• Current Issue • Ad. Rates • Writer's Guidelines • Archives • Circulation

Minnesota Technology Magazine - Fall/Winter 2006

The Million Dollar Question

What are VCs and angel financiers looking for? A safe return on their investments. Here are steps you can take to provide that—and get the funding you need.

BY SARA AASE
Sara Aase is a Minneapolis-based freelance writer.

The Million Dolar Question To land its $12 million private equity investment last spring, Destineer Studios, a Plymouth-based videogame producer, spent about eight months holding face-to-face meetings with 40 venture capital firms (VCs) spread throughout the United States. That's 80 hours of meetings, plus travel time. "People generally say you'll speak with 30 to 60 venture capital firms before you end up being comfortable," says Peter Tamte, Destineer's founder and president. "You want to know what the real deal is, right? You're not going to take the first offer that comes in the door."

Destineer ultimately went with Buenos Aires-based Exxel Group, after it met with the firm in its New York City offices. But the close of the Destineer deal is something of an end to the story. VCs and angels ultimately invest in only a tiny percent of the hundreds of proposals they see, making the question, "What do they look for?" the one that startup CEOs want answered. You have to look to the back story—or the untold hours of work that went into each company's initial success, and the homework its leaders did before they approached potential investors—for answers. VCs and angel investors will tell you that each success story has the same components—what Mac Lewis, founder of Minnetonka-based technology venture firm Sherpa Partners calls the three-legged stool:

A well-differentiated plan to make money
A large and growing target market
An experienced management team.

Michael Gorman, managing director of Minneapolis-based Split Rock Venture Capital, says there are specific elements that need to be in place for a deal to be considered. "In all venture investments, venture capital investors are looking for a combination of a compelling market opportunity where a new idea or technology will materially change the dynamics of that marketplace, and make an impact on a large market portfolio," he says. "And that has to be married to a management team with the skills and background to translate that promising idea into a compelling business."

Potential rewards

On the flip side, it's just as important to consider the capabilities a venture firm brings to you, and to weigh the risks and rewards of a partnership. "Entrepreneurs should do due diligence before they invest time into a VC firm," says Dan Carr, founder and president of The Collaborative, a Minneapolis networking organization that hosts an annual venture finance conference. "You don't pick up a phone book to do this."

Get a referral, Carr advises. Find out what the VC's reputation is in your industry, and how its portfolio of companies has done. Talk to the portfolio companies that failed. Ask around—chances are you know someone who knows someone who works at a venture firm you want to approach. "You should know why it makes sense for you to talk to them," Carr adds, noting that a tight marriage of interests, market knowledge, and capabilities will bring far more value than money to the table. "They bring a ton of contacts that can help you open sales channels, do hiring, and potentially do future fundraising with investment banks."

Ultimately, both parties seek relationships they hope will last for many years, says Jeff Liebl, vice president of marketing and business development for St. Cloud-based xTech, a data mining firm that offers its technology to direct marketing companies. Last spring, xTech got $8 million in first-round financing from Split Rock Ventures. (Prior to joining xTech, Liebl spent eight years in Silicon Valley, where he brought Ubiquity Software public on the London Stock Exchange.) "What you want from a venture finance group is a partnership to help grow the business together," he says.

Potential risks

At the same time, before taking the plunge, executives should understand the bottom-line realities driving a venture deal. Especially if things go wrong. It's helpful to keep in mind that investors typically want to see a path to profitability of a year to 18 months, and will want to cash out within five to seven years—meaning your company will go public or be acquired. That can mean that your financing partners might ask you to step aside as CEO, or seek to liquidate the business faster than you'd like. "Entrepreneurs need to understand how investors would make money," Lewis says. "If I ask you, 'Are you willing to step aside if you're not right for the job,' and the answer is 'no,' then you should probably rethink. To take funding from people, the implied deal with the investors is they're going to do whatever it takes to maximize the value of that investment."

Angel or VC?

WHAT'S THE DIFFERENCE, ANYWAY?

Typically the size of the initial investment, size of the firm, and how much early influence it wants to exert separates angel and venture capital investors. An angel might be able to invest, say, $200,000, an amount too high for friends and family and too low for venture firms. But the lines are hardly clear-cut. Minnetonka-based Sherpa Partners, for example, calls itself an early-stage venture firm. Its fund, currently closed, invested amounts of $250,000 to $1 million into early-stage technology companies. TC Angels, a new group of 38 angel investors, invests from $50,000 to $2 million in medical and information technology companies, as well as other companies that fit the group's diverse backgrounds, says chairman John Alexander, who expects his group to invest in eight to 12 companies. (In October, TC Angels announced its first investment. The company is Edina-based UnityWorks! Media, which produces streaming video ads and other video content.)

Both Sherpa's Mac Lewis and Alexander talk about "adding value" to the companies they invest in, in the form of coaching and advice. The only area where they might differ is in degrees of maturity. Lewis says Sherpa wants to see companies more fully up and running, with more management in place than an angel might expect. One element that remains the same for both kinds of investors, though, is unstinting focus on growing at a pace that will ensure a rapid, profitable return on investment.

—S.A.

Case Study: Destineer

With all of the above in mind, here's a look at how Destineer navigated its journey to venture financing, plus advice and insights from other local companies, VCs, and angels.

