Valuable Advice on Venture Capital Funding

This fall, I had the honor to become involved with the Center for Entrepreneurship (CFE) at the University of Michigan. CFE, to my surprise, is not housed within the Ross School of Business as you would think—rather, it lives within the College of Engineering.

Why is that?

Well, CFE’s tagline, which has always rung true for me, is “the commercialization of innovation”. Keeping that in mind, its placement in Michigan’s engineering school—with its ability to produce consistently extraordinary innovation and innovators—makes perfect sense.

Recently, we were fortunate to have Paul Brown—U of M regent and managing partner of a venture fund called eLab Ventures—visit and speak to our class about venture capital (VC) funding. Fun fact: Paul held my current position at CFE last year—co-teaching Finding Your Venture with Brian Hayden.

I wanted to share a few golden nuggets from Paul’s presentation that you might find helpful in your journey through entrepreneurship.

The Structure of Venture Funds

Paul explained how venture funds—the legal entities that hold the assets—are organized and why understanding the structure is critical to success. Managers of venture funds raise money from investors and do so by convincing them that the strategy they plan to employ is smart and sound.

The manager of the fund makes commitments to the investors and then has to live up to them. If they don’t live up to their commitments, they will struggle moving forward and, worst case scenario, could end up getting sued.

For example, a VC firm may have pitched the strategy that their fund was going to invest in startups focused on solving big data issues at Fortune 500 companies. If you bring them an idea in the consumer goods space, even if they think it is the greatest idea in history, they can’t invest, and must stay focused on employing the strategy the investors bought into.

It’s also important to understand the magnitude of the fund and what size investments they are capable of making. And this goes in both directions. For instance, let’s assume a venture fund has $60M under management. They are most likely not a good fit if you are looking for $80,000 to get your business through the next six months as you work on your minimum viable product (MVP)—this is more appropriate from friends and family or an angel investor.

If you are looking to build a plant and assemble a sales force in Southeast Asia for $20M, the VC firm is most likely not going to put a third of its investible assets into your project—you need to find a bigger fund.

When approaching a venture capitalist, ask questions about their strategy and their ideal investment size before wasting everyone’s time. Make sure there is a reasonable fit and, if so, pitch away. If not, keep hunting.

Lessons in Venture Capital Funding

During his presentation, I asked Paul, “What makes you run for the hills during a VC pitch?”

His answer was beautiful and simple: if the founder can’t make the value proposition make sense in a few sentences—if I feel like I need a PhD to understand what they are pitching—I am gone. Second, if they can’t provide definition and describe their target buyer, I am gone.

Another question Paul got asked was, “What makes you lean in and need to know more during a VC pitch?”

To this, he responded that if what they are doing hasn’t been done before and solves a major pain point, I lean in. When I realize the customer will be crawling across the table to buy their product, I won’t let them leave the room without a signed term sheet.

Fume Date

Another nugget of wisdom Paul touched on is not waiting until you need the money to approach funding sources. He then used the phrase fume date, which is a VC term for the date you are going to run out of money.

In Grind, I talk about burn rate, which is the cash you are burning monthly. Fume date, however, is burn rate cross-hatched with time to figure out when your business shuts down.

Paul mentioned the simple fact that a short runway to fume date puts the entrepreneur in a precarious position, because they need the money quickly and therefore must settle for whatever terms the VC/banker/investor is presenting.

Ideal VC Pitch

Well before you need the money, start meeting with and developing relationships with funding sources. When somebody presents to a VC and is out of money, it represents poor business management skills and automatically counts as a strike against them, regardless of the idea.

Paul’s ideal candidate will come and present their idea, talk about what they are currently working on and what they will be accomplishing in the next 90 days. Sixty days later, they will give an update that they have accomplished what they said they were going to do and present their next 90 days.

Again, sixty days later they will present a progress update, talk about what they are going to be doing in the next 90 days and mention they are going to be seeking funding in the next 60 to 90 days. Then, according to Paul, the checkbook is open, the pen is out, and he is ready to support this venture. At this point he knows they are well organized and are meeting deadlines.

In essence—put a realistic plan in place, manage your business, execute and meet your commitments, all the while managing your cash. Know your burn rate, know your fume date and, if you really want to be a dream candidate, make moving selling product and generating revenue one of your early commitments you are going to live up to.

Angel Investors

Paul also stressed the importance of the angel investor. These critical investors fund startups when they are simply ideas and are typically funding the process of going from ideation to MVP. While the angel makes smaller bets, they make a lot of them.

An angel investor doesn’t typically bring much in the way of management expertise or strategic guidance. They are simply a funding source that gives entrepreneurs a shot at getting their idea to market—meaning they are not professional investors or managers like venture capital firms. A VC brings expertise and a huge Rolodex to the table—typically, the angel investor does not.

Angel investors are high net-worth people who are putting money to work in extremely risky scenarios. They understand what they are doing and the amount of risk they are taking, and usually use convertible debt that has a term and interest rate. But that’s not what they’re in the game for.

Angels don’t want their money back with an 8% coupon, they want their investment to turn into equity, so when you do end up getting venture funding, they receive a percentage of the company—taking advantage of the discounted rate they originally negotiated. Their ideal scenario is the value of what they invested becoming a percentage of the company during round one venture funding. If their equity value is a factor of 20X more than what they put in, it’s a massive win.

Angel investors take huge risk and look for huge payouts. They make a lot of small investment knowing most are going to fail, but the ones that hit and pay out large make up for those losses, and they get a nice return on capital in the aggregate.

Quick side note: if an angel is looking for you, as the entrepreneur, to provide a personal guarantee, it demonstrates inexperience and you should politely move on to another group.

Find Your Stage

This brings to mind the stages of development for an entrepreneur. You need to make sure you are with a firm that specializes in your stage. Angel, as mentioned before, is the very early first stage. They provide seed money to get an idea off the ground.

Then there are firms like Paul’s eLab Ventures, that are early-stage VC and have great skill at critical things like forming teams, identifying early engineering problems, etc. There are also VCs that have taken many companies public and are suited for round two or three funding.

Understand the value a VC firm is bringing to you based on their experience facilitating other startups through your phase, and make sure they have the necessary skillsets to assist with what you need. Check their references and talk to other companies they have worked with—you are vetting them as much as they are vetting you.

I would personally like to thank Paul Brown for speaking to our Find Your Venture class. Our students and I got a ton of value from the talk, and now hopefully you did, too.