How to Get Venture Funding, page 7

The VC Process, continued

If the VC moves ahead, the next step is the due diligence process. The extent of this process varies, but it can be massive. The entrepreneur should expect to explain business and technology issues, and to answer objections based on weaknesses in either the business or technology model. Many pieces of documentation may be required as part of this review, which may be conducted by associates and technologists on staff at the VC, or by consultants hired by the VC.

Assuming the entrepreneur passes the due diligence review, he or she will be presented with a term sheet. The term sheet outlines conditions that must be met before funding, and the terms of the funding, e.g., how much money for how much equity at what valuation. Normally, the VC will receive equity in the form of a preferred series of shares with rights ahead of other shareholders.

The best way to effectively negotiate a term sheet is to have another term sheet from another VC. In other words, you should almost never be talking to just one VC. To be successful, you should be in parallel process and negotiation with at least three VCs.

The question of the valuation of the enterprise is crucial because it determines the percentage of enterprise equity the investors receive. For example, $2 million invested at a $4 million valuation represents a 50 percent stake, while $2 million invested at a $10 million valuation is only 20 percent. Pre-money valuation is the term used for the enterprise value prior to the new investment; post-money valuation is the term used for the enterprise value—which has been increased by the amount of the investment—following the investment.

Different Stages of VC Funding

Different VCs specialize in different stages of funding. Some prefer early-stage funding, and others prefer late-stage funding. More typically, a single venture will pass through various stages of funding as it passes successive milestones. One or several firms may provide that funding.

A seed round is initial funding provided by an entrepreneur, his or her friends and family, angel investors or—in some cases—venture funds. When the seed round is professionally supplied, it will be explicitly intended to achieve specific goals. For example, seed funding is often earmarked to build a management team and to create a product prototype.

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