Once you have successfully presented and interviewed with a venture capital firm, you may undergo a second round of qualification in order to be considered a “finalist” for venture funding.  In this process, one of the important steps a VC firm must take is valuating your start up business.

What is business valuation? And how does a VC firm valuate a company that is not yet earning revenue?

Below are a few ways that a VC firm analyzes your product, people, and markets to determine whether a business capital investment is a good choice. Here are a few steps you’ll encounter in the valuation process:

Comparables

A start up company with no documented revenue history may be valued much like real property – through comps or comparables. A VC firm may determine a business investment opportunity by looking at other existing companies with strong similarities to the one they are considering. They will talk to other investment analysts and specialists, examine 10K reports, and perhaps even research public documents to find good comps.

DCF or NPV Method

Whether a company is earning revenue or not, a VC firm may perform a discounted cash flow (DCF) or net present value (NPV) method to determine current value. By taking the projected cash flow for the next three to five years, a VC firm can adjust cash flow factors, risks, and assumptions to determine if the company is a good business investment opportunity.

Size of Market

VC firms will definitely take a look at the size of the potential market. Knowing whether a new start up company can capture a percentage of an existing market share could give them insight into current venture funding valuation.

People in Your Company

It’s not just the product or service that makes your new company successful – it’s the people too. This is actually one of the top factors VC firms will use to valuate a company. If a new company has an exceptional management team, it is more likely to succeed and meet projected financial targets, and thus, this factor increases the value of your start up. 

Product Qualities

Of course, a good business investment opportunity will solely rest upon the product in question. Your new business idea or product will be heavily scrutinized about its uniqueness, intellectual property or patent potential, and even brand strength.

Be prepared to be flexible and sharing with your information if a VC firm wishes to valuate your company. With your cooperation, you can be sure that a VC firm can make a valid venture funding decision.

You have successfully navigated negotiations with your venture capital firm. Congratulations!

But what happens next? After all the terms have been negotiated, the venture capital firm will draw up a term sheet that summarizes all the important items, as well as the proposed structure of the deal.

A term sheet is simply a summary, and all summarized items will be expanded upon later in the closing documents. While the term sheet is non-binding, it is still used as a document to set forth expectations of both parties until the actual closing.

Included in a term sheet you may find:

o   The total invested dollars provided by the venture capital investors

This may be a single dollar amount, or broken down into separate disbursement amounts at agreed times in the future.

o   The target date for closing the venture deal

The closing for venture capital doesn’t happen overnight. Due diligence is still required. Usually the closing is set on an average of 60 days from the date of the term sheet.

o   The division of capitalization of the company

This is where you will see who will own what part of the company after the closing occurs. For instance, a venture capital deal might require that they own 55 percent of the company, and the founders will retain a 45 percent ownership stake.

o   The type of security the venture capital firm will eventually own

If the goal is an IPO, the venture capital firm will clarify up front whether they desire to own preferred stock, common stock, or perhaps convertible debentures.

o   The number of shares

In addition to the type of stock, the venture capital firm will outline how many shares it requires to purchase up front at the IPO.

o   Dividend distribution

The term sheet may also set forth how future dividends are to be paid to the venture capital firm as stockholders.

o   Distribution of sale proceeds

If the company is sold prior to an IPO, the term sheet also will explain how final sale proceeds will be distributed to both founders and venture capital investors.

Though the term sheet is not a binding document, it is created as a reminder of the terms agreed up on in negotiations. With the term sheet, all parties have a clear understanding, and there are no disagreements up to closing time.

As a matter of need, entrepreneurs with a great business idea and a start up company want money immediately to continue on the journey to success. However, a venture capital firm who is willing to invest in a new start up company also has a need to be thorough in its due diligence. Thus, there exists a division of practicality between the wants of an entrepreneur and the needs of a VC firm.

Entrepreneurs who fail to understand this practical funding timeline also are likely to fail in their business. Budgeting time for venture capital investment funds to arrive to the bank can prevent many mistakes along the road to capitalization. How can a new business survive if existing capital is almost on empty before applying for venture funding?

After getting an approval from the VC firm, how long do you wait before obtaining venture capital funding? The answer is always, “it depends.”  

