2.04 – Daring to use Venture Capital
Venture capital is a professionally managed pool of funds, typically operating as a limited partnership. The managing general partner assembles a pool of investors—both individual and institutional, such as pension funds and insurance companies—whose money they invest on behalf of the partnership.
Venture capitalists usually invest during the second round of funding, seeking fast growth and quick returns. This often creates a conflict between their goals and the entrepreneur’s long-term vision for the company.
In the late 1990s, venture capitalists shifted their focus to Internet companies, investing in ideas rather than established intellectual property. They funded companies like Amazon.com and Buy.com, which weren’t projecting profits for several years. However, when stock valuations plummeted in late 1999 and early 2000, venture capitalists reevaluated their strategies. They didn’t stop investing in Internet companies but began to better evaluate opportunities.
Venture capital still funds less than 1% of all new ventures, mostly in technology areas such as biotechnology, information systems, the Internet, and computer technology. To understand how you might use venture capital, it’s essential to grasp the cost of raising capital and the process involved.
Calculating the Real Cost of Money
Raising money, whether from private or venture capital, is time-consuming and costly. Many entrepreneurs in traditional businesses opt for slower growth using internal cash flows. However, if you decide to accelerate growth with outside capital, you need reasonable expectations. Here’s what you need to know:
- Time Commitment: Raising money always takes longer than planned, often twice as long.
- Preparation: Plan to spend several months seeking funds, additional months for the investor to agree, and possibly six more months before receiving the money.
- Financial Advisors: Use experienced advisors to assist in raising money.
- Management Team: Ensure a strong management team is in place, as raising money will take you away from your business when you need to be there most.
- Start Early: Begin looking for money before you actually need it.
Even after finding an ideal investor with aligned goals and good rapport, they may still back out of the deal. Always have a backup plan if the deal starts to fall through.
Investors often prefer to buy out your early investors, including friends and family, to avoid dealing with many small investors. Explain this possibility to your early funders to prevent awkward situations. If you don’t agree to the buyout, the investor might walk away.
Raising capital involves upfront costs, including preparing and printing the business plan, travel, and time. If seeking substantial funds, you’ll likely need financials reviewed by a CPA and a prospectus outlining the investment risks and rewards. After receiving the capital, costs of maintaining it, such as interest on loans and investor updates, can usually be paid from proceeds. Additional back-end costs may include investment-banking fees, legal fees, marketing costs, and brokerage fees, potentially reaching 25% of the total amount raised.
Tracking the Venture Capital Process
Venture capitalists analyze your deal, decide to invest, draft a term sheet, and conduct due diligence. This process can be complex but generally follows a predictable pattern. Here’s what venture capitalists look for:
- Investment Duration: Venture capitalists invest for a specified period, typically five years or less, expecting a substantial return (around 50% or more). The return is proportional to the venture’s risk.
- Board Involvement: Venture capitalists often want a seat on your board of directors to influence business strategy and policy.
Approving Your Plan
Venture capitalists scrutinize your business plan to ensure you have a strong, committed management team with industry experience. They evaluate your product and market for substantial opportunities and competitive barriers, such as patents. If they see significant growth potential, they may call for a meeting to confirm your team’s capabilities.
Doing Due Diligence
If the initial meeting is successful, venture capitalists conduct thorough due diligence to verify your team and business concept. Once satisfied, they draft legal documents detailing the investment terms. Note that money is rarely released in one lump sum; it’s usually disbursed in stages tied to achieving specific goals.
Crafting The Deal
Approach venture capitalists from a position of strength. Desperation can lead to unfavorable deals. Prove that your business concept is strong and viable. Every deal consists of four parts:
- Capital Amount: Reflects the need, risks, and return timing.
- Timing and Use: Specifies how and when the money will be used.
- Return on Investment: Outlines the expected return for investors.
- Risk Level: Determines the amount of equity demanded based on risk and investment size.
By understanding these aspects, you can negotiate effectively with venture capitalists and secure the necessary funding to grow your business.
