share valuable thoughts what achievements and traction points a startup must reach before it becomes attractive to an institutional investor.
- Establish a relationship and assess fit. VCs like to fund people that they know, so if you can develop a real connection and dialog with him before you’re actually out fundraising, it definitely aids in that process. And more importantly, an entrepreneur can use (an) initial informal conversation(s) to get a sense of if there’s a match, both in investment profile and intangible interpersonal dynamics (i.e. personality fit).
- Demonstrate your ability to execute. The best way to sell a VC on your startup is to tell them what you want to do and how you’re going to do it - then actually go accomplish that plan. It’s much better for an investor to “see a movie rather than the picture” as a way for him to assess the capacity to perform. An early conversation empowers an entrepreneur to set goals and benefit from achieving them. VC deal with a lot of startups, so they are very aware that plans and timing do always change. Having a relationship with a VC allows him to understand why those changes happen to see (and get excited about) the accomplishments as they happen.
In many ways, the old adage is very true: the best way to receive funding is ask for advice, and best way receive advice is to ask for funding. So I do believe there are real benefits to informal conversations with VCs before you’re really fundraising – in moderation. After all, entrepreneurs ha ve a company to build. And venture investors are just one of the many many different constituents that are important to speak with early in a company’s lifecycle.
However, it’s important to realize that as soon as you present your idea to another person within the firm beyond your primary contact, you’re officially fundraising. This situation means that your best foot should be forward. At this point you’re not seeking feedback and help, but rather you’re seeking investment. And if you’re looking to optimize the outcome of a fundraise, you should be talking with more than one capital source.
Some would argue that if you’re talking with VCs that your company will develop a reputation in the marketplace of being “shopped around.” But again, I would draw a distinction between individual conversations and presenting to more than one person at the firm. Scuttlebutt in the marketplace is just that, and is a reflection on reality. If you really are actually fundraising for a long time then that reputation will indeed develop; but if you’re truly seeking open advice/feedback/input/connections, that will resonate instead especially if you set those expectations in the conversation.
So what is the entrepreneur at the beginning of the post doing facing his situation? He put the full partnership pitch on hold and is starting a real fundraising process when he is ready.
COMMENTARY: Besides speaking with the startup founders, researching the industry and competitive environment, determining if the startup is filling a real market need, and obtaining proof-of-concept, I don't normally like contacting VC's for their advice about a particular idea or technology. It is just too early. I almost always prefer to do a conference call with the firm principals with the intent of performing a cursory due diligence and feeling out the team for competence, motivations, personality and committment to the venture.
Courtesy of an article dated March 25, 2010 appearing in Genuine VC
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