If you ask an entrepreneur how quickly they expect VC funding to arrive at their bank, the answers are not surprising. According to a poll conducted by the authors of the book, Inside Secrets To Venture Capital, entrepreneurs answered:

Time to Closing       Entrepreneurs’ Response

Under 30 days           22%

30-60 days                  25%

60-90 days                  20%

90-120 days                15%

120 days or more       18%

In contrast to the answers provided by entrepreneurs, the same question was posed to VC firms about how long entrepreneurs should expect the funding process to take. Here are the results of their responses:

             Time to Closing        VC Firm Response

Under 30 days             1%

30-60 days                  18%

60-90 days                  45%

90-120 days                26%

120 days or more       10%

You can see the chasm separating entrepreneurs’ expectations and the VC firms’ closing reality. Almost half of entrepreneurs expect to receive funding in 60 days or less, while the actual average funding time is between 60 and 90 days.

However, when VC firms were asked about their quickest funding time, 80% responded that they were able to fund in less than 60 days, and 41% were able to fund in 30 days or less.

The point is clear. Entrepreneurs should budget plenty of time to obtain venture funding. Never wait to the last minute to approach VC firms. You never know when you’ll receive a “yes” answer, and then you can expect at least 2 months or more before funding arrives.

When you get the nod from a venture capital firm for start up funding, your work is still not done. A simple “yes” answer is not the end of the road for your search for capital. Subsequently, you must sit across the table from your venture capital firm and negotiate the terms of the deal.

Should you do this alone? Or should you have someone trained and experienced in legal business entities and capitalization on your side?  Most entrepreneurs are not experienced in business partnership negotiations and are new at obtaining capital. It would reason, therefore, that having an attorney on your side during your venture capital negotiations would serve you best.

Why would hiring an attorney be beneficial? After all, it’s just another expense – and not a cheap one. However, an investment in an attorney may be worthwhile, as he or she will look out for your interests and attempt to negotiate the best terms for you.   

However, this does not mean that you must have an attorney sit with you at the negotiation table. Although some entrepreneurs might choose this option, simply having an attorney available to review the proposed term sheet and offer negotiation advice would work as well.

Here is what an attorney might help you with:

Compliance

One of the most important jobs an attorney will perform for you is to assure that every term you and your venture capital firm decide upon is within state and federal regulations and securities laws.

Realistic goals

Your attorney will help you see reality through your dreams. Most entrepreneurs want to keep full control over their start up company, but start up funding requires that some control be given away to the venture capital investor. An attorney will help advise you of your choices for outside capitalization and keep your feet grounded.

Fairness

An attorney will ask, “is this transaction fair?” An experienced litigator might be able to spot an unfair deal and advise you of your possible reactions.

Explanations

Do you know what an antidilution clause is? Or a conversion provision? An attorney will help explain the terms with which you are unfamiliar and their implications to your business.

Are the rewards of an attorney worth the cost? Most likely. Having an attorney on your side can help you get the best deal possible. Whether an attorney is at your side during negotiations or just available to review and offer advice, this legal specialist is a good investment for your start up company.

While every potential venture capital deal hinges on various factors, there are three important valuation factors that fit across the board for venture capital firms. Here is a look at the top three valuation factors that could give you an edge when approaching a venture capital firm.

1. Management is Everything

In a poll conducted by the authors of Inside Secrets to Venture Capital, venture capital firms were asked to rate the factors they use to determine the value of a potential investment. By far, the top rated factor was the quality of management.

VC firms were asked to rate the factors on a scale of 1 to 5, with 5 being the highest importance. The numbers were overwhelmingly in favor of the management team, with nine out of every ten VC firms rating this factor a 4 or 5. Seven out of ten rated this top factor a maximum of 5. The average rating for management team was 4.5, and no other factor even came close.

What does this tell you? Make the effort to recruit and attract the best possible people for your company. VC firms know the value of a management team who can weather storms and guide a small business to big success.

2. Size of Market

The next most important factor in the poll was the size of the market. The average rating for this factor was 3.8 out of 5.  30 percent of venture capital firms rated this as the highest importance. Thus, it is important for you as an entrepreneur seeking start up capital to find a market that is sizable, yet penetrable.

3. Product Qualities

Product quality was actually third on the list of top importance to venture capital firms. Only 25 percent of respondents said this was top importance, and the average rating (out of 5) was 3.7.

Along with product quality, venture capital firms look at the product’s uniqueness, the brand strength, and potential patent and intellectual property assets.

With these factors in mind, now you have an inside look at what venture capital firms are seeking. Be sure you design your new company with these top factors, and you will stand a better chance of getting a “yes” for venture capital.

Getting a “yes” answer from a venture capital firm can be an exciting time for an entrepreneur who’s trying to raise capital for his new start up business. But an approval only means progressing to the next stage of getting the venture funding: the negotiations.

