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  The First Step: Understanding the Process Profile of a Typical Venture Capital Fund Professionally managed venture capital funds provide seed, startup and expansion financing as well as management/leveraged buyout financing. Venture capital firms are typically established as partnerships that invest the money of their limited partners. Since investors in venture capital funds have specific return-on-investment requirements, a venture capitalist must evaluate potential investments with a similar return-on-investment consideration. Many funds invest between $2-$3 million in any one venture over a period of three to five years and look for companies with a market potential of $50 - $100 million. Venture capitalists will be looking for a 30-40% or more, annual return on investment and for a total return of 5 to 20 times their investment. Venture capitalists are not passive investors. Usually they become involved as advisors to management and/or members of the company's board of directors. By actively participating, venture capitalists seek to maximize their return. An entrepreneur should exact the same diligence in evaluating the benefits that a particular venture firm can provide the company. - Do the venture capitalists have experience with similar types of investments? - Do they take a highly active or passive management role? - Are there competing companies in their portfolio. - Can they help provide contacts for distribution channels and executive search? The Valuation Process It is critical for an entrepreneur seeking venture capital to assess the value of the company from the perspective of the venture capitalist and to appreciate the dynamics of the entrepreneur/venture capitalist relationship. This relationship revolves around a tradeoff. Funds for growth are exchanged for a share of ownership. The entrepreneur gives up a large share of ownership, possibly a majority stake, while the venture capitalist seeks a substantial return on investment. Entrepreneurs seek to raise as much money as they can while giving up as little ownership as possible. Venture capitalists strive to maximize their return on investment by putting in as little money as possible. Through the negotiation process, the two parties come to an agreement. While each has their individual goals, both parties should agree on one mutual goal -- to grow a successful enterprise. The first step in the negotiation process is to determine the current value of the company. Factors include stage of development, product revenues, expense history, management teams, and company goals. The best way to build value in a company is to achieve goals and milestones within the time frames designated in the business plan. Many entrepreneurs "bootstrap" themselves during the early stages with money coming from family, friends, private investors or money-raising strategies such as consulting or custom development. Pricing and Control: The Investors' Perspective Pricing venture capital deals involves the estimated future value of the entity being financed and is highly subjective. Theoretical approaches can be used to estimate the company's future value and the corresponding percentage ownership that the investor requires -- in other words, estimated future value based on the venture's expected profitability and estimated earnings multiples. The estimated percentage ownership the investor must receive can then be calculated to derive the desired return on investment. Remember that venture capital investors expect an annual rate of return of 30% to 40% or more. If the estimated future market value is high, a smaller percentage of ownership will provide the required return. Continue to Step 2 of 3 > |
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