Venture Capital

What is it?

Many of the best-known entrepreneurial success stories can give a large tribute of their growth to financing from venture capitalists. Over the many years that entrepreneurs and small businesses owners have been around, there have been countless amounts of legit business ideas however the funds and resources were not there to make the idea possible. That is where venture capital comes in. Essentially, venture capital is funds that flow into a company during pre IPO, Initial Public Offering, in the form of an investment rather than a loan. These funds are controlled by the venture capitalist, investor who invested the VC, which require a high rate of return and are secured by a substantial ownership position in the business [1].

Venture capitalists not only add capital to the company, but skills as well. Many VCs take a role in managing entrepreneurial companies at an early stage and potentially reach much higher rates of return. Most venture capital investments are done in a pool arrangement where many investors unite their investments into one sizeable fund that invests in many different startup companies. A venture capital fund refers to a pooled investment vehicle that primarily invests the financial capital of third party investors in opportunities that are too risky for the standard venture capitalists. Being able to obtain venture capital is one of the hardest steps when first starting your business, but once one can overcome this hurdle your business or idea has significant potential for rapid growth.

Venture Capitalists make loans to young companies and in return receive very high returns on their investments. Rates on average are around 20% but can reach 30%, even 50%. The difference between banks and venture capitalists is VCs regularly take equity positions as well. This means instead of paying cash in the form of interest and principle, one can give a portion of their or other owner’s interest in the company in exchange for the venture capitalists backing.

Venture capital is usually most attractive to new companies with limited experience and operating history. Companies wishing to raise capital require exceptional qualities such as innovative technology, potential for rapid growth, impressive management team and well developed business plan. According to Entrepreneur.com, venture capitalists typically reject 98% of opportunities presented to them.

 

How VC works

For small start-up business and private companies the process of acquiring and investing venture capital has a certain routine that is usually followed. In order to receive the funds needed a company must construct a detailed and well thought out Business Plan. This plan is the driving force that could make or break a business’s VC opportunities; it works a selling point for your business.
Once a business plan is in place the company must go about finding Venture Capital firms that are in the market to invest their funds. Many firms set up specific funds that are used to invest in certain types of business. Finding the firm that fits your business is a key factor. Once the Venture Capitalist has looked over the plan they will decide whether or not they feel strongly enough in the projected returns of the company, the growth of the company and the general feasibility of the company. Typical venture capitalist look to receive roughly a 20% return a year on their investment. Based on the development stage of the company there are around 6 stages of financing that Venture capitalists offer [2].
“Seed Money” is referred to as the first sum of money that is invested into the company, usually to get an idea in motion. “Start-up”, is when the firm needs to cover expenses that are incurred in the start up phase. The “First Round” is typically used for manufacturing and early stage sales. “Second-Round” is used for working capital within early staged companies that have not yet incurred profits. “Third-Round” is also referred to as Mezzanine Financing is typically associated with expansions within a newly profitable business. “Fourth-Round” also referred to as Bridge Financing, is used to take the company public.
Many companies that seek venture capital will need more than one contribution from their venture capitalists. It is typical for a venture capitalist firm to invest 3 to 4 installments into the company, before the smaller business become public. These contributions do not go un-rewarded. Based on the size of the investment the venture capitalist will acquire either stocks or places on the board of directors of the company [2]. This exchange of ownership is determined within the first stages of the venture capital agreement. It is important to remember that the ownership in the company can greatly be diluted based on the size of the investment that is received.
Finding VC
Venture Capital is not a scarce resource. According to morebusiness.com “Over 600 active institutional venture capital firms manage over $35 billion of capital available for investment in early, expansion and late stage growth companies”. With the vast amount of funds available the problem that arises is starting your search of the firms. Many firms have separate pools of funds set up to be invested into certain industries. This can pose as an obstacle when searching for the right firm to help out. The internet can play a vital role in finding such firms, there are many companies that compile information and organize charts that help distinguish the different types of industries certain firms are investing in. A highly credible source is “Pratt’s Guide to Venture Capital Sources” [3].
It is important to contact the prospective investors through another source such as an accountant, lawyer, business broker [3] . This helps to give creditability to your business. For every 100 business plans that are looked through only one company will receive an investment.

 

Venture Capital Firms

Venture capital firms are usually arranged into partnerships. The executive of the company being invested in will become the general partner who will manage the company and the investors will become the limited partner.  A few of the different types of venture capital firms are listed below [4].

§  Private venture capital partnerships- Are considered the largest source of capital and usually look for businesses that have the ability to generate a 30% return on the investment annually. They like to actively participate in the planning and management of the businesses they finance.

§  Investment Banking Firms- Provide expansion capital, capital used to expand a newly profitable company, by selling a company’s stock to public and private equity investors.

§  Industrial venture capital pools- Typically focus on investing in firms that have a high likelihood of success and growth, like high-tech firms or companies using technology in a unique manner

 

Angel Venture Capital

As opposed to large firm venture capitalists, angel investors are a form of private venture capital that comes from a single individual or a small network of investors. In 2007, there were an estimated 250,000 active angel investors in US. According to IBank.com, “unlike a regular venture capital firm, which will provide funding for growing businesses for expansion–as well as to help save failing businesses–angel investors will usually only provide start-up capital for new businesses”. Angel investors tend to be extremely wealthy individuals and the money that they provide for their investments is out of their own pocket. Because these investments are from individuals, the amount invested will be substantially less than with the standard venture capital firm. An angel network is a group of angel investors pooling their investments together. These networks can be as small as ten or less or can reach up to a couple hundred.