Negotiating a venture capital deal can look daunting, especially to a new entrepreneur who has not “gone through the ropes” of the entire venture funding process. Most VC firms realize this fact and subsequently have an upper hand in most deals. However, you can succeed in VC firm negotiations if you follow these helpful tips:

1. Never Negotiate When You’re Desperate for Capital

If you need money NOW, you are at a steep disadvantage at the negotiating table. When you are desperate, you may be willing to give up too much in the negotiations, which means you will be left with a deal that doesn’t benefit your new company as well as you had hoped.

2. Know the Quality of VC Firm You Are Dealing With

You should always ask yourself, “Are these the type of people with whom I want to partner?”  Keep in mind that a quality VC firm provides much more than just funding, and a good partner may be worth giving up some points during the negotiations. A VC firm that can help guide the business growth process is worth its weight in the coins they invest. Ask other startup companies, and check references (they check yours…why shouldn’t you check theirs?).

3. Retain a Good Lawyer

Having a legal specialist in your corner is always a wise choice. Find an attorney who has had previous experience with venture funding. Your attorney will be able to point out potential hazards in a deal and suggest negotiating points.

4. Keep the Big Picture in Mind

It is easy to get caught up fighting for relatively unimportant negotiating elements.  Know which brides you are willing to die on, as well as the ones where you can let the water run their way.  Choose your battles, and keep the big picture in mind – and that is getting the funding you need from an investor you trust.

5. Treat Negotiations as a Partnership

In negotiations, treating your venture capital firm like a partner will have better results than treating them like an adversary. Negotiations should be friendly, but with your points stated firmly. Know that there is some give and take with negotiations. Reaching an agreement will be more satisfying when you consider that the VC firm is there to help you and your company succeed – not to take over your company.

Since the slump of the economy starting in late 2007, companies funded by venture capital firms also have seen a decline in the number of initial public offerings.  Stock investors are simply not putting money into new companies, but 2010 may see a return of new IPOs from venture capital-backed companies.

During a recession, skittish stock investors tend to act conservatively with their money, selling stock to put funds into more safe investments that will help retain value, such as gold or government issued securities. Putting money into a new, untested stock company is just another risk that investors are not willing to take.

What 2010 Will Bring

However, according to a recent article from the Wall Street Journal, 2010 looks promising for newer, small company valuations. In fact, the end of 2009 showed a more fair valuation in stock prices than over the last two years.

What does that mean for stock investors?  Stocks are realizing a more accurate valuation, which means that investors are placing their trust and funds back into equities.  Thus, with a higher risk tolerance this year, stock investors may be more attracted to buying stock in new VC-backed IPOs, especially since IPO stocks are typically discounted as a compensation for investor risk.

In addition, venture-backed companies who issue an IPO are typically considered small or mid-cap investments. There is a wide range of investors who do want to invest in these types of stock categories, including mutual funds and larger corporate investors like insurance companies. Small to mid cap venture-backed companies will be of interest to them as they seek to increase the value of their stock portfolios in 2010.

The Growth in IPOs This Year

Just how many new venture capital-backed IPOs could we see in 2010? 2009 saw only 8 such IPOs, according to information from Dow Jones VentureSource. But according to the WSJ article, one expert projects 30 to 50 new IPOs could happen this year. In fact, the Dow Jones VentureSource already has 33 venture capital-backed IPOs filed with the SEC.

So far in 2010 no venture capital-backed companies have made an IPO showing. However, if the data is correct, 2010 could actually see the return of the IPO for venture capital investment companies.

2009 saw a severe drop in the total number of new small businesses funded by venture capital firms. While total small business funding is down, 2010 looks to bring in more investment opportunities for VC firms in a few select areas. One of those sectors is clean technology.

The Profile of VC Funding Today

According to a report published by MoneyTree from PricewaterhouseCoopers, LLC and the National Venture Capital Association (NVCA), the 3^rd quarter of 2009 saw an increase in venture capital funding driven by the clean technology sector. One of the clean tech deals was the ninth largest venture capital deal since 1995.

Not only is clean technology getting more deals, but they are receiving business funding over the long-haul. Mark Heeson, president of the NVCA says that this type of funding is “a gradual and deliberate industry shift towards a longer term venture capital investment strategy.”

This tells us that venture capital companies are looking more toward sectors like clean technology, biotechnology and life sciences, where business funding occurs over an extended period, sometimes 10 to 12 years. These companies often have multiple rounds of venture capital financing over that time period, and they have a longer average time to accomplish its exit strategy.

This is not to say that shorter-term small business investment opportunities will be overlooked. Heesen goes on to say that the mix of sectors that VC firms invest in will become more balanced between shorter-term IT companies, as well as longer-term bio- and clean technology companies.

The Promise of Clean Tech

Clean technology includes companies that specialize in alternative and renewable energy sources, pollution and recycling, power supplies, conservation, and green transportation. These types of companies are founded to produce more energy efficient methods of producing and using electricity, as well as create fuels and electricity with fewer carbon footprints.

Clean technology is seeing an increase in the number of firms due to a variety of reasons. One is the simple fact that most people are interested in clean fuel technology and methods that help save the planet, thus creating a market for these products. Second, the U.S. government also is encouraging clean technology, with tax incentives and guaranteed loans for clean technology companies.

Clean technology is still emerging and is at a young stage. With the help of government backed financial aid and increased business funding from venture capital firms, clean technology may become the most sought-after VC investments.

“Your mission, should you choose to accept it…”

Although your mission for your startup business doesn’t have to be impossible, it should inspire venture capitalists to learn more. 

Understanding the Mission Statement

A mission statement is often overdone and misunderstood.  Some businesses tend to focus on rhetoric and bullet-point statements that try to state every value and objective of the company.  Unfortunately, a poorly written mission statement does very little to help a company and does even less in helping obtain VC financing.  A business without a mission statement, or a poorly written one, will have a more difficult time convincing VC firms that they are on a mission to make money.

Rather, you should have a mission statement, but one that is succinct and states your company’s main objective or goal.  Your mission statement should be no longer than one or two sentences, which is no easy task. 

The Value of the Mission Statement to Venture Capitalists

Why do VC firms consider well-written mission statements important?  First and foremost, the mission statement succinctly summarizes the ideas contained within the business plan.  Reading these few sentences can prompt the venture capitalists to read more or simply move onto the next company.   

In addition, developing a powerful mission statement can be very beneficial to the entrepreneur and the management team.  In obtaining VC funding, having a clear goal is of the ultimate importance, and a mission statement can help you refine your ambitions into a profitable, achievable endeavor. 

Make sure your mission statement is incredibly clear.  A business who wants to “penetrate the medical technology industry” does not adequately describe how it will serve the industry or its customers.  A broad mission statement will not only bore venture capitalists, but will close the doors to your funding potential.   

Make it easy for VC firms to know what your business hopes to accomplish.  Write and re-write a constructive mission statement that highlights the main point of your business. 

Use your mission statement as a hook for gaining the attention of VC firms. 

New and startup businesses may get their proverbial foot in the door of venture capital firms by securing a joint venture with another established and reputable company.  Venture capital funding is difficult enough to obtain as it is, but with the help of a big business name on your side, your business may walk to the head of the class in a VC firm. 

In most joint ventures, an agreement is drawn up between two companies or business owners to share in a business venture strategy and share the profits resulting from it.  A simple joint venture may be cross promoting a business or bundling products for merchandise sales.  A more complex joint venture might be the formation of a new company to pursue a separate business prospective.

In the case of trying to obtain VC financing, it may be just a simple category joint venture that gets you in the door.  Why?

Instant Credibility

Say you started a business manufacturing a new high-tech coffee or hot beverage holder.  If you approached the coffee giant, Starbucks, with a proposal to sell your innovative container exclusively in their stores and they agreed, you would then gain instant credibility with any venture capital firm by having the Starbucks’ name and reputation at your side. 

Or perhaps you have invented a new or innovative bottling process that has been picked up by PepsiCo.  Knowing the brand and market share that PepsiCo has on the soft drink market, your VC proposal could be a gold mine with the right capitalization.

Access to Large Markets

Though VC firms do not invest as much into retail businesses, you may have a green flag with your joint venture with a big name company.  They know that you would have access to a potentially large market with a company like Starbucks as your product distributor.  With a large market comes the need for expanded production and manufacturing, which would be a prime reason for the need of venture capital. 

An example of instant access to a large market is an innovative idea that could be used in conjunction with licensing agreements with the likes of Disney or comic book characters.  A new, innovative product like glow stickers or action figures could land you a joint venture licensing agreement with Disney or DC Comics.  With that green light for product development and access to an already established market, your chances at VC funding grow substantially.

Time to Market

Expanding into national and global markets takes time.  It takes time to get the marketing word out and time for the customer base and demand to increase.  That time span decreases considerably when you have a big name as a joint venture partner.  With the credibility and customer base already established, you can more easily convince a potential venture capital firm your need for capital expansion. 

When you are ready to take your new or existing business to the next level and want to try raising venture capital, don’t forget the potential and favorable possibilities with joining forces with an already established company.