I’ve talked to a few entrepreneurs in recent days who are credible operators but have never raised early-stage venture funding in the past.  I thought I might start a short series on demystifying the VC Process with some of my own thoughts and a link or two to the blogs of other folks.  There has certainly been a lot written on this by other VC’s, entrepreneuers, and bloggers.

I’m starting with Financial Plans – counter-intuitive I know.  No rhyme or reason really… it’s just on my mind.

The strange thing about financial plans for early stage companies is that they are always wrong.  So what’s the point?  Brad Feld had a post on this a while back.  In my opinion, there are 3 things that VC’s are looking for in a financial plan, at least in the early stages of evaluating an investment:

1. What are the levers of this business? What are the core assumptions that drive the entire viability of the business model?  Does the entrepreneur understand this? Are the underlying assumptions at least in the ballpark with other companies with similar characteristics?  Usually, I try to get a feel for this in a first meeting, and also try to get a feel for what needs to happen in order for the company to scale.  In subsequent diligence, I might do some deeper sensitivity analysis to see what the business looks like under different scenarios.

2. What is the mindset of the entrepreneur? There are two subcomponents to this.  On the cost side, I’m trying to understand how agressively the entrepreneur is going to spend her capital. While top line assumptions are hard to forecast and largely out of a manager’s direct control, spending is something that can be controlled and forecasted.  Looking at expenses are helpful for #1, but also to get a sense for the pace at which the entrepreneur wants to grow the operation, what she deems as the highest priority items to accomplish, and how efficiently she thinks she can run the business.  This is where pattern recognition is helpful, as we are able to benchmark the spending expectations of an entrepreneur with other companies that we’ve been involved with to see if the entrepreneur is being realistic and if we can be helpful in this way.

The second component is to understand what kind of a company the entrepreneur is trying to build.  Does the entrepreneur see this as a company that can go public?  Is it the kind of company can could get sold in 2 years for $15M with modest investment?  Is it somewhere else along the spectrum?  Diffferent investors have different philosophies about the kind of companies they are hoping to fund, and the financail plan provides a high-level read of the scale that the entrepreneur is shooting for.

3. What will it take to get to the next financing? This is the most practical question that I ask myself.  The hope is that the investment I make either takes a company to profitability or allows them to raise more capital in the future at a meaningfully higher valuation.  Growing a large and successful company is rarely a linear process, so I spend a lot of time thinking about how to make sure the next 12-24 months significantly enhances the company’s value.  For example, a company building an expensive MMOG would require significant initial capital, and probably will require an additional raise before the first paying customer plays the game.  The entrepreneur and the investor needs to be wary of this, and think about what other tangible milestones will be necessary to make sure they get appropriate credit financially for all their sweat and progress.

Parting Thought: These three considerations are just a starting point, but hopefully clarifies how I think through the financial plans I come across.  But one concern I have is that entrepreneurs may try to game their plans to produce numbers that “fit” a particular VC’s model.  I think this will ultimatley hurt the credibility of the entrepreneur and does a disservice to the business.  There are a variety of different financing options out there, and it’s important for companies to choose the option that fits the stage and operating plans of the business.