Introduction to Venture Capital
What Venture Capital Firms Look For Size of the Venture Capital Proposal Maturity of the Firm Making the Proposal Management of the Proposing Firm The "Something Special" in the Plan Elements of a Venture Proposal Provisions of the Investment Proposal Ownership Control Annual Charges Final Objectives Types of Venture Capital Firms The Importance of Formal Financial Planning Checklist for Negotiating with Venture Capitalists
Introduction to Venture Capital
Venture capital has become quite a buzzword in the last
few years. Because of its immense coverage in the media,
many business people think that it's somehow a shortcut to
wealth. Is it easy to get? Not so easy as some would have
you believe. One financial broker told us that when he
approached some venture capitalists to fund a patent
appraised at $25 million, he found out that, as he put it,
"No one will give you seed money. 'You bring the
prototype, and we'll give you what you want."
We've said that business startups are among the most
difficult things to sell. This is true, except as regards
venture capitalists. Venture capital can also be used to
finance the entrepreneur who is planning to buy out a
partner or is negotiating to acquire an existing business.
At the same time, venture capitalists focus on highly
specialized areas, such as computer software or bioscience
engineering. Ideally, a venture capitalist seeks the
security of a banker with the upside potential of an
enterprise.
When evaluating a project, venture capitalists do not
necessarily require more information from the borrower or
client than a banker does, but they do work within narrow
areas of interest. A venture capitalist might invest in
genetic engineering because the industry might have
established what the risk is and what the expected return
will be. But if you brought them a scheme to franchise
service stations, you wouldn't get past the lobby.
Similarly, labor-intensive businesses set up a red flag
for venture capitalists. Labor, after all, turns over, and
any new learning curves will cost the owner of such a
business money for training. Accordingly, venture
capitalists seek association with enterprises that can
plateau quickly and feed and develop on the strength of
existing technology or other process.
It's during the early stages of corporate development,
when the business is still privately owned and operated by
the entrepreneur, that venture capital is most readily
available. This is because the venture capitalist can
obtain the greatest leverage on his investment by fixing a
rate of return on capital invested that is consistent with
his level of risk.
Venture capital is normally given in exchange for an
equity position in the company. It's not uncommon,
however, to structure as debt capital 90 percent of the
funds provided. This is usually convertible to shares of
common stock in the company at a predetermined price. The
remaining 10 percent or so is allocated for an equity
position. Because of the high-risk nature of venture
capital, it usually precedes bank financing and helps fill
the gap that entrepreneurs often face when trying to
obtain start-up or working capital for their business.
A borrower's or client's arrangement with a venture
capitalist should be considered temporary, to the extent
venture capitalists prefer to fund a venture, watch it
multiply greatly in value, then cash out by seeking to get
the venture acquired or by taking it public. Actual
numbers will vary, but a venture capitalist would usually
like to be assured that he'll recoup three to five (or
sometimes 10) times his original investment, within five
years. If he puts in $500,000, he wants to see $2.5 to $5
million coming back within five years.
Venture capitalists as a type of investor/lender have
developed methods or keys they use to deal with industries
they specialize in. They have assorted formulas that
determine the present value of a business and its
projected future value, and while they realize that each
particular deal develops a life of its own, they also have
a feel for their chosen industries and know what the risks
and the potential rewards are. They will look at a given
deal within that context.
Valuation is important for venture capitalists, you need
to be able to value your business with a view toward
making realistic projections. Once you've finished the
business plan; you must place a value of the goals of the
business, its technology, and its management team.
One shortcut method of valuing a business for venture
capital purposes is to divide the desired loan amount by
the percentage of equity you are giving away. So if you
plan to raise $1 million for 20 percent of the common
stock of the company, its value would be $5 million. If
you seek $1 million for 30 percent of the company, the
company would be valued at $3.3 million. These values,
like the equity, are negotiable. The critical point for
you to know is that you need to determine a value at the
time of financing, and project a value three years hence,
based on what should be the strong earnings projections
made in the business plan's pro forma.
To project earnings by the third year, factor in projected
profit percentages. Let's say you project $100,000 in
profits, averaged over the first three years of operation.