Since angel investors provide venture capital for new, upcoming businesses, the investment is a very risky one. A substantial number of new companies fail and a large percentage of angel investments are lost altogether. Because a very sizeable amount of upcoming companies fail, angel investors charge a very large high rate of return. This rate can sometimes reach up to 30% or more. When deciding on which companies to invest in, angel investors are very picky because of the new business’s very high failure rate. Companies will be examined for growth potential and many times will not be invested in unless they are expected to return 1000% in five years, according to IBank.com.

Below is a pie chart representing the different types of companies that angel investors mostly invest in. High-tech sectors make up the majority of the investments of angel investors  in the same way as venture capital firms.

 

WHAT VENTURE CAPITALISTS LOOK FOR

When seeking venture capital, it is important to understand what venture capitalists are looking for.  Understanding the key components of their interests will ensure you are communicating with them in the most effective and influential way.  First, one must realize the different ways venture capital firms and banks evaluate businesses.  One way of explaining the different ways in which banks and venture capital firms evaluate a small business seeking funds is that banks look at its immediate future, but are most heavily influenced by its past. Venture capitalists look to its longer run future.  Venture capital firms and individuals are interested in many of the same factors that influence bankers in their analysis of loan applications from businesses. All financial people heavily weight their decisions and analysis on business history and past operations, the amount of money needed and what it will be used for, and the potential earnings.  Although it may seem that banks and venture capitalist evaluate and look for the same things, but venture capitalist look much deeper into the product of service.  Venture capitalists look much more in depth at the features of the product or service and the size of the market than commercial banks.  Venture capital firms have much more personal investment in a company than commercial banks.  They hold stock in the company, adding their invested capital (personal money) to its equity base for future growth. Because they take on much more personal risk, they analyze the product much more closely than banks.  They heavily 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.  Venture capitalists tend to invest more in high tech, high growth companies that will bring quick returns.  A common estimate is that they look for three to five times their investment in five or seven years.  When approaching venture capitalists, having a sound business plan with a strong product or service with high growth potential will sound much more appealing than a small growth business idea.  The key thing to remember when seeking a venture capitalist is remember they are taking on a very large risk when investing into your project.  You can decrease the riskiness aspect of your business and increase the trust by remembering these key points.

§   Have a strong introduction- First impressions are everything in the business world and the introduction of your business sets the tone for your proposal.  Start out with a firm handshake, a brief summary of what you are about to present and act as professional as you can throughout.  Confidence is crucial because if you are not certain of yourself or your business, they will not be confident in you.

§  Strong Management- Having strong management creates structure and a well-built business base.  Venture capitalists will provide you with some managerial expertise and guidance, but displaying an already strong management will sound even more appealing.

§  Growing market- Heavily stress how your product or service is a part of a growing market. This is possibly the most important thing to remember when speaking with potential venture capitalists.  A growing and expanding marking is one of the most vital things venture capitalist look for because it ensures your business is not a in a failing market.

§  Unique product or service- Venture capitalists want something new and fresh that is different from other products or services in the industry.  If your product is highly innovative, explain to the venture capitalist how the industry can utilize your product of service.  If you product or service is an adaptive innovation to existing products, focus on how your product is different than any other product in the market.

§  Sound business plan- Having a well thought-out and organized business plan ensures your business is realistic and profitable.  Prepare in advance a formal business plan you can present to potential venture capitalists.

§  High profitability- Demonstrate how your business can bring high returns to your investors through the use of past sales, future projections and industry analysis.  High profitability is what venture capitalists are looking for so display how your business will be beneficial and not a loss.

Touching on these key points will guarantee venture capitalists received all the information needed to evaluate your business.  Venture capitalists look for a well presented business idea that will generate high return from a professional entrepreneur than can be trusted with their money.

 

ELEMENTS OF A VENTURE PROPOSAL

Purpose and Objectives – a summary of the product or service idea

Proposed Financing – the amount of money you’ll need from the beginning to the maturity of the project proposed, how the money will be used, and how you plan to structure financing

Marketing – heavily stress on the current market your product or service is in. Is it in a stage of growth or decline?

History of the Firm – if this is an existing business proposal, present any historical facts or financial data.

Description of the Product or Service – a full description of the product or service offered by the firm and the costs associated with it.

Financial Statements – include any past financial statements that relate to your product or service.  If this is a novel business idea, you will skip this part.

Capitalization – a list of shareholders and how much is invested to date

Biographical Sketches – the work histories and qualifications of key owners/employees. A business owner or key managers may present their resumes at this point.

Problems Anticipated and Other Pertinent Information – discuss any active lawsuits, tax or patent difficulties, or any legal contingencies that may affect the project your are proposing.

Advantages – Sell your product! Discuss what is special about your product, service that gives your product a unique advantage.

 

References

1)    www.entrepreneur.com/

2)    http://www.money.howstuffworks.com/Fquestion3981.html

3)    www.morebusiness.com/Frunning_your_business/Ffinancing/Fvent-cap

4)    www.ibank.com/venture-capital-loans

5)    http://www.mycapital.com/companies/venturecapital101

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