Venture Capital and the Finance of Innovation, Second Edition

principle, channel analysis should be an important component of the customer and
projection categories (see earlier discussion). Many potential markets are characterized
by standards battles, powerful wholesale players, and relationship-driven
sales at several points in the value chain. Indeed, the analysis of channels is the most
important step in understanding whether a large market is indeed “addressable.”
Partners
Many startup companies are particularly reliant on a few partners. We use the term
“partners” loosely here to mean anything from key suppliers, development partners,
and firms with any kind of cooperative agreement. VCs should certainly speak with
any partners and confirm that the relationships are healthy and stable. A highreputation
VC can be particularly influential in attracting and retaining partners, a
strategy that has particular value in businesses where potential partners and customers
need to see some evidence of credibility.
Money
How has the company been financed up to this point? How well does it take care of
its cash? What exactly does it intend to do with the investment? VCs should insist
on a high level of financial controls (hence the common requirement to add a CFO)
and should make sure they understand the cash situation of their portfolio companies
at all times. Many startups begin on shoestring budget and do not have the
discipline to handle the large new sums from a VC investment. Furthermore, this
analysis must include a reasonable estimate of the total amount of financing that
would be required to reach a successful exit. It is not uncommon for VCs to find
investments that meet the market and management tests but nevertheless are not
viable investments, because their cash needs are so great. The classic example here
is in early stage drug development. To bring a drug through the approval process
has become such an expensive proposition that only a few early stage companies
can qualify for VC financing. Companies with high cash needs are said to have a
high burn rate, meaning that they “burn through cash at a high rate”. The burn rate
can also be used to calculate how long a company can last between rounds of
investment.
Transaction Terms
7.2 THE INVESTMENT PROCESS 143
Although VCs should certainly rely on lawyers for the careful checking of legal
language in the final contracts, there is still work for VCs to do in crafting economic
terms specific to each transaction. Many of these terms will be introduced in
Chapter 8 and then discussed in Part III of the book. Transaction terms are a duediligence
subject, because it is the information uncovered by due diligence that
should lead VCs to ask for (or, in some cases, demand) certain terms in the final
contract. Furthermore, the negotiation of these specific terms will often provide
insights into specific concerns and private information of management.