If the average return on the shareholder's capital in the
industry is 16 percent, the business will be valued at
approximately $600,000 down the line. If the venture
capitalist is being asked to invest $200,000, he is
entitled to one-third of the business. In the normal
course of negotiating, he will ask for more. But remember
that all of these numbers are negotiable.
Documentation of projections and the strength of the your
management team are important to venture capitalists. In
the management area, the venture capitalist is concerned
with three areas: growth, profits, and cash flow. These
priorities often differ from those of the entrepreneur.
It's a common mistake for the entrepreneur to manage his
business for growth first, profits second, and cash flow
third. The results can be disastrous. If the business
grows faster than the cash flow, the company is soon out
of cash and unable to meet is obligations. The venture
capitalist is looking for the entrepreneur who understands
cash flow and manages the business by balancing sales
growth with profits and cash flow, allowing the company to
expand using internally generated funds. Once the company
becomes profitable the venture capitalist can plan for
secondary financing to ensure the company's continued
growth and profitability. But in the meantime, the venture
capitalist must be assured that you understand the need to
manage cash flow.
There are a couple of hundred professionally managed
private venture capital firms in the United States.
Additionally, another thousand or so venture capital
sources are available. The most traditional source for
venture capital is the Wall Street investment banker. Most
major investment-banking firms are interested in examining
new business ventures and new business ideas. They can
arrange for private financing by forming a syndicate
(limited partnership) of investors who will do the initial
financing for an equity position in the company.
If the investment banker handles the venture capital, the
money' can be returned to the investors by a public stock
offering. The private investors are satisfied, and the
company gets additional working capital at a time when
it's most needed. In return for arranging the financing,
the investment-banking firm charges a fee and gets a right
of first refusal to underwrite the public sale of the
company's stock.
Private venture capitalists provide start-up or
acquisition capital. They usually maintain relationships
with a wide number of smaller investment-banking firms.
Not only do these firms provide capital, but they usually
work closely with management and, as the company develops,
plan future financing. They may arrange for additional
capital from private sources or for public financing
through the facilities of one of their investment-banking
connections.
SBIC's function as venture capitalists from time to time.
Though their lending limits are often set by the
government, they can generally handle most size deals.
Most SBIC's do not maintain contact with the investment
banking community because they are not necessarily looking
to secondary public financing as a means of being repaid.
They lend money on a three-, five-, or seven-year basis.
The loans are amortized, so the principal is returned over
time. This is a primary consideration when deciding
whether or not to use an SBIC for venture capital or for
more traditional methods of structuring business borrowing
for your clients. Since the venture capitalist as such
looks for the return of his capital from secondary public
financing, the company not only conserves cash but obtains
additional cash down the road. SBIC money has to be repaid
from the profits and cash flow of the company. This is at
a time when the company is growing and needs all the cash
it can get to finance that growth.
What Venture Capital Firms Look For
One way of explaining the different ways in which banks
and venture capital firms evaluate a small business
seeking funds, put simply, is: Banks look at its immediate
future, but are most heavily influenced by its past.
Venture capitalists look to its longer run future. To be
sure, venture capital firms and individuals are interested
in many of the same factors that influence bankers in
their analysis of loan applications from smaller
companies. All financial people want to know the results
and ratios of past operations, the amount and intended use
of the needed funds, and the earnings and financial
condition of future projections. But venture capitalists
look much more closely at the features of the product and
the size of the market than do commercial banks.
Banks are creditors. They're interested in the
product/market position of the company to the extent they
look for assurance that this service or product can
provide steady sales and generate sufficient cash flow to
repay the loan. They look at projections to be certain
that owner/managers have done their homework. Venture
capital firms are owners. They hold stock in th( company,
adding their invested capital to its equity base.
Therefore, they examine existing or planned products or
services and the potential markets for them with extreme
care. They invest only in firms they believe can rapidly
increase sales and generate substantial profits.
Why? Because venture capital firms invest for long-term
capital, not for interest income. A common estimate is
that they look for three to five times their investment in
five or seven years.
Of course venture capitalists don't realize capital gains
on all their investments. Certainly they don't make
capital gains of 300% to 500% except on a very limited
portion of their total investments. But their intent is to
find venture projects with this appreciation potential to
make up for investments that aren't successful.