AN EXPERIENCED TEAM

Tamte successfully built computer software and videogame companies (MacSoft and Bungie Software, makers of the Halo videogames) and worked for Steve Jobs at Apple Computer before founding Destineer Studios in 2001. In 2003, successful video game entrepreneur Paul Rinde (WizardWorks Group and Atari) joined Destineer as CEO. Destineer sells videogames and develops military-training simulation programs, and in 2005 attracted funding from In-Q-Tel, a private venture group formed by the Central Intelligence Agency (CIA).

What if you have great business potential, but a short resume or virtually no team? This is a common but not insurmountable problem that many startup entrepreneurs face. "Surround yourself with a board of directors or an advisory board of people who have that experience," Carr advises. "You can't always be fully decked out with a management team if you haven't raised money, so identify the holes you have on your team and show the VCs how you would propose to fill those holes."

A GROWING MARKET

"For a long time the large videogame publishers have funded the industry," Tamte says. "But pure growth is causing VCs to finally look at this market."

Tamte and Rinde knew they wanted to seek further funding to take advantage of a market that's expected to expand to $50 billion by 2009. Many otherwise great businesses aren't attractive to venture firms if they aren't playing in a large market from which they can grab a sizeable piece, Gorman says. "They want to see revenues of $100 million when you're up and running—and the potential for a $500 million to $1 billion market down the road," he notes.

A COMPELLING MARKET NICHE

The investors Tamte met with liked Destineer's hard-to-duplicate business model, built on a connection between creating training simulations for military organizations and commercial videogames adapted from that knowledge. Also, Destineer is one of the few firms in the industry that is both its own game developer and publisher, which means it retains more rights and, therefore, revenue streams from its products. "We can capture a larger portion of dollars from sales," Tamte says, noting that fact makes Destineer attractive as an investment. "We have a better ability to grow the overall valuation of our business." Fast, profitable growth, in turn offers a good chance of a tangible payoff for investors. "Products that have high gross margins help the business fund itself," says Gorman. "They're helpful to growing a business quickly and profitably."

PUTTING IT ALL TOGETHER

Having all the components to attract financing is just step one. Next, you'll pour a lot of energy into analyzing your business growth potential and goals; how much money you need; who represents your best financing prospects (and how to be referred to them); and preparing a concise, polished executive summary, PowerPoint presentation, elevator pitch, and the backup research required to help a venture capital firm through the due diligence phase.

These guys see thousands of business plans a year, so you've really got to grab their attention up front. THE PRESENTATION

You'll need to prepare (in reverse order of how you'll present them, a business plan) a PowerPoint presentation, and an executive summary of about two to three pages. The business plan should include:

definition of the product or service
target market
value proposition
sales/distribution model
advertising/marketing model
cost of acquiring new customers
analysis of your competition
overview of management team
how much money you'll need to raise
the expected break-even point
the expected point of profitability
exit strategies.

You'll extract the PowerPoint presentation and executive summary from the plan, Lewis says, as well as your "elevator pitch," or your ability to describe the business and investment opportunity in about 20 seconds.

Venture firms ask for the executive summary first, making it the most critical piece. "The introductory sentences have to explain how you're going to make a lot of money in a unique way," Tamte says. "If you can't boil it down into those couple of sentences, you have to keep working at it. These guys see thousands of business plans a year, so you've really got to grab their attention up front."

If your executive summary passes muster, you'll be asked for a formal business plan or presentation. Roughly half of the firms Tamte approached then showed enough interest to ask for follow-up documentation such as market research, sales summaries of particular products, and competitive information.

NEGOTIATING

Entrepreneurs sometimes complain about a lack of confidentiality or onerous deal terms when negotiating with venture firms. "Watch out for people who are just trying to borrow information," says Robert Weber, CEO of Sartell-based Freeze.com, an online marketing firm that raised $15 million in a first round of financing from Boston-based Alta Communications in the last quarter of 2005. "Especially with a firm that might work with businesses competitive to your own."

Having been on both sides of the venture fence, Lewis understands the trepidation about confidentiality, since most venture firms will not sign nondisclosure agreements. "A firm doesn't want to get sued by someone with a plan they saw two years ago with the same idea but a totally different market and execution strategy as the one they're funding today," he says. The solution, he adds, is to go with your instincts and disclose only what you're comfortable in disclosing. "We say at the initial meeting that we don't need to know anything that detailed about your technology."

Tamte says he was "shocked" at the deal terms some VCs offered, which he felt left little incentive for him to stay with the company after it would be acquired—a term the buyer will often stipulate to ensure a smooth transition. "You have to be very careful and think about what's going to happen three and four years down the road," he says. "It's a given that you have to provide a strong rate of return for the VC. The question is in the nitty-gritty of what happens when things don't go exactly according to plan."

Lewis says it's important to remember that VCs want to succeed as badly as you do; they must answer to shareholders, and if they screw up, they won't get to do another fund. "Sometimes venture firms are jerks, put out terms that are totally selfserving, and may not be good partners," he says, adding that those reasons help highlight the importance of due diligence and picking firms for reasons other than just money. "I encourage entrepreneurs to get to a point where two to three firms want to invest. Then you can be relatively sure you're getting an arms-length set of terms."