Venture capitalists represent the most glamorous and appealing form of financing to many entrepreneurs. They are known for backing high-risk companies in the early stages, and a lot of the best-known entrepreneurial success stories owe their early financing to venture capitalists.
When many entrepreneurs write a business plan, obtaining venture capital backing is what they have in mind. That’s understandable. Venture capitalists are associated with business success. They can provide large sums of money, valuable advice, priceless contacts, and considerable prestige by their mere presence. Just the fact that you’ve obtained venture capital backing means your business has, in their eyes at least, considerable potential for rapid and profitable growth.
Venture capitalists both lend to and make equity investments in young companies. The loans are often expensive, carrying rates of up to 20 percent. They sometimes also provide what may seem like very cheap capital. That means you don’t have to pay out hard-to-get cash in the form of interest and principal installments. Instead, you give a portion of your or other owners’ interest in the company in exchange for the VC’s backing.
When Venture Capital Is an Option
Venture capital is most often used to finance companies that are young without being babies and that are established without being mature. But it can also help struggling firms as well as those that are on the edge of breaking into the big time.
The following are the major types and sources of capital, along with distinguishing characteristics of each.
Seed money. Seed money is the initial capital required to transform a business from an idea into an enterprise. Venture capitalists are not as likely to provide seed money as some other, less tough-minded financing sources, such as family investors. However, venture capitalists will back seedlings if the idea is strong enough and the prospects promising enough. If they see something new and exciting (usually an aspect of technology) and foresee rapid growth (and a strong potential for high earnings), they may jump in and back a fledgling startup. It’s a long shot, but it does happen.
VCs, however, are less likely to provide equity capital to a seed-money-stage entrepreneur than they are to provide debt financing. This may come in the form of a straight loan, usually some kind of subordinated debt. It may also involve a purchase of bonds issued by the company. Frequently these will be convertible bonds that can be exchanged for shares of stock. Venture capitalists may also purchase shares of preferred stock in a startup. Holders of preferred shares receive dividends before common stockholders and also get paid before other shareholders if the company is dissolved.
Seed money is usually a relatively small amount of cash, up to $250,000 or so, that is used to prove a business concept has merit. It may be earmarked for producing working prototypes, doing market research, or otherwise testing the waters before committing to a full-scale endeavor.
Startup capital. Startup capital is financing used to get a business with a proven idea up and running. For example, a manufacturer might use startup capital to get production underway, set up marketing, and create some actual sales. This amount may reach $1 million.
Venture capitalists frequently are enthusiastic financiers of startups because they carry less risk than companies at the seed money stage but still offer the prospect of the high return on investment that VCs require.
Later-round financing. Venture capitalists may also come in on some later rounds of financing. First-stage financing is usually used to set up full-scale production and market development. Second-stage financing is used to expand the operations of an already up-and-running enterprise, often through financing receivables, adding production capacity, or boosting marketing. Mezzanine financing, an even later stage, may be required for a major expansion of profitable and robust enterprises. Bridge financing is often the last stage before a company goes public. It may be used to sustain a growing company during the often lengthy