Build Your Cap Table

Key Factors to Consider When Pitching Venture Capitalists

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12 Minute Read
Posted by Wade Myers on April 29, 2022

When raising venture capital for your startup, it’s critical to consider the questions and answers addressed in this blog. Here, Wade Myers, a serial entrepreneur who has founded dozens of companies and invested in hundreds more, shares his wealth of experience in pitching venture capitalists.

Questions to Ask a VC When Getting to Know Them and their Firm

There are two stages of questions to determine a venture capital firm's fit with you and your company: a) questions you want to answer for yourself prior to making contact to qualify the VC in terms of the broader fit and, b) questions you want to ask the VCs once you've made contact to further qualify them since you are considering partnering with them for years.

Before You Make Contact with a Venture Capital Firm

These are the questions to find the answers to before you contact them so you don't waste your time or their time by contacting them. Review these items to make sure they line up with you and your business:


Industry or Type of Business

The firms will always have a specific industry or group of industries and/or certain types of businesses as a focus for their investments, such as “software”, “medical technology”, or even as specific as "SaaS business models”. Having a specific focus both reduces their due diligence time to investigate a potential investment and increases their ability to leverage their industry expertise and network.


Geography

Many firms also have specific geographic areas of focus for their investments – especially Venture Capital firms – that reduces their travel time to portfolio companies and increases their ability to leverage their local management talent and business network.

Size

Nearly all firms have specific investment amounts that they invest in any one deal, such as “$1 million - $2 million per company” or “up to $25 million per company”. This maintains a consistent strategy per their published investment strategy with their limited partner investors, maintains their risk profile and potential returns, and maintains a consistent process and staff leverage.

Stage and Type of Deal

Nearly all firms have a specific stage and type of deal focus for their investments such as “seed capital” or “growth capital” or “buy-out capital”. This focus increases their ability to leverage their business network and their ability to leverage their company stage expertise.

Syndication of the Deal

Most firms have a specific strategy for how they approach investments in terms of working with other investment firms such as “co-investor”, “lead investor”, or “controlling position”. This again helps them maintain a consistent strategy, their risk profile, their potential returns, a consistent process, and staff leverage.

Timing

All firms have timing cycles that they follow in terms of a fund life and stage that affects their ability or willingness to make investments. For example, if a firm is at the end of one fund life and is busy marketing to investors to raise a new fund, they will not have the time, willingness, or even capital to make an investment. Conversely, if a firm has recently closed on a fund, their willingness to do a deal will be high and they will usually aggressively pursue opportunities to build momentum.

Once You Are Engaged in Discussions with a Venture Capital Firm

These are the questions to ask once you've met them to determine whether or not you really want to partner with them:

Firm Experience

Do they have experience with exactly the type of situation you are facing and can they provide significant leverage for you to help you accomplish your goals in addition to the money? How connected are they in your industry? What is the quality of the ideas they are sharing with you for how you can improve your business model and your strategy?

Team Experience

Have they been entrepreneurs as well, or are they finance types that will have a harder time empathizing with what you are going through? Will you get time and attention from the senior partners or will you be stuck primarily with inexperienced junior team members that cannot add the same value? Has the team been together for some time or are they still going through their own forming and storming stages as a team?

Personalities

Do you like them and their style? Are they humble servant investors that truly want to help you succeed or are they arrogant jerks? You are going to partner with them for five to ten years and you want to make you like them and can trust them through the inevitable ups and downs of the early stage.

References

Do they have good references from other entrepreneurs that have lived through all stages of a relationship with them? Can they provide you references to entrepreneurs that failed but would still have good things to say about them and their character?

Process

Can they clearly explain their investment and due diligence process or is it more a "seat of the pants" approach?

