Diary of a deal: Hope, disappointment and renewal

Note: This is the first in a series of inside stories detailing actual venture capital transactions. Dates, numbers and other details have been changed to protect the private nature of the information.

A few years back, our fund closed an investment in a company targeting a consumer product to a fast-growing market. The company was led by an industry-seasoned team doing its first venture capital-backed opportunity — and their first start-up together. Over the previous three years the founders had secured some $500,000 from individual investors but were stalled by an inability to secure additional individual investor support.

Professional start-up money was also hard to come by. As many companies discover, venture capital tends to be a game for companies with investment needs over $3 million to $5 million. The smaller end of the market is limited to a very small subset of funds. Luckily for this company, ours is one of those funds.

The business plan showed the company was planning to build on the $1 million it had booked in sales the previous year to $10 million in five years. Most VCs would pass on an opportunity that showed “only $10 million” — the vast majority of early-stage venture capital funds require companies to show five-year sales targets ranging from $50 million to $250 million. Smaller funds, however, are able — subject to “buying in” at an appropriate price — to realize adequate returns on companies that show more modest growth — if all goes well.

The original plan called for $500,000 of equity to get the company to its fifth-year sales target. While we tend not to believe business plans that show movement to profitability funding by only a single round of finance (unless they are close to profitability when we fund), we went forward with hope, and with the expectation that we’d likely be providing more capital in second and/or third rounds. Venture capital investors always assume future financings and reserve for that likelihood.

Disappointment

The company fell short of its plan. Reasons varied from market environments (beyond their control) to excessive optimism (within their control). While we maintained our faith in the quality of the team and of their unique positioning, we were disappointed. Moreover, we had to consider alternatives.

After four years and three small additional financing rounds, the company reached 60 percent of the original plan. While sales had grown threefold since our original investment, the plan and our return model required growth closer to five- or sixfold to make the return worth the risk.

In venture capital, there is an expectation that a venture that has high risk elements requires a return commensurate with that risk. So while sales growth was “good,” it needed to be “great” to meet expectations.

As we reflected on the opportunity, we assessed that we were right about the team, product and market space but wrong about the speed of take-up.

A venture capital investor’s “model” works as follows: (a) come up with a realistic picture of achievable growth and capital requirements to support that growth; (b) if company is below plan (as most are), ensure that you understand whether the reason stems from poor execution (a management issue), market conditions (typically beyond control of management) or just a bad bet.

If (a) is the problem, then it’s incumbent upon the board to address this, either by complementing and/or substituting the original team. If (b) or (c) is the problem, then the choices may be more limited and, from management’s perspective, concerning. A bad market (and/or a bad bet) means that further financial support of the company may not the best use of capital for investors — the phrase “throwing good money after bad” tends to come out in conversations at the fund’s investment review discussions.

Often, an investor’s choices are limited — in this circumstance, to finding a new investor to “take out” an old investor’s position (typically at limited/no profit to old investors) or to sell the company.

Ever optimistic, management argued that success was “just around the corner” and if “you just give us one more round of capital, we’ll make up for our shortfall and get on the growth path again.” Unfortunately, we didn’t see that likely outcome and so pursued strategic alternatives — code phrase for sale or recapitalization. We engaged an investment banker to put together a selling document. Though the company’s sales were small, we felt that there was a compelling story for the right buyer. Turns out, we were wrong.

The company was too small to sell to either a strategic buyer or a larger private equity firm (private equity is venture capital writ large — average investments are upwards of $5 million, typically in companies with sales north of $5 million to $10 million). With the company low on cash and us reluctant to continue to provide equity, we were in a difficult place.

Renewal

Luckily, this story appears to have a happy ending. Failing to find a viable path with our Plan A, we set out to pursue Plan B: try to cobble together a small (under $1 million) financing round to be led by angel investors to keep the company going. If we could not achieve this, the company would likely have to consider shutting down.

In the midst of this challenging financing outlook, the company secured its first million-dollar customer, creating the sense — and reality — that it might be at the inflection point of growth.

With this new sense of hope, we recognized the opportunity to pursue larger professional investors, rather than angels, and approached three venture funds that typically invest more than $2 million per company. Currently, all three have expressed interest in the company, and we are hopeful of having a financing closed prior to summer’s end.

So, where it seemed we were on the cusp of a worst-case scenario, we now have a very optimistic future ahead of us. Every day is a new day, and in the world of venture capital, life can be a real roller coaster – in this case, from hope to despair to renewed optimism. It’s all part and parcel of the world of early-stage investing.

Michael Gurau is president of CEI Community Ventures, a Maine-based venture capital fund that operates in northern New England. He can be reached at mhg@ceicommunityventures.com.