Venture capital is a risky business, because it's
difficult to judge the worth of early stage companies. So
most venture capital firms set rigorous policies for
venture proposal size, maturity of the seeking company,
requirements and evaluation procedures to reduce risks,
since their investments are unprotected in the event of
failure.
Size of the Venture Capital Proposal
Most venture capital firms are interested in investment
projects requiring an investment of $1,000,000 to
$15,000,000. Projects requiring under $1,000,000 are of
limited interest because of the high cost of investigation
and administration; however, some venture firms will
consider smaller proposals, if the investment is
intriguing enough.
The typical venture capital firm receives over 1,000
proposals a year. Probably 90% of these will be rejected
quickly because they don't fit the established
geographical, technical, or market area policies of the
firm-or because they have been poorly prepared.
The remaining 10% are investigated with care. These
investigations are expensive. Firms may hire consultants
to evaluate the product, particularly when it's the result
of innovation or is technologically complex. The market
size and competitive position of the company are analyzed
by contacts with present and potential customers,
suppliers, and others. Production costs are reviewed. The
financial condition of the company is confirmed by an
auditor. The legal form and registration of the business
are checked. Most importantly, the character and
competence of the management are evaluated by the venture
capital firm, normally via a thorough background check.
These preliminary investigations may cost a venture firm
between $5,000 to $10,000 per company Investigated. They
result in perhaps 10 to 15 proposals of interest. Then,
second investigations, more thorough and more expensive
than the first, reduce the number of proposals under
consideration to only three or four, Eventually the firm
invests in one or two of these.
Maturity of the Firm Making the Proposal
Most venture capital firms' investment interest is limited
to projects proposed by companies with some operating
history, even though they may not yet have shown a profit.
Companies that can expand into a new product line or a new
market with additional funds are particularly interesting.
The venture capital firm can provide funds to enable such
companies to grow in a spurt rather than gradually as they
would on retained earnings.
Companies that are just starting or that have serious
financial difficulties may interest some venture
capitalists, if the potential for significant gain over
the long run can be identified and assessed. If the
venture firm has already extended its portfolio to a large
risk concentration, they may be reluctant to invest in
these areas because of increased risk of loss.
However, although most venture capital firms will not
consider a great many proposals from start-up companies,
there are a small number of venture firms that will do
only "start-up" financing. The small firm that has a well
thought-out plan and can demonstrate that its management
group has an outstanding record even if it is with other
companies) has a decided edge in acquiring this kind of
seed capital.
Management of the Proposing Firm
Most venture capital firms concentrate primarily on the
competence and character of the proposing firm's
management. They feel that even mediocre products can be
successfully manufactured, promoted, and distributed by an
experienced, energetic management group.
They look for a group that is able to work together easily
and productively, especially under conditions of stress
from temporary reversals and competitive problems. They
know that even excellent products can be ruined by poor
management. Many venture capital firms really invest in
management capability, not in product or market potential.
Obviously, analysis of managerial skill is difficult. A
partner or senior executive of a venture capital firm
normally spends at least a week at the offices of a
company being considered, talking with and observing the
management, to estimate their competence and character.
Venture capital firms usually require that the company
under consideration have a complete management group. Each
of the important functional areas - product design,
marketing, production, finance, and control - must be
under the direction of a trained, experienced member of
the group. Responsibilities must be clearly assigned. And,
in addition to a thorough understanding of the industry,
each member of the management team must be firmly
committed to the company and its future.
The "Something Special" in the Plan
Next in importance to the excellence of the proposing
firm's management group, most venture capital firms seek a
distinctive element in the strategy or product/market
process combination of the firm. This distinctive element
may be a new feature of the product or process or a
particular skill or technical competence of the
management. But it must exist. It must provide a
competitive advantage.
Elements of a Venture Proposal
1. Purpose and Objectives - a summary of the what and why
of the project.
2. Proposed Financing - the amount of money you'll need
from the beginning to the maturity of the project
proposed, how the proceeds will be used, how you plan to
structure the financing, and why the amount designated is
required.
3. Marketing - a description of the market segment you've
got or plan to get, the competition, the characteristics
of the market, and your plans (with costs) for getting or
holding the market segment you're aiming at.
