Raising Money From Venture Capitalists Versus Investment Banks.

Q: We’re a small startup with an innovative product in the social-networking / communications / UGC monetizing realm, at a pre-alpha stage of development. We have a number of potential deals on the table, the most attractive of which is to raise a large sum ($4mm) through a private placement with an investment bank. This deal has no strings attached, comes with a very high pre-money valuation and would cover two years of operating costs – SOUNDS GOOD TO ME!

Every VC we’ve met with expresses what seems to be prejudice against investment banks and the strategy we are considering, pointing out that they, the VCs, are the “smart money” with the “contacts” and “experience” as well as some other arguments as to why we should give up WAY more of our company to THEM for WAY LESS money.

What’s your word on this conundrum? My partner and I have talked to a number of entrepreneurs and they all say “stay away from VCs, take the money and run your business!” In fact, most of the people we talk to have had very negative experiences with VCs and question the notion of “smart money” altogether.

A:  (Jason)  It goes without saying (but I’ll do anyways) that I think reputable VCs are indeed smart company builders who will provide learned guidance in how to build your business and provide much more to your success than just money. 

I’m not here to bash raising money from investment banks – plenty of our companies at some point in their lifecycle do just that, but consider some of the advantages raising money from a VC versus an investment bank:

– Venture Capitalist will add a lot more value as board members being professional small company board members;

– Venture Capitalists will price your deal accordingly for the funding round.  Banks have been known to price early rounds too high and thus making future rounds very hard to consummate without diluting your first investors;

– Venture Capital financing will normally bring 1-3 shareholders to your company, whereas investment banks tend to bring many different individuals.  Consider information requests, annual meetings and issues involving dealing with individual shareholders if your business does not scale as planned; and

–  The bank may not be able to raise the money.  It’s not investing personally, rather attempting to find others to invest in your company. If they fail, you’ve wasted a lot of time and money drafting a PPM, etc. – documents that you wouldn’t create if funding via a venture capitalists.

As for “no strings attached” – I’m not sure what you mean, but banks only get paid if they get the deal done, so make sure they have your interests in mind, not just theirs.

One last point: I’m not sure where you are located, but in our neck of the woods, I think most entrepreneurs have had positive experiences with the VCs.  Again, you need to make sure they are reputable, but most professional VCs dealing with sophisticated entrepreneurs have good experiences together in both successful and problem-esque companies altogether.

  • sir , im new in enterpreneurship, i need VC for my project, sir can u tell something about how to prepare project report which is send to VCs

  • I think at the end of the day, what makes investment bankers and PPM route attractive is that it’s much easier to get their attention and interest.
    I realize it’s not impossible to get the opportunity to pitch to VCs, but it’s a long road if not already connected to the community.
    The due diligence process and road ahead with a VC firm is also (as far as what I’ve read) longer, more complex and never guaranteed until the papers are signed.
    For some of us, we just want the money so we can do what we are dreaming of achieving with minimum red tape.

  • I think there are a few other reasons to fund early stage companies through VCs:
    1. If the company goes south in a year or two there is almost no risk of lawsuits from VCs; with individual investors this is a very real risk
    2. Dealing with a bunch of investors who are usually unsophisticated can become very time consuming and totally unproductive; while the VCs demand time their objectives are to build the company
    3. If you have not successfully built a company before you are likely to make a lot of mistakes which most VCs can help you avoid
    4. If the company performs, even if you miss the plan, the VCs will usually be there for the next round of capital raising; with individual investors there is no comfort that they will fund you in the future
    5. I have worked with VCs a couple of times as a CFO and my experience is that things get disagreeable when the CEO can not realize the error of his ways despite several attempts.

  • Robert,
    Those are all good and valid points you make.
    Although, even through the PPM route, you only accept accredited investors and always ensure they sign appropriate documents which state they are entering into a high risk investment.
    More VCs are becoming interested in providing seed money, but that is not what the majority of VCs invest in. If you cannot self-fund or bootstrap the company to a certain appealing level for VCs, you do limit your options for funding sources.
    A lot of entrepreneurs will tell you that they rather have the reign of their companies. Is that taking higher risks? Sure is, but that’s why we’re entrepreneurs!!
    I guess it boils down to, I don’t disagree with what VCs have to offer but it’s not easily accessible and the alternatives are good options for the right company and people.
    A company with a good solid income model doesn’t necessarily need to consider the VC route. Many companies who use VCs require a lot of upfront support to test, prove and bring their technology or product to market.
    Their are just so many factors to consider. That’s why this blog is so great to read!

  • Ann
    My thoughts on A Round capital and when you are ready are here http://sophisticatedfinance.typepad.com/sophisticated_finance/2007/07/a-round-capital.html

  • Donna Murdoch

    Although I would never throw stones at another investment banker (I am one myself) – the first thing that concerned me in your story was the “very high pre-money valuation”. Realize that your banker is not offering you that amount of money, as you would be offered by a venture capital firm. They are telling you how they will try to “sell” your deal to potential investors and what they hope to get. Make sure it is a fair, comparative valuation – and not an attempt to sell you on the firm and what they can do for you. Until it is done, it is not done. It is all done on a “best efforts” basis.
    Of course if the banker has many private clients and it will be done through high net worth investors, there is more of a chance they will achieve a pre-determined valuation. But if they are approaching institutions, that is not the case.
    I will tell you that, although we do try to give our clients a general idea of what they can expect in a valuation (verbally) – we rarely put valuations on deals any more. Because it doesn’t matter! An institutional investor will tell you what they are willing to pay, regardless of the valuation on the PPM/Summary. They will also tell you the terms (preferred, common) – and although there must be a baseline for some of these items in a book – realize they are just that. A baseline. The investment banking firm is saying “we will try to get this”. But it is always done on a best efforts basis, with no guarantees.
    The market will price itself when it comes to institutions – and you will get a fair price (assuming you get some offers/term sheets)
    HOWEVER, the right investment bank will also have contacts – and help you in many decisions. They will help you get READY for VCs, help you refine and present your pitch, define your message, narrow your search to the firms who are most appropriate for your deal.
    BUT, remember, it is not an offer or a guarantee. There are so many benefits to having a good investment banker (I’ve written other posts) – but it is important to recognize the difference. You really only have one offer on the table (the VC). The other offer is saying “we will try to get you a better deal” without a guarantee of what it will be.
    If the banker is good, they will help you sort through offers, and help you negotiate terms. They’ve done it so many times, and will have ideas for negotiation that you would never think of. You are paying them (downside) but they only work for you (upside) and thus are your advocate.