How to Finance Your Business with Venture Capital

Few venture capital funds invest in the infancy stage of a company, and those that do are likely to insist on significant changes.
Hossam Salib took a layoff package in 2002 from ADC Telecommunications, where he managed a team of product developers, because he wanted to start a new company in the telecommunications industry. He started shopping his idea for Aktino Inc. of Irvine, California, to West Coast venture capitalists. At the same time he brought in three other founders¡ª Ben Itri, Michail Tsatsanis, and Ray Nagele¡ªwith strong backgrounds in communications systems, product development, operations, and telecommunications regulatory issues¡ªto take the idea to the next step.
Venture capital firms raise hundreds of millions of dollars from wealthy individuals, companies, and institutional investors for the purpose of buying an ownership piece of young, fast-growth companies. Venture capitalists (VCs) won’t even look at most firms, and they invest in less than 1 out of every 100 deals at which they do look. It is often said that VCs don’t invest in small businesses; they invest in young, big businesses. Even the best VCs have imperfect forecasting skills. In baseball parlance, they expect 1 out of 10 investments will be a home run and 3 others will be doubles. The riskiest point of investment is at the idea stage that Hossam was shopping around in 2002.
“Convincing somebody when you have nothing is very tough,” says Aktino chief executive Bruce Kimble. “You have to execute or you don’t get the money.”
One of Hossam’s pitches was to Foundation Capital in Menlo Park, California, which specializes in telecommunications, e-commerce, and Internet technologies and is willing to take a hands-on role with start-ups. One of the key values of VCs at this early stage is their ability to introduce entrepreneurs to industry leaders and key individuals who can strengthen the management team.
Even before making any investment, Foundation Capital worked with Hossam to scale back his complex and expensive idea to one more likely to get off the ground and receive initial and follow-up investments. Aktino became a producer of a family of products that would enable telecommunications companies to deliver high-speed services to customers over existing copper-wire systems. While major telephone companies have invested heavily to convert to fiber optic lines, Aktino can serve about 1,400 smaller and rural companies that can’t afford that conversion. The Foundation Capital VCs went with Hossam to talk with several potential customers about their likelihood of using Aktino’s products if those items were developed. Companies are loath to make a commitment or even give statistics to startups, even in the company of well-respected VCs, but these conversations helped Foundation Capital assess its risk of investing in Aktino.
Foundation Capital and Aktino founders put together the terms of an $8 million seed round of investment. But the VCs had one more demand: strengthen the management team with either a new chief executive or vice president of engineering. Aktino brought in both, Bruce Kimble with 20 years of management and operating experience as the chief executive, and Willen Lao with more than 10 years of experience developing DSL technology as chief engineer.
Aktino’s experience illustrates why many entrepreneurs avoid venture capital investment at the earliest stages. Demands to reshape the company, the concept, the market, and the management team are common. Entrepreneurs have to be highly flexible to secure this type of funding. Sometimes the VCs’ demands are essential and correct, and sometimes they are disastrous. Aktino’s flexibility secured not only Foundation Capital’s support but seed investments from two other funds and a second investment round of $17 million in the fall of 2004 when the first products were delivered to customers.
Kate is a financial consultant and a part time blogger who loves to write on business articles,she has written this article for William Lauder.