4. History of the Firm - a summary of significant
financial and organizational milestones, description of
employees and employee relations, explanations of banking
relationships, recounting of major services or products
your firm has offered during its existence, and the like.
5. Description of the Product or Service - a full
description of the product (process) or service offered by
the firm and the costs associated with it in detail.
6. Financial Statements - both for the past few years and
pro forma projections (balance sheets, income statements,
and cash flows) for the next 3-5 years, showing the effect
anticipated if the project is undertaken and if the
financing is secured (This should include an analysis of
key variables affecting financial performance, showing
what could happen if the projected level of revenue is not
attained.)
7. Capitalization - a list of shareholders, how much is
invested to date, and in what form (equity debt).
8. Biographical Sketches - the work histories and
qualifications of key owners / employees.
9. Principal Suppliers and Customers.
10. Problems Anticipated and Other Pertinent Information -
a candid discussion of any contingent liabilities, pending
litigation, tax or patent difficulties, and any other
contingencies that might affect the project you're
proposing.
11. Advantages - a discussion of what's special about your
product, service, marketing plans or channels that gives
your project unique leverage.
Provisions of the Investment Proposal
What happens when, after the exhaustive investigation and
analysis, the venture capital firm decides to invest in a
company. Most venture firms prepare an equity financing
proposal that details the amount of money to be provided,
the percentage of common stock to be surrendered in
exchange for these funds, the interim financing method to
be used, and the protective covenants to be included.
This proposal will be discussed with the management of the
company to be financed. The final financing agreement will
be negotiated and generally represents a compromise
between the management of the company and the partners or
senior executives of the venture capital firm. The
important elements of this compromise are: ownership,
control, annual charges, and final objectives.
Ownership
Venture capital financing is not inexpensive for the
owners of a small business. The partners of the venture
firm buy a portion of the business's equity in exchange
for their investment.
This percentage of equity varies, of course, and depends
upon the amount of money provided, the success and worth
of the business, and the anticipated investment return. It
can range from perhaps 10% in the case of an established,
profitable company to as much as 80% or 90% for beginning
or financially troubled firms.
Most venture firms, at least initially, don't want a
position of more than 30% to 40% because they want the
owner to have the incentive to keep building the business.
If additional financing is required to support business
growth, the outsiders' stake may exceed 50%, but investors
realize that small business owner/managers can lose their
entrepreneurial zeal under those circumstances. In the
final analysis, however, the venture firm, regardless of
its percentage of ownership, really wants to leave control
in the hands of the company's managers, because it is
really investing in that management team in the first
place. Most venture firms determine the ratio of funds
provided to equity requested by a comparison of the
present financial worth of the contributions made by each
of the parties to the agreement. The present value of the
contribution by the owner of a starting or financially
troubled company is obviously rated low. Often it is
estimated as just the existing value of his or her idea
and the competitive costs of the owner's time. The
contribution by the owners of a thriving business is
valued much higher Generally, it is capitalized at a
multiple of the current earnings and/or net worth.
An equation for determining the venture capitalist's share
of ownership in a company would be:
N
I x (1 + RR)
E = Nth PAT x PEM
where:
E = venture capitalist's percentage ownership
I = venture capitalist's investment
RR = venture capitalist's compounded rate of return
N = number of years the venture capitalist expects
to hold the investment before cashing out
Nth PAT = after-tax profit venture is expected to generate
in year venture capitalist plans to cash out
PEM = price/earnings multiple at which company might
be valued in Nth year
Financial valuation is not an exact science. The final
compromise on the owner's contribution's worth in the
equity financing agreement is likely to be much lower than
the owner thinks it should be and considerably higher than
the partners of the capital firm think it might be. In the
ideal situation, of course, the two parties to the
agreement are able to do together what neither could do
separately: 1) the company is able to grow fast enough
with the additional funds to do more than overcome the
owner's loss of equity, and 2) the investment grows at a
sufficient rate to compensate the venture capitalists for
assuming the risk.
An equity financing agreement with an outcome in five to
seven years which pleases both parties is ideal. Since of
course, the parties can't see this outcome in the present,
neither will be perfectly satisfied with the compromise
reached. It is important, though, for the business owner
to look at the future. He or she should carefully consider
the impact of the ratio of funds invested to the ownership
given up, not only for the present, but for the years to
come.
