By Bill Oxford
Understanding the Process
Professionally managed venture capital funds provide seed money to entrepreneurs. Typically, VC firms establish partnerships, in which to invest the money of their limited partners. Venture capitalists invest in companies for a short period of time for a substantial total return.
Research is vital to targeting the right venture capitalists. Criteria for selecting the right venture capitalist include geographic, industry specialization, stage of development, size of investment preferences, investment role, and co-competitive ventures.
Writing a Business Plan
The first step is a striking, sound business plan. The business plan must immediately grab the venture capitalist’s attention.
A good plan is crucial, first as a management tool, and second as a means to obtain financing. While the plan is an essential element in securing financing, it should also be an operating guide to the business, with the goals, objectives, milestones and strategies clearly defined and well written.
A good business plan will demonstrate the viability and growth potential of the business, while showcasing the entrepreneur’s knowledge and understanding of what is needed to meet the company’s objectives. The venture capitalist’s first glance at the business plan is their initial opportunity to evaluate the individuals who will manage the business and to measure the potential for return on their investment.
Prepare the Financials
Realistic financial forecasts within the business plan are important to attract investors and retain their interest to participate in future rounds of financing. The financials must accurately reflect the various product development, marketing and manufacturing strategies described in each section of the plan.
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.
Purpose of Financial Forecast
Developing a detailed set of financial forecasts demonstrates to the investor that the entrepreneur has thought out the financial implications of the company’s grown plans. Investors use these forecasts to determine if (a) the company offers enough growth potential to deliver the type of return on investment that the investor is seeking, and (b) the projections are realistic enough to give the company a reasonable chance of attaining them.
Content of Financial Forecasts
Investors expect to see a full set of cohesive financial statements. It is customary to show monthly statements until the break even point or profitability is reached. Thereafter, quarterly statements should be prepared for two years, followed by yearly data for the remaining time frame.
Assumptions to Use in Forecasts
– Cost of Sales
– Product Development
– Other Expenses
– Balance Sheet
– Cash Flows
Beyond the Three Steps
Alternate Financing Sources
– Friends & Relatives
Many companies have financed their development stages through the help of friends and relatives.
– Debt Instruments
Business purchase/expansion monies can be attained through a variety of debt instruments. Consider equity options, flexible payment terms and convertible debt.
– Joint Ventures
Any company can benefit from having a strong corporate partner.
Tips to Getting Noticed
– Spend time writing a succinct and persuasive executive summary, BUT write the body of the business plan FIRST.
– Create a professional, graphically pleasing document. Make sure it is indexed for easy reference. Number copies, sequentially, so that investors will know that only a few copies are being distributed. Include a cover letter addressed to a specific contact and follow up with a phone call.
– Use references or introductions from sources respected by venture capitalists. Have your plan referred through an accountant or attorney with a strong venture capital practice.