A (venture) capital idea

The costs of developing a technology or idea into a product and then marketing it successfully can be high, and they are often more than anticipated. Entrepreneurs frequently start new companies from home, taking little or no salary. Business angels, or wealthy individuals, may also provide start-up and other early-stage financing. Banks may not want to lend more than a small amount, so new capital will have to come from venture capitalists (VCs).

What is venture capital?
Venture capital provides equity capital to finance the start-up, development, expansion, restructuring, or acquisition of a company. Venture capital firms provide this money from pools of capital invested by private investors or institutions such as banks and pension funds. VCs typically put this money in small companies with rapid growth rates and focus on early stage investing because it often produces the highest returns.

In return for this medium- or long-term financing, the VC receives a share of the company’s equity, usually 25–50%. VCs do not invest to receive a dividend, but to allow the company to expand and increase the value of their investment. They provide not only money but also contacts, advice, and experience. A VC typically seeks a nonexecutive board position and attends monthly board meetings.

About 700 venture capital firms in the United States manage roughly $210 billion. In 2000, the average venture fund was $145.4 million, with VCs investing more than $100 billion in more than 5000 companies. The stumbling economy and terrorist attack in September 2001 combined to reduce investment volume, but 2001 is still expected to be on par with 1998 and 1999 levels.

Who gets the money?
VCs invest in young companies that have the greatest potential for growth. Most venture capital firms provide capital ranging from $250,000 to $10 million or more. Typically, VCs have minimum and maximum amounts that they will invest. Because VCs wish to increase the value of their investment in a company, they evaluate potential investments by using several criteria, including the market potential, management team, and technology or product, as well as the rate of return.

The market size is key. Innovative projects that create an entirely new market obviously have a better chance of achieving high growth rates than projects that target established markets in which there is competition. Numbers vary depending on the source, but venture-funded companies are usually expected to grow to at least $25 million in sales within 5 years and to show a longer-range growth of $50–100 million in less than 10 years.

VCs must be convinced that management can deliver on its plan and is capable of building a multimillion-dollar business. The managers’ backgrounds must show that they possess the requisite skills and expertise. VCs look for previous experience in building and managing growth, as well as the ability to hire top people.

“With management, we look to find some pattern of achievement,” explains Harry Rein, principal founder and managing partner at Canaan Partners, a venture capital firm in Rowayton, CT. “If you miss this you’re in trouble. It doesn’t matter whether there are two scientists from the lab presenting the business idea or an entire team. Every situation is different. In some cases, the experience is there; in others, someone has done something so well many times, we’re willing to take a risk on that person.”

The product or technology is, of course, the linchpin of all these activities. Proprietary is good. Patents, copyrights, trademarks, and other intellectual property rights to a product or service are a competitive advantage. A unique product that offers benefits over existing products will improve the odds of getting VCs interested in your solution.

Finally, the size of the investment is a major factor. An important measure of the growth potential of an investment is the internal rate of return (IRR), which is usually set between 40 and 60% per year. However, even a high IRR will not produce significant amounts of cash if the amount of capital invested is small. More important is the fact that the cost of a small investment is as great as, or proportionately greater than, that of a large investment. For this reason, some VCs will not consider investing less than $500,000.

The business plan
A VC should be approached in a series of planned steps. One of the first actions you should take is to develop a clear business plan that sets out a convincing case for financing. The business plan provides the details of the business’s current position and its strategy for the future. Remember that VCs are financial specialists, so the information you provide will be closely examined. In general, the business plan should cover at least the first five years of operations and must demonstrate convincingly not only the commercial viability of the business but also its potential for rapid growth that generates a high rate of return.

After the business plan is complete, develop an approach strategy. First, research different venture funds to uncover their strengths, reputations, and preference for industry sector or stage of company development. Be sure that you approach a VC who is appropriate for your business or market. Then, if at all possible, get a personal introduction or referral to improve your chances of being considered for funding. Finally, send the executive summary of your business plan to your target VCs along with a letter requesting a meeting.

Interested VCs will set up an initial meeting to interview key members of the team and review the business plan. You will need to demonstrate not only a clear understanding of your business and of the barriers to entry, but also that you have the necessary drive, ambition, and experience, as well as a vision for the company’s growth. Bring the business plan to the meeting, and be prepared to discuss it in detail, especially the financial projections, forecasts, and potential returns.

If the VC thinks your business has potential, a series of follow-up meetings will take place, during which the business will be thoroughly evaluated by the VC. “We look at . . . the long-term viability of working with the individual and our ability to act as coach,” explains Rein.

If the VC decides to provide financing for your company, an offer will be made. Rein estimates that it takes about one and a half to three months from initial contact to signed agreement. Your company may receive one or more rounds of venture financing; not all of the committed capital may be provided in the first round.

Reaping the rewards
After you have successfully negotiated an agreement, an interim period begins during which you must execute the plan and develop the business with the active participation of the VC. At a predetermined point, however, the VC will exit from the investment. An early stage investment may take 7–10 years to mature, whereas a later stage investment might take only a few years. The exit strategy calculates how the VC will realize liquidity and receive value for his investment.

Because most companies that VCs invest in are private enterprises, a VC realizes a return on the investment only if the company goes public with an initial public offering (IPO) or undergoes a merger or acquisition (M&A). Although an IPO may be the most glamorous type of exit, and in recent years has delivered the highest returns, most successful exits of venture investments occur through an M&A. Sometimes, the VC is involved in the IPO and an M&A. One company that Canaan Partners guided through both was International Network Services, a data communications network product services company that was acquired by Lucent Technologies after the IPO.

The current situation
Although the process of funding a start-up with venture capital is relatively straightforward, the current economic climate makes it difficult to do so. IPOs raised $7.1 billion in fresh capital for 77 companies in the third quarter of 2000. The third quarter of 2001, however, gives a different picture. Only five venture-backed companies went public in the three-month period ended September 30, raising just $280 million. Not only has the number of IPOs fallen, but the average market capitalization of post-IPO firms has dropped by more than half, and the amount of capital that companies have tried to raise through IPOs has plummeted. Moreover, not only is the stock market’s volatility reducing the investment returns from stock sales, but September 2001 was the first month in more than a decade that witnessed no new offerings (1).

Yet all is not gloom and doom. Industry experts caution that comparisons with venture capital funding in 1999 and 2000 are unrealistic. Investments through the first three quarters of 2001 totaled $25.4 billion, far exceeding the full-year 1998 figure of $17.5 billion. Full-year 2001 is expected to reach $30 billion, making it the third largest year in history (2).

A closer look shows that while equity investment in venture-backed startups fell in the third quarter of 2001, a total of $6.5 billion was invested in 601 financing rounds. In the two months after the September terrorist attacks, VCs invested almost $1 billion in computer software companies alone. The biopharmaceutical and semiconductor industry sectors are also successfully navigating the difficult economic climate. Biopharmaceuticals ended the quarter at $581 million raised in 51 deals, and semiconductor companies raised $432 million in 44 rounds of financing (2). But the weak are being culled from the herd, and only the strongest business plans and management teams can succeed.

References

1. Venture Economics and the National Venture Capitalist Association (NVCA) Research Survey, 2001; available at www.nvca.org.
2. PricewaterhouseCoopers MoneyTree Survey, in partnership with VentureOne, 2001; www.pwcmoneytree.com/highlights.asp.