Control
Control is a much simpler issue to resolve. Unlike the
division of equity over which the parties are bound to
disagree, control is an issue in which they have a common
(though perhaps unapparent) interest. While it's
understandable that the management of a small company will
have some anxiety in this area, the partners of a venture
firm have little interest in assuming control of the
business. They have neither the technical expertise nor
the managerial personnel to run a number of small
companies in diverse industries. They much prefer to leave
operating control to thc existing management.
The venture capital firm does, however, want to
participate in any strategic decisions that might change
the basic product/market character of the company and in
any major investment decisions that might divert or
deplete the financial resources of the company. They will,
therefore, generally ask that at least one partner be made
a director of the company.
Venture capital firms also want to be able to assume
control and attempt to rescue their investments, if severe
financial, operating, or marketing problems develop. Thus,
they will usually include protective covenants in their
equity financing agreements to permit them to take control
and appoint new officers if financial performance is very
poor.
Annual Charges
The investment of the venture capital firm may be in the
final form of direct stock ownership which does not impose
fixed charges. More likely, it will be in an interim form-
convertible subordinated debentures or preferred stock.
Financings may also be straight loans with options or
warrants that can be converted to a future equity position
at a pre-established price.
The convertible debenture form of financing is like a
loan. The debentures can be converted at an established
ratio to the common stock of the company within a even
period, so that the venture capital firm can prepare to
realize their capital gains at their option In the future.
These instruments are often subordinated to existing and
planned debt to permit the company invested in to obtain
additional bank financing.
Debentures also provide additional security and control
for the venture firm and impose a fixed charge for
interest land sometimes for principal payment, too) upon
the company. The owner-manager of a small company seeking
equity financing should consider the burden of any fixed
annual charges resulting from the financing agreement.
Final Objectives
Venture capital firms generally intend to realize capital
gains on their investments by providing for a stock buy-
back by the small firm, by arranging a public offering of
stock of the company invested in, or by providing for a
merger with a larger firm that has publicly traded stock.
They usually hope to do this within five to seven years of
their initial investment. (It should be noted that several
additional stages of financing may be required over this
period of time.)
Most equity financing agreements include provisions
guaranteeing that the venture capital firm may participate
in any stock sale or approve any merger, regardless of
their percentage of stock ownership. Sometimes the
agreement will require that the management work toward an
eventual stock sale or merger. Clearly, the owner-manager
of a small company seeking equity financing must consider
the future impact upon his or her own stock holdings and
personal ambition of the venture firm's aims, since taking
in a venture capitalist as a partner mar be virtually a
commitment t sell out or Bo public.
Types of Venture Capital Firms
There is quite a variety of types of venture capital
firms. They include:
1. Traditional partnerships-which are often established by
wealthy families to aggressively manage a portion of their
funds by investing in small companies;
2. Professionally managed pools-which are made up of
institutional money and which operate like the traditional
partnerships;
3. Investment banking firms-which usually trade in more
established securities, but occasionally form investor
syndicates for venture proposals;
4. Insurance companies-which often have required a portion
of equity as a condition of their loans to smaller
companies as protection against inflation;
5. Manufacturing companies-which have sometimes looked
upon investing in smaller companies as a means of
supplementing their R & D programs (Some "Fortune 500"
corporations have venture capital operations to help keep
them abreast of technological innovations; and
6. Small Business Investment Corporations (SBIC's) - which
are licensed by the Small Business Administration (SBA)
and which may provide management assistance as well as
venture capital. (When dealing with SBIC's, the small
business owner-manager should initially determine if the
SBIC is primarily interested in an equity position, as
venture capital, or merely in long-term lending on a fully
secured basis.)
In addition to these venture capital firms there are
individual private investors and finders. Finders, which
can be firms or individuals, often know the capital
industry and may be able to help the small company seeking
capital to locate it, though they are generally not
sources of capital themselves. Care should be exercised so
that a small business owner deals with reputable,
professional finders whose fees are in line with industry
practice. Further, it should be noted that venture
capitalists generally prefer working directly with
principals in making investments, though finders may
provide useful introductions.
