FUNDING A RAPIDLY GROWING VENTURE (PART TWO)
The Venture Capital Market
Private venture capital companies have been the bedrock of many high-growth ventures, particularly in the computer, software, biotechnology, and telecommunications industries. Because venture capitalists rarely invest in start-up ventures outside the high-tech arena, the growth state of a new venture is where most entrepreneurs consider approaching them. Waiting until this stage is advantageous to the entrepreneur because using venture capital in the start-up phase can mean giving up significant control.
Venture capital is, quite simply, a pool of money managed by professionals. These professionals usually assume the role of general partner and are paid a management fee plus a percentage of the gain from any investments. The venture capital firm takes an equity position through ownership of stock in the company. It also normally requires a seat on the board of directors and brings its professional management skills to the new venture in an advisory capacity. The ability of an entrepreneur to secure classic venture capital funding depends not only on what the entrepreneur brings to the table but also on the status of the venture capital industry.
The Sequence of Events in Securing Venture Capital
To determine whether venture capital is the right type of funding for a growing venture, the entrepreneur must understand the goals and motivations of venture capitalists, for these dictate the potential success or failure of the attempt. The venture capital company invests in a growing business through the use of debt and equity instruments to achieve long-term appreciation on the investment within a specified period of time, typically three to five years.
By definition, this goal is often different from that of the entrepreneur, who usually looks at the business in a much longer frame of reference. The venture capitalist also seeks varying rates of return, depending on the risk involved. An early-stage investment, for example, characteristically demands a higher rate of return, as much as 50 percent or greater annual cash-on-hand return, whereas a later-stage investment demands a lower rate of return, perhaps 30 percent annually.
Depending on the timeframe for cash-out, the VC will expect capital gains multiples of 5 to 20 times the initial investment. Very simply, as the level of risks increases, so does the demand for a higher rate of return. This relationship is not surprising. Older, more established companies have a longer track record on which to base predictions about the future, so normal business cycles and sales patterns have been identified, and the company is usually in a better position to respond through experience to a dynamic environment. Consequently, investing in a mature firm does not command the high rate of return that investing in a high-growth start-up does.
Usually, the first thing venture capitalists look at when scrutinizing a potential investment candidate is the management team, to see whether experienced people with a good track record are in place and able to take the company to the next level of growth. In addition to experience, venture capitalists are looking for the commitment to the company and to growth; because they recognize that growing a company requires an enormous amount of time and effort on the part of management team. Once they have determined that the management team is solid, they look at the product and the market to see whether the opportunity is substantial and whether the product enjoys a unique or innovative position in the marketplace. Product uniqueness, especially if protected through intellectual-property rights, helps create entry barriers in the market, commands higher prices, and adds value to the business.
The other major factor is the potential for a significant growth and the amount of growth possible, because it is from the consequent appreciation in the value of the business that the venture capitalist will derive the required return on investment. The venture capitalist weighs that potential for growth against the risk of failure and the cost of achieving the growth projected. Therefore, when negotiating with venture capitalists, entrepreneurs should have a good sense of the value of the business.
Armed with an understanding of what venture capitalists are looking for, the entrepreneur is prepared to begin the search for a company that meets his or her needs. Because the venture capital community is fairly close-knit, at least within regions of the country, it is wise not to “shop” the business plan around looking for the best deal. It is important to do some search on the local venture capital firms to determine whether any specialize in the particular industry or type of business that the entrepreneur is growing. Getting recommendations from attorneys and accountants who regularly deal with business investments is an excellent way to find these VC firms. In fact, the best way to approach venture capitalists is through a referral from someone who knows the VC.
Once a venture capitalist company has been chosen, stay with that company unless and until it becomes apparent that the deal will not work. Under no circumstance should the entrepreneur be talking with two companies at the same time. The venture capital community is small, and negotiating with two VC companies at once may well leave the unwise entrepreneur with no firm wanting to invest.
The venture capital company will no doubt ask for a copy of the business plan with an executive summary. The executive summary is a screening device – if it can’t be immediately determined that the entrepreneurial team’s qualifications are outstanding, the product concept innovative, and the projections of growth and returns on investment realistic, the company officials will not bother to read the rest of the business plan.
On the other hand, if they like what they see in the plan, they will probably request a meeting to determine whether the entrepreneurial team can deliver what they project. This may or may not call for a formal presentation of the business by the entrepreneur. During the meeting, the initial terms of an agreement may be discussed, but the entrepreneur’s team should not be too eager to discuss issues such as owner compensation until the venture capitalist indicates that a deal is imminent. It is very important not to hype the business concept or make claims that can’t be substantiated. Venture capitalists have literally seen it all, and they recognize puffery the moment they hear it. Any potential negative aspects, however, should be disclosed and ways to deal with them proposed.
If the meeting goes well, the next step is due diligence – that is, the venture capital firm has its own team of experts check out the entrepreneurial team and the business thoroughly. If the venture capitalists are still sold on the business, they draw up legal documents to detail the nature and terms of the investment and declare that “the check is in the mail.” Entrepreneurs should not expect to receive it immediately, however. Some venture capitalists wait until they know they have a satisfactory investment before putting together a partnership to fund the investment. Others just have a lengthy process for releasing money from the firm. The money is typically released in stages linked to agreed-upon goals. Also realize that the venture capital firm will continue to monitor the progress of the new venture and probably will want a seat or several seats on the board of directors, depending on its equity stake in the company, to ensure that it has a say in the direction the new venture takes.
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