Raising
Venture Capital - Small Buisness Start Up Loans
How to
Raise Venture Capital Money
Venture capital financing is a method used for raising money, 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
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.
Size of the Venture Proposal.
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.
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.
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.
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
Purpose and Objectives
Include a summary of the what and why of the project.
Proposed Financing:
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.
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'
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
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.
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 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.
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 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.
Food For Thought
We've all heard, and probably said, things
like "I'm going to go on a diet as soon as summer vacation is over" or
"I'm planning to start my own business as soon as I get some money
saved."
Planning is important, but it is action that gets things done. If you
just PLAN to lose weight, or just PLAN to start a business, it never
happens. If you wait until the time is right, or all the circumstances
are in your favor, it never happens.
The way to make things happen, the way to follow your dreams, is to
take action. Today and every day. Find something you can do right now,
today, that will bring you closer to your goal. Don't put it off until
the time is right. No matter how insignificant your action may seem,
it gets you started in the right direction. Continue taking action
every day and you start to gain momentum. Before you know it, you're
in so far that nothing can stop you.
What have you been putting off? Life is too precious to spend it
waiting. Take action today. Do your dream now.
Did you know that your mind "thinks" about 60,000 thoughts every day?
Just by the sheer volume of them, your thoughts have a huge impact on
your life.
Whether you think you can or you think you can't, you're right.
Everything you do begins in your mind. Success is an inside job. You
can choose to think empowering thoughts or you can settle for limiting
thoughts. You can think the same old thoughts over and over again, or
you can expose yourself to new experiences, concepts and
possibilities. It's completely up to you and the way you choose to
think.
Look for the opportunities in every situation. Constantly think to
yourself, "I can do it." Use those 60,000 thoughts to program yourself
for success. When you believe in what you're doing, and believe that
you can do it, you'll find a way to make it happen.
The things that regularly occupy your thinking, have the power to
drive your life. Your mind is too powerful to ignore. Take control of
your thoughts and you will have control of your destiny.
Small things, repeated over and over again, are vastly more powerful
and influential than big things done just once.
One of my primary reasons for developing The Daily Motivator was the
realization that success is most reliably achieved through consistent
effort. You can go to workshops and seminars, and hear powerful,
motivating speakers. These experiences can be very influential. Even
more powerful, however, are the things you do on a daily basis to stay
focused on excellence, accomplishment, possibilities and
opportunities.
Truly successful people realize that meaningful, lasting success does
not, can not come overnight. Great accomplishments are not one-time
efforts, but rather the culmination of a long line of repeated
efforts.
The gold-medal Olympic swimmer does not just show up at the
competition and win the race. For years beforehand, she practices her
start, her stroke, her turn, her breathing, fine-tuning each aspect to
the nth degree. Often the race is won by mere hundredths of a second.
Yet the effort needed to win that race is measured in years.
Success in any endeavor comes from consistent, determined, focused
effort. The way to guarantee that you'll be at the right place at the
right time, is to be at the right place ALL the time. Stay focused
every day on the habits of success.
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