The Importance of Formal Financial Planning
In case there is any doubt about the implications of the
previous sections, it should be noted: It is extremely
difficult for any small firm - especially the starting or
struggling company - to get venture capital. There is one
thing, however, that owner - managers of small businesses
can do to improve the chances of their venture proposals
at least escaping the 90% which are almost immediately
rejected. In a word - plan.
Having financial plans demonstrates to venture capital
firms that you are a competent manager, that you may have
that special managerial edge over other small business
owners looking for equity money. You may gain a decided
advantage through well-prepared plans and projections that
include: cash budgets, pro forma statements, and capital
investment analysis and capital source studies.
Cash budgets should be projected for one year and prepared
monthly. They should combine expected sales revenues, cash
receipts, material, labor and overhead expenses, and cash
disbursements on a monthly basis. This permits
anticipation of fluctuations in the level of cash and
planning for short term borrowing and investment.
Pro forma statements should be prepared for planning up to
3 years ahead. They should include both income statements
and balance sheets. Again, these should be prepared
quarterly to combine expected sales revenues; production,
marketing, and administrative expenses; profits; product,
market, or process investments; and supplier, bank, or
investment company borrowings. Pro forma statements permit
you to anticipate the financial results of your operations
and to plan intermediate term borrowings and investments.
Capital investment analyses and capital source studies
should be prepared for planning up to 5 years ahead. The
investment analyses should compare rates of return for
product, market, or process investment, while the source
alternatives should compare the cost and availability of
debt and equity and the expected level of retained
earnings, which together will support the selected
investments. These analyses and source studies should be
prepared quarterly so you may anticipate the financial
consequences of changes in your company's strategy. They
will allow you to plan long term borrowings, equity
placements, and major investments.
There's a bonus in making such projections. They force you
to consider the results of your actions. Your estimates
must be explicit; you have to examine and evaluate your
managerial records; disagreements have to be resolved-at
least discussed and understood. Financial planning may be
burdensome but it's one of the keys to business success.
Now, making these financial plans will not guarantee that
you'll be able to get venture capital. Not making them,
will virtually assure that you won't receive favorable
consideration from venture capitalists.
Checklist for Negotiating with Venture Capitalists
I. Amount of Financing
A. Present
1. Schedule
2. Milestones
B. Future
1. Schedule
2. Milestones
II. Form of Financing
A. Equity
1. Number of Shares
a. Price
b. Percentage of capital stock
2. Warrants
a. Exercise price
b. Term
B. Debt
1. Convertibility
2. Interest rate
a. Present
b. Escalation
3. Amortization
4. Prepayment
5. Security
6. Insurance
7. Co-signers and guarantors
8. Acceleration
III. Controls Governing Financing
A. Amount of stock issued
B. Dividends
C. Sale of assets
D. Borrowing
E. Current ratio
F. Working capital
G. Inventory
H. Accounts receivable
I. Fixed Assets
J. Employment of major shareholders
IV. Shareholder Relations
A. Employment contracts
1. Term
2. Salary controls
3. Assignment of new products to company
4. Agreement not to compete
B. Escrow arrangement
1. Percentage of shares in escrow
2. Vesting overtime
3. Ownership rights
C. Rights of investors
1. Right of inspection
2. Right to elect board member(s)
3. Right to act on default
V. Financial Statements
A. Monthly income statement, balance sheet and cash
flow statement
B. Monthly update on projections
C. Audited reports at year end
D. Weekly/monthly/quarterly management meetings
VI. Provisions Against Default
A. Levels of working capital
B. Change in management of stock control without
consent of venture capitalist
C. Submission of financial statements to venture
capitalist on a regular basis
D. Failure to pay principal or interest to any
lender on schedule
E. Failure to perform covenants established with
the venture capitalist
F. Failure to obtain consent from the venture
capitalist for
1. Dividends distribution
2. Mergers or consolidations
3. Acquisitions or investments
4. Sales of divisions
5. Borrowings
6. Changes in executive compensation
VII. Remedies Available to the Venture Capitalist
A. All notes payable to the venture capitalist
B. Venture capitalist right to elect board of
directors
C. Forfeiture of escrowed stock to the venture
capitalist
VIII. Closing Expenses Paid by Company
A. Legal Fees
B. Finder's Fees
C. Out-of-pocket expenses
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