The first step in starting your new business venture is to identify a market need and the product or service that will meet that need. Too often than not, high-tech products and businesses are launched because the founders are fascinated by their new technology without determining whether the technological advance will cost-effectively meet the customers’ needs. As such, products and services should be defined and shaped in response to the real problems being experienced by real customers.

The founders must determine the competitive edge that will make the proposed product preferable to comparable products currently used in the target market. Will the product accomplish the job faster, be easier to use, more reliable, cheaper to produce or service? Will these advantages be long- or short-term in nature? Critical evaluation is necessary to ensure that the technological advances will provide cost-effective and reliable solutions to the customers’ problem or fill new market requirements.

Once your product is determined in terms of a market need, you should evaluate the market. What type of customers will need the edge that the product offers over competing products? Is it a product that will be used by individuals, by small businesses, by large corporations, by the government, or by foreign customers?

Selecting a venture capitalist
Selecting the right venture capitalist is as important as picking the right founding team. Take the time to talk to the venture capitalist to ensure that you can work well together. Look for someone who knows your industry.

An ideal candidate would be someone who knows the product or market and is located close enough to your company to be available when you need help. It is also important as you launch your business to get people who have the depth and breadth of experience that you may initially lack.

If chosen correctly, venture capitalists can provide a wealth of information on management techniques, problem solving and industry contacts. They also can provide you with a broader perspective on your products, market fit, as well as additional funding as your company grows.

What VCs look at
In the US, venture capitalists look for companies that they believe have the potential to achieve $100 million a year in revenues within the next five years.

Some founding teams with sound track records are able to raise venture capital without a business plan or even a product prototype. Most people, however, find it necessary to seek a small amount of "seed money" either from friends and relatives or from venture capitalists.

This seed money is used to support the fledgling company while a business plan is written or a product prototype is being developed.

However, it is very difficult to get seed financing for unproven start ups. This is where the "angel investors" come in. They are normally successful entrepreneurs with self-generated wealth in a related industry. These type of investors understand the merits and weaknesses of a business idea. More importantly, these investors prove to be invaluable in helping pull together the company.

In the first round of venture capital financing, one tries to raise sufficient amount of capital to fund the product development. The business plan usually sets a demonstrable risk-reducing milestone, such as having a working product ready for production. Given the seemingly inevitable delays in product development and the time it takes to arrange the next round of financing (at least, two to four months), helps build some cushion around the finance being raised.

What do venture capitalists want?
Most venture capitalists aim for a company that can grow to $100 million or more in revenues, given the existing realities, in five years. They look for large markets where there is a demonstrable need for the product that the company plans to develop. In fact, most venture capitalists say that they would rather take a technology risk (can the product be developed?) than a market risk (will people want the product?).

Venture capitalists also tend to "invest in people" rather than in ideas or technologies. Hence, strength of the management teams is the most crucial element in raising money.

Valuing a company
Determining the value of a company at an early stage is more of a "mystic" than a calculated formula. In theory, investors attempt to estimate the value of the company at some time in the future (say 10 to 20 times earnings in five years).

They then discount that value to a present value with a desired rate of return. If the investor is looking for a ten-fold return in five years and the company is expected to be worth $50,000,000 in five years, it may be worth $5,000,000 today.

In practice, however, venture capitalists estimate the amount of cash required to achieve some development milestone and, often without regard to how much that is, equate that amount to 50-60 per cent of the company (fully diluted for employee stock options). The best way to find out how a company is likely to be valued is to look at what valuations venture capitalists are giving to other companies at the same development stage and in the same general market area. After that, the venture funding, valuation is easy. Just multiply the fully diluted outstanding capital of your company by the price per share paid by the last round investors.

Employee stock options
After completing the first round of venture financing, companies establish employee stock purchase and stock option plans to provide equity incentives for the employees.

Start up companies are highly risky and cash flow constraints often mean that employees will be asked to accept below market salaries to conserve cash in the start up phase. Consequently, equity plans are essential to attract and retain top quality people in a start up.

The number of shares reserved for employee plans is typically 10-20 per cent of the outstanding shares. Usually, such early stage companies establish a fair market value for common stock for such employee plans within a range of 10 to 20 per cent of the most recent value of the preferred stock.

Considering an acquisition
Many good companies discover after a number of years of effort that it is going to be difficult, if not impossible to attain the level of revenues and profits set forth in their initial business plan.

The product development cycle could be longer than anticipated, the markets too small, the entry barriers great, distribution channels clogged, the company may not be able to develop follow-on products, or the management team may not be up to the challenge of expanding the company beyond a certain size.

While such difficulties may restrict the company’s future growth, the company’s product or management team could still be valuable in the hands of a strategic buyer. For such companies, an acquisition may provide the investors with quicker and better path to liquidity.

Alternatively, many technology companies have used acquisitions of related products or companies as a means to accelerate their own growth in the critical mass necessary for success. Since changes seems to be the only constant in the life of a hi-tech company, one needs to keep an open mind on the advisability of being acquired or acquiring other companies.

Second round of financing
At the next appropriate financing "window", or when a company begins to run out of cash, a second round of venture capital is required.

If it has been a successful company and has proven its ability to execute a business plan to perfection, money can be raised at a substantial premium over the first round, perhaps one and one-half to two and two and one-half times the first round price. The first round investors will participate in the second round also, typically providing one quarter to half the money in the second round. A lead investor representing the "new money" generally determines the second round price and the terms and conditions. Successful companies are often valued in the range of one-half time expected revenues for the next 12 months.

Typical start up questions
What is vesting?
Vesting requires founders to earn their stocks over time. The company retains a right to buyback unvested stock on termination of employment.

Why do I want vesting?
Vesting protects the other founders from an ex-founder becoming wealthy on their efforts if that ex-founder quits before he or she has earned his or her stock.

How is venture financing structured?
Generally by selling convertible preferred stock. Employees will continue to buy common stock at a price of 10 to 20 per cent of that paid by the outside investors.

What do I have to give away in negotiations with venture capitalists?
You’ll have to give the preferred stock basic preferences, some form of anti-dilution protection and registration rights. You’ll also have to agree to certain restrictions on how you run your company.

What should I try to avoid in negotiations with venture capitalists?
Avoid mandatory redemption, redemption premiums, and excessive restrictions on how you run your company.

How do I protect my technology?
Use non-disclosure agreements and consider patent, tradermark, trade secret and copyright protection at an early stage.

How do I choose a lawyer?
Choose one with substantial start up experience who understands your business. It is also helpful if the lawyers have the intellectual property, corporate and security laws, domestic and international tax, and litigation experience that your company will need as it grows.