6 Mistakes to Avoid When Pitching Venture Capitalists

As an investor, I hear these claims again and again. These claims actually hurt an entrepreneur’s credibility with VC and other investors:

  • "My idea is bigger than Google or Facebook"

  • "We are the Uber of __________" (fill in the blank)

  • "We’ve been focused on product and haven’t had time to meet with any customers"

  • "We need $______ million" (but don't provide any details on how you arrived at that number)

  • "Here's my plan" (a one-page high-level financial forecast with no details, no unit economics, and no backup for that wild Revenue spike or 65% EBITDA that no company on the planet has ever achieved)

Here is a more detailed list of novice mistakes that will raise red-flags when pitching venture capitalists.

1. Unrealistic Revenue Ramp

You may feel that if you don’t show sales of $100m - $200m+ in Year 5 that you may not be exciting enough for investors, but it’s unreasonable to see a plan with that level of explosive growth if you can’t properly articulate how to get there and if your model doesn’t include all of the implications of that kind of hockey stick performance such as copious amount of venture capital, tremendous sales and marketing infrastructure, and deep losses for extended periods of time (consider the fact that Salesforce.com has perpetually lost money with only periodic bursts of profits and spends 50% of Revenue on just marketing expenses). But the issue isn’t just the level of revenue in the “out” years, it’s also several other revenue-related items.

Many plans show revenue in the very first month, even though a lot of groundwork, product development, and marketing are often needed to presage those sales. I’m much more impressed with a plan that shows a launch and preparation phase of a few to several months prior to anticipating any revenue, especially if there is a long product development cycle and sales cycle. Let’s face it: if you have a six-month sales cycle (e.g. it takes 6 months from generating a lead to closing a deal), it’s ridiculous to model any revenue in Months 1 – 6.

Further, many startups build a sales forecast assuming that competitors will never take a bite out of their market or that prices will never be affected. The harsh reality is that competitive advantages will always get competed away and pricing almost always experiences competitive pressure. Startups should plan on lots of market “noise” from new entrants and copycats that will dilute their marketing efforts and at least raise your cost of customer acquisition.

Be careful not to show a plan with cushy annual price increases and ever-increasing growth rates. It’s just not credible.

2. Unreasonably Low Level of Employees and Related Expenses

Starting out with a blank slate and trying to guess at what it takes to build out your idea is hard, and one of the most difficult parts is trying to figure out how many employees are required at various stages of your plan and growth. But getting this wrong can be a real hit to your credibility. I recently reviewed a financial model that showed hundreds of millions of revenue with only 35 employees in Year 5, clearly not a very detailed plan on the staffing model.

But the fact that it is difficult to predict and connect your employees to your revenue gives you an opportunity to impress your investors if you use a high degree of rigor in your financial model.

Because it is highly likely that the vast majority of your headcount will be driven by your revenue scale, it’s important to have a bottoms-up unit economic model where you can tie direct labor, direct sales, and direct customer support to each offering to ensure that your headcount automatically grows in proper alignment with your revenue.

Additionally, many plans completely leave out or at least greatly underestimate the employee-related expenses. Adding an employee is far more costly that just their base salary and in many cases will range between 35% to 50% or more of the base. And, importantly, these employee-related expenses have many different methods of scaling: some are annual expenses, some are flat, some are a percentage of base salary, some are one-time upon recruiting, some are related to turnover, etc. Some should be accrued, such as bonuses. It can be a daunting task to model all of this to be sure.

However, we made this very easy in our Pro Forma model: users input over a dozen employee-related expenses just once and the model automatically applies those assumptions to all employees across four different types of employees and even automatically accrues items such as annual bonuses and properly reflects the impact on cash and the liability on the Balance Sheet. And if you don’t have time to research all of those inputs, with one click of a button, we pre-populate all of those 50+ assumptions for you based on our market research. Easy peasy.

3. Sky High Earnings

I cannot even begin to count how many startup financial statements I’ve seen that show Earnings Before Interest, Taxes, Depreciation, and Amortization (EBITDA) rates of 50%, 60%, 70% and even 80%+ in the “out years”, such as Years 3, 4, and 5 of their plan. Literally, almost every single startup pitch I’ve seen has such ridiculously high earnings rates.

