Company Logo Saturday, October 22, 2005

Repeat players boost venture capital

RON DERUYTER, RECORD STAFF

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Entrepreneurs who have a track record of starting and running successful businesses are dream investments for venture capital funds.

They know how venture capital works and have lots of credibility.

"Repeat entrepreneurs are a reasonably easy investment decision," Ron Dizy, a partner in Celtic House Venture Partners, said this week during a panel discussion that explored the mysterious world of venture capital.

But repeat entrepreneurs don't walk through the door every day.

About 20 to 30 per cent of the venture capital deals Ottawa-based Celtic House does involve repeat entrepreneurs. The rest are first-time entrepreneurs who aren't familiar with the ins and outs of venture capital and have to prove they can hit the home run that will make the high-risk investment in their firm pay off.

The panel discussion, titled What Goes On Behind Closed Doors, was held at the Waterloo Inn and organized by the Communitech technology association and PricewaterhouseCoopers.

The panellists -- Dizy, James Goldinger of TD Capital, Tim Jackson of Tech Capital Partners, Les Lyall of GrowthWorks, Ron Patterson of MMV Financial and Mark Usher of RBC's technology banking group -- covered topics such as the ideal deal, the investment process, problem areas, the pitch, valuations and the relationship after the deal is signed.

THE IDEAL DEAL

Most funds invest in early stage companies, firms that have great ideas but minimal sales. They generally look for three things -- breakthrough technology, a good management team and a big market opportunity.

Jackson said Tech Capital, a fund that invests only in firms in the Waterloo Region area, looks for disruptive technology, technology that will change the way people do business.

Disruptive technology has potential to generate significant sales and increase the value of a company to hundreds of millions of dollars so that the fund can get the return on its investment, typically 30 to 40 per cent a year, it needs to satisfy its investors, he said.

Lyall, senior vice-president of GrowthWorks, a fund that manages $800 million in assets, said the strength of the management team becomes increasingly critical as a company grows and seeks additional rounds of venture financing.

"I would rather see strong management and a not-so-great business plan than a great business plan and weak management," he said.

THE INVESTMENT PROCESS

Firms looking for venture capital should approach a fund through someone the fund already knows.

"If a deal comes over the transom with no referral, there is a low chance of getting funds," Dizy said. "It is not that we wouldn't love to spend a day on every deal that comes in. We can't. There are too many of them. We have to find ways to filter them."

So far this year, Tech Capital has looked at 140 proposals. Jackson said it did "light-duty due diligence" on 28 and "heavy-duty due diligence" on just three of them. It issued a term sheet, the document that describes the terms of a deal, in just one case.

Goldinger, investment partner in Boston-based TD Capital Ventures, said entrepreneurs have to make sure they approach funds that have a focus and style that suits their business. You are hiring someone who will be on your board and have a lot of control over your business so you need to make sure you hire the right person, he said.

PROBLEM AREAS

Nothing bugs venture capitalists more than over-selling the business and its prospects.

Dizy said business owners will tell him they have no competition, but a search on Google quickly indicates that's not the case. Or they will name blue-chip customers. But when you question them, "they will say: 'I saw a friend at a wedding who knows someone at Sony'," Jackson said.

Dizy joked that he would be disappointed if a start-up's Power Point presentation didn't include a "hockey stick" growth curve. But stretching the truth is a mistake, he said.

"You need to be as aggressive as you can be in your slides, but you still have to be credible," he said.

THE PITCH FOR MONEY

Short is better than long, Dizy said. Thirty minutes is enough to explain why your technology is so great.

Some entrepreneurs question whether the fund will understand their technology. But the onus is on them to make sure the fund understands its significance, Dizy added.

The pitch is a simple process at Tech Capital. A business plan isn't required, Jackson said. "We just need answers to three questions: What is the technology; who are the people; and what is the size of the market?"

Credibility is the key, Lyall said.

Venture funds are "swinging for the fences" when they invest in a start-up, so you need to deliver on your promise to hit a home run, he said.

VALUATIONS

The dollar value of an investment prospect determines how much ownership interest a venture fund will take for the funds it invests.

It tends to be a contentious issue because business founders want to get as much money as possible while giving up as little ownership as possible. Venture capitalists want the largest ownership stake possible in return for the funds they put in.

"Valuation is very serious," Goldinger said. "The penalties for screwing it up are high, both if you value it too high or value it too low."

If the value is too high, the company's value won't grow enough to give the fund a sufficient return. As a result, it may block efforts to raise more money or sell the business, he said. If the value is too low, the founders won't be motivated to grow the business.

"The only time it works is if it is a win-win situation," he said.

Tech Capital typically takes a 50 per cent stake for investments of $1.5 million to $2 million. That may seem high, but it reflects the risk of investing in early-stage businesses, Jackson said.

Business founders sometimes get too worked up over valuations and the size of their stake, he said.

"At the end of the day, whether you as founder own 10 per cent or 15 per cent or 20 per cent, if it is a successful venture-backed business, you are going to make an awful lot of money."

AFTER THE DEAL

Venture funds don't disappear after they hand over the money. They sit on your board, and demand to be kept informed about what is going on.

"It is a highly-disciplined environment," Lyall said. "These people are expecting you to deliver."

The funds have plenty of experience and are there to help, Dizy said.

"Treat them as a sounding board. The best CEOs we work with aren't the ones who say: 'This is what we are doing.' The best ones say: 'Here is where I'm going. What do you think'?"

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