Venture capital financing is a method used for Raising Cash For Business and Getting Investments for Business, but less popular than borrowing. Venture capital firms, like banks, supply you with the funds necessary to operate your business, but they do it differently. Banks are creditors; they expect you to repay the borrowed money.
Venture capital firms are owners; they hold stock in the company, adding their invested capital to its equity base. While banks may concentrate on cash flow, venture capital firms invest for long-term capital. Commonly, these firms look for their investment to appreciate three to five times in five or seven years.
One way of explaining the different ways in which banks and venture capital firms evaluate a small business seeking funds 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.
What Venture Capital Firms Look For (Raising Cash For Business)
Banks are creditors. They're interested in the product/market position of the company for assurance that this product or service can provide steady sales and generate sufficient cash flow to repay the loan. They look at projections to be certain that owners/managers have done their homework.
Venture capital firms are owners. They hold stock in the 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. The reason for this is that 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 risky due to the difficulty of judging the worth of a business in its early stages. Therefore, most venture capital firms set rigorous policies for venture proposal size, maturity of the seeking company, management of the seeking company, and "something special" in the plan that is submitted. They also have rigorous evaluation procedures to reduce risks, since their investments are unprotected in the event of failure.
Most venture capital firms are interested in investment projects requiring an investment of $250,000 to $1,500,000. Projects requiring under $250,000 are of limited interest because of the high cost of investigation and administration; however, some venture capital firms will consider smaller proposals if the investment is intriguing enough.
The typical venture capital firm receives over 400 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 carefully investigated. These investigations are expensive. Firms may hire consultants to evaluate the product, particularly when it is 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 $2,000 and $3,000 per company investigated. They result in perhaps ten to fifteen 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.
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. Raising Money From Investors.
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. Getting Investments for Business.
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 "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.
Most venture capital firms concentrate primarily on the competence and character of the 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 competition problems. 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. Raising Money From Investors.
Next in importance to the excellence of the management group, most venture capital firms seek a distinctive element in the strategy or product/market/process position of the company. 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 - Getting Investments for Business
Purpose and Objectives
Include a summary of the what and why of the project.
Proposed Financing: You must state the amount of money you will 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.
Marketing: Describe 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.
History of the Firm: Summarize the 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.
Description of the Product or Service: Include a full description of the product (process) or service offered by the firm and the costs associated with it in detail.
Financial Statements: Include statements for both the past few years and pro forma projections (balance sheets, income statements, and cash flows) for the next three to five 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.)
Capitalization: Provide a list of shareholders, how much is invested to date, and in what form (equity/debt).
Biographical Sketches: Describe the work histories and qualifications of key owners and employees.
Principal Suppliers and Customers, Problems Anticipated and Other Pertinent Information
Provide 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. List the names, addresses and the
telephone numbers of suppliers and customers; they will be contacted to verify your statement about payments (suppliers) and products (customers).
Provisions of the Investment Proposal
What happens when, after the exhaustive investigation and analysis, the venture capital firms 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. 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.
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' equity in exchange for their investment.
This percentage of equity varies, of course, and depends on 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 capital 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.
Financial valuation is not an exact science. The final compromise on the worth of the owner's contribution 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 the parties cannot 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 is a much simpler issue to resolve. Unlike the division of ownership over which the venture firm and management are likely to disagree, control is an issue in which they have a common interest. While it is 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 nor the managerial personnel to run a number of small companies in diverse industries. They much prefer to leave operating control to the 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.
They also want to be able to assume control and attempt to rescue their investment 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.
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 given 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 (and possibly principal) on 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.
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 may be virtually a commitment to eventually sell out or go public.
Types of Venture Capital Firms
Traditional Partnerships are often established by wealthy families to aggressively manage a portion of their funds by investing in small companies.
Professionally Managed Pools are made up of institutional money and which operate like the traditional partnerships.
Investment Banking Firms usually trade in more established securities, but occasionally form investor syndicates for venture proposals.
Insurance Companies often have required a portion of equity as a condition of their loans to smaller companies as protection against inflation.
Manufacturing Companies have sometimes looked upon investing in smaller companies as a means of supplementing their research and development programs.
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 that 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 three 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 five years ahead. The investment analyses should compare rate 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 is 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 must be resolved - or at least discussed and understood. Financial planning may be burdensome but it is 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.
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