Three Things Every Lawyer Needs to Know About Venture Capitalists
If I've heard it once, I've heard it a million times. You probably have too. A bright-eyed young entrepreneur comes into your office, shares his or her vision for starting a new business, and says “I hope to work myself to the bone for three or four years, build a good foundation, and then get some VC funding to turn it into an empire.” What's a lawyer to do? Jot down “client goal to seek VC funding in a few years, circle back when needed” and call it a day? How would you go about helping a client find a VC to invest in his or her business, let alone aid in the critical negotiations? While volumes can (and probably will) be written on this topic, here are the top three things you need to know about venture capitalists and how they work.
- It's All a Numbers Game, and You Need to Start Playing Now
Your best client calls and requests your presence at a key meeting with a VC. You are happy to help with such an important task. The session begins with a little chitchat and quickly turns to business. Getting into the flow of things, the VC tells your client that to invest in the company, he needs to get an IRR in the projected exit year of at least 45%, but the DCF his team used to calculate the value of the business came up with a projected EBITDA (Earnings Before Interest, Taxes, Depreciation, and Amortization) in the exit year of only $1 million, which means that the company would need to hit an EBITDA multiple of 10.0 to reach the desired level of IRR, but the average EBIDTA multiple in the client's industry is only 5.5. Everyone at the table may be wondering, "What the hell did this guy just say?".
All of the above used terms are standard financial jargon relating to how a business enterprise can be valued and, perhaps more importantly, how the future value of the business can be projected to grow (or shrink, as the case may be). We will get into what these terms mean another time. The important thing to focus on now is that venture capitalists live and breathe the terms of finance and accounting. That means you need to at least have a working knowledge of what these terms mean as well. At least, that is, if you want to represent your client competently. The time to learn things how to read a balance sheet, an income statement, and a statement of cash flows is now. You also need to understand the basics of how a business is valued and the different types of methods used to do so. No one should expect you to be an accountant – you are a lawyer after all – but you can't properly counsel your clients in this arena if you can't understand what the key players are talking about.
- VC Firms Have Their Own Goals and Motivations, and You Need to Understand Them
This one should be simple, right? VCs want to make money, so all your client needs to do is show the VC how that will be accomplished. This is true, of course, but the reality is more nuanced. Venture Capital is akin to gambling: a VC firm invests money in many different companies knowing that sometimes the company will fail (and thus the investment will be lost entirely), sometimes the investment will only break even, and, on rare occasions, the investment will turn a nice profit. This is an inherently risky business. As a result, VCs are always on the lookout for ways to minimize the risk of making a losing investment while at the same time maximizing the odds of hitting a home run. Note that I said the object is to minimize risk, not eliminate it, which any VC knows is impossible.
The interests and motivations of the VC firm and the individual VC analyst, however, may often be in tension. An individual VC who never loses or makes money, but only ever breaks even, is not destined to have a long career. VCs accept some level of risk because taking on risk is the only way to make a profit. And the bigger the profit, the better the individual VC prospers. At the end of the day, the VC hopes that the profits far outweigh the losses.
How can this knowledge be used to help your client? By knowing the motivation, you can help the client avoid unforced errors. Avoiding obvious “red flags” that may signal unwanted risk is the best way you can help your client. Does the business look like it is run as a professional operation or a hobby? Are corporate forms and standard accounting practices always followed, or does the owner treat the company like one big piggy bank? No VC is going to invest money in what appears to be a shady or shoddily-run outfit. This is where your job as a counselor really comes into play and can help your client make a good first impression.
- Quality is King, both in Product and Personnel
Finally, lawyers need to understand how important quality is to VCs. Venture Capitalists ideally look for two things: steady and responsible leadership with a clear vision and a great product or service that people want. Having only one of these things will not be enough. This can be seen as a follow-on to the prior point. No one is going to invest in a company with a subpar product. A company with a great product may attract funding, but if the business leaders have no idea what they are doing or are irresponsible, they will be given a pass. This is yet another area where the lawyer's role as a counselor is essential. If you can find a way to help your client grow into a responsible leader of his or her business, and if your client develops the product well, then you will have done your job.