What’s so crazy about that?

We’ve already pointed out the example of Salesforce.com, so let’s consider the fact that even the largest, highest-scale, most valuable and profitable companies on the planet don’t come close to that. In the most recent full year’s financials available as of January 2017, the top seven most valuable companies in the world looked like this in terms of their EBITDA:

  • #1 Apple was at 27.8% EBITDA,
  • #2 Google was at 26.2%,
  • #3 Microsoft was at 23.3%,
  • #4 Amazon was 3.4% EBITDA,
  • #5 Facebook was at 34.7%,
  • #6 Johnson & Johnson was at 27.5%, and
  • #7 Coca-Cola Company was at 19.6%.

When I scan a startup’s financial summary as a potential investor, one of the first things my eye is drawn to is the EBITDA % they are forecasting. It’s my quick credibility check. Trust me: please don’t show an EBITDA over 30 – 35%, even in Year 5. Ever. Potential investors will be impressed if you have a deeper sense of what’s reasonable on the big picture level and if you can speak fluently about analogous business models and realistic earnings.

4. Woefully Inadequate Levels of Capital Investment

Most entrepreneurs dramatically underestimate how much capital is required to fully fund the build-out of their solution, invest in sales and marketing, weather a downturn, hit breakeven, and reach the projected growth rates. I am one of them.

After having launched a dozen or so other startups, I launched a venture-backed company 13 years ago that is instructive. My financial model suggested a $1m initial investment in the software infrastructure, followed by a $0.5m/year software maintenance expense. I poured all of my wisdom of having already been a software CEO for several years into my detailed financial plan (the precursor to what the Startup Financial Model has turned into).

It would be kind to say that I was off by a mile. Yes, the company has grown into an Inc. 5000 company operating in 20 states, but our initial expense was $2m -- not $1m -- and our annual upkeep, updates, and extensions have continued at the rate of at least $2m per year over the history of the company. So, in sum, my “plan” (and it was a rigorous plan) for the software investment/expense for 13 years would have been $7m, but the reality has been $26m, nearly 4x higher than my plan. Ouch.

One of the biggest issues for an entrepreneur that underestimates how much capital they need only becomes clear when they have to go back to their investors to get more money. It’s the quickest way to lose credibility with your board, go through a down round, and suffer massive dilution. Trust me, you don’t want to go there.

5. Astronomical Investor Returns

Part of the issue with these mistakes is that they compound when combined. If you’ve overestimated your growth and earnings rates, underestimated expenses, and underestimated your capital requirements, you will naturally end up with greatly inflated investor returns. I saw one plan recently that showed the Preferred Series A investors getting a 92x return in five years. Yes, that can happen once in a great while, but it would be much more reasonable to show a 5x to 20x return. It just looks plain silly to have a financial model that shows some astronomical number that everyone will know is a total moonshot.

One of the features I built into the Pro Forma Startup Kit is a Cap Table and a very detailed investor return analysis by investor class, from Seed investors to Preferred investors, both Series A and Series B. This gives you the kind of analysis that enables you to make the necessary changes across the landscape of your plan to quickly and easily create rock-solid output that gives you more confidence as you pitch and hopefully leaves your potential investors with nods of appreciation.

6. Weak Support for Assumptions

Business plans and financial models are all about making assumptions such as the size of the market, customer switching behavior, website visitor conversion rates, free trial conversion rates, customer acquisition cost, pricing, contract term and retention rates, billing and working capital assumptions, salary and benefits assumptions, etc. Your financial model is your chance to show the robustness of your thinking, which is an indication to investors of the potential quality of your execution.

But yet this is an area that is often alarmingly inadequate in most business plans. When asked where a specific assumption came from, you don’t want to stumble for the answer or admit that you just pulled it out of thin air.

When I was in the middle of raising $12m in venture capital in the 2002 – 2003 post dot com crash era (when it was almost impossible to raise capital) for the Inc. 5000 company mentioned above, my financial model included scores of critical assumptions. In the notes section of my model, I included a detailed table for each of those core assumptions that showed my market research: the source of the information, the data from that source, and then a bottom-line weighted average of the data.

That average for each assumption was then entered into the model. Every single one of those core assumptions had at least three inputs from three different sources, while some had as many as a dozen sources. And while I did get many turndowns from potential investors – which is typical – I usually got lavish praise for the depth of explanation behind each assumption.

What about Investment-related Expenses?

Are a venture capitalist firm’s investment-related expenses passed onto a startup? It's all over the map. I've raised money from Venture Capital and Private Equity firms from all regions of the U.S. for various startups and middle market companies that I've been involved in and there is no one, single answer. Here are the key points...

Generally VCs and PE firm operate under a fee model of charging annual management fees to their limited partner (LP) investors as well as a carried interest on the upside, however some operate as fundless sponsors (mostly later-stage growth or buyout PE shops) and will charge a lot more fees to the portfolio company because of how they structure their fees.

But despite their investment and fee model, many VCs and PEs will try to get "whatever the market will bear" in terms of fees charged to their portfolio companies.

I've seen some of the bigger brand firms be the most greedy at double dipping by charging portfolio companies simply because they thought they could get away with it. However, that was mostly due to their hubris rather than their skill. LP agreements sometimes will call that out and limit the fees the investment firm is charging the portfolio companies because ultimately it affects the management team's value and the LP's value to the benefit of the VC/PE professionals. FINRA has stepped in as well and clamped down on PE firms charging success fees to portfolio companies for helping them raise or restructure debt.

In most cases, VCs will at least charge travel-related expenses to attend board meetings and in some cases a board fee on top of that. I've also had numerous VCs and nearly all PE firms charge legal and due diligence fees to the portfolio company after closing or even taking those expenses out of closing proceeds.

In one deal, I had three leading VCs involved (all were big brands, all early stage, and all had multi-billion dollar funds) that wired their funds into an escrow account set up by the lead law firm that prepared the preferred investment docs (representing the lead investor) and the law firm netted out their outrageous fees from the escrow first, and then wired me the balance.

Then after closing, when the other two VCs found out what happened, they promptly sent me their attorney's invoices because they didn't want to get left out of feeding at the company trough. So, even though the Term Sheet didn't spell it out and I doubt that any of the funds' LPs knew, I was out $250k in the first week. (Part of the issue is that when the fund tells their counsel to send an invoice to a portfolio company, there is zero accountability and the invoice is usually shockingly high.)

I've also seen PEs charge significant management fees to portfolio companies for their "services." The worst was a deal that I ended up walking away from where their fees were not only very high as a starting point, but they escalated each year. Over a typical 5-year investment time horizon, their fees would have amounted to over $2m charged to the company I was negotiating to sell to them, which would have had a significant impact on me and the rest of the management team as we were rolling a fair amount of equity into the new deal. They explained that it was normal for them because of the low fees they charge their LPs - again it had to do with their investment style and fee model.

So, there is no consistent answer, but it is a good thing to clarify at the LOI or Term Sheet stage. It's often a nasty surprise at -- or after -- closing simply because the entrepreneur did not ask about it or was unaware of how it might work.

Conclusion

Pro Forma’s Startup Kit not only helps you create a killer pitch deck that venture capitalists will love, it also includes standard agreement templates that will accelerate the closing process. Pair this kit with Pro Form’s Cap Table Planning and Financial Modeling apps, and you have an integrated package that includes everything you need–pitch deck, agreements, financial model, cap table and terms sheet summaries–to enhance your credibility with VC’s and accelerate the capital raising process. Get started today!

 

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