For entrepreneurs about to seek funding for their startups, there’s nothing like practicing their pitch to savvy MBA students playing the role of venture capitalists (VCs). That’s what real entrepreneurs do annually in University of North Carolina’s Venture Capital Investment Competition (VCIC). Student teams from business schools around the world compete to see which, in the view of the seasoned VC partners who act as judges, performs best on such VC skills as due diligence, deal negotiation, and investment decisions.
Although only one team will emerge the winner from among the 78 schools that began competing last September in 13 countries on three continents, everybody gains. The students learn what it will take to win funding for their own startups someday and what it’s like to work for a venture capital firm. The entrepreneurs hone their pitch and negotiation skills, learn what VCs expect of them, and get valuable feedback about their business models—more than 25% of the startups who present at VCIC go on to raise venture funding.
For three startups presenting at one of the U.S. regional contests, hosted by my school, Boston University’s Questrom School of Business, these lessons emerged most clearly from intense engagement with six well-prepared student teams:
Go big or go home.
To maximize returns, VCs prefer to invest in startup ideas that target large markets. One of the more interesting startups at our event proposed to remake the apartment leasing process by connecting pre-qualified tenants with landlords who paid a fee for each lease signed—a less costly alternative to long vacancies. But during the due diligence stage, some serious reservations about growth arose: How quickly could additional towns be added to the network? Would every city have enough customers to make expansion profitable? For VCs, the time and effort to complete due diligence for a $1 million deal is essentially the same as for a $10 million one. VCs prefer the latter, while angel investors prefer the former. As this startup learned, you need to present ideas that are scalable and implementable in a short time frame. Otherwise, for VCs, the economics aren’t worth it.
It’s better to own a small slice of a big pie than a big slice of a little one.
In nearly every due diligence session this year, the entrepreneurs balked at giving up too much equity in exchange for funds, especially when multiple funding stages were proposed. In one instance, the student VC team wanted a 40% equity stake in exchange for a $2 million investment that would bring the startup’s total value to $5 million. The entrepreneur managed to negotiate the equity stake down to 35%, but no lower. Without funding, founders retain most of the equity, but their companies are unlikely to grow to anything like the scale required for a big payday. The lesson: dilution isn’t a four-letter word. Smart entrepreneurs realize that it’s better to have 10% of the equity in a $5 million business than 51% of a $1 million business. And in giving up a great degree of control, a founder often receives immense financial and non-financial resources in return.
There’s no substitute for experience—throughout your startup.
All three of this year’s startups sported some impressive leaders and other personnel with outstanding skills. But the student teams, having received the entrepreneurs’ written pitches 72 hours prior to the event, took care to investigate the depth of experience throughout each startup’s organization. In one case, they found little experience beyond the founder and the chief technical officer. Further, in negotiating deal terms, the student teams, like all VCs, carefully considered each startup’s stock option pool and insisted on a vesting schedule that incentivized experienced personnel to stay the course and grow the business rather than cash out early. VCs know that long before a liquidity event, a majority of startups have to “pivot”—altering their original business model, sometimes dramatically, as they learn more about potential markets for their product or service—if they are to survive and grow. It can be a difficult time, fraught with peril. VCs bank on the entire team, not a rock star or two, to make sure the company gets through it successfully. That’s in line with the long-held wisdom of the VC industry that it’s better to back an A-team with a B-rated idea than the other way around.
As special as you are, you’re not as special as you think.
Entrepreneurs live and breathe their businesses every day, pouring their passion and their sweat equity into what they believe is a world-beating idea. Not surprisingly, when it comes to negotiating a deal they believe that they’re unique, deserving of more favorable terms. At every turn in the VCIC competition, all of the entrepreneurs pressed for such special considerations. But as the students well knew, a founder’s company is only one among many in a VC’s portfolio of investments. VCs want uniformity in deal terms—in option pools, board structure, liquidation preferences, and anti-dilution provisions. Otherwise, they will have to face the displeasure of investors in their fund who don’t see why one company should be allowed to generate less return than others in the portfolio. Each team in the competition knew they would impress the judges by getting buy-in from the entrepreneur they were negotiating with while holding the line on standard deal terms. None of the entrepreneurs managed to break that resolve.
The winners? The team from Dartmouth’s Tuck School of Business. But the entrepreneurs won big, too. A startup providing resources for managing required continuing education units for medical personnel received the most bids from the student teams and proceeded through the negotiation stage in record time. For another startup, victory lay in impressing one of the VC partner/judges—a few days after the contest, he expressed a desire to help the company find funding. And all of the entrepreneurs profited from some hands-on lessons about what VCs think about scalable ideas, equity, experience, and deal terms that will stand them in good stead when the stakes are real.
– Greg Stoller is actively involved in building entrepreneurship, experiential learning and international business programs at Boston University’s Questrom School of Business. He is also an entrepreneur and co-founder and host of the Language of Business ®, an independently produced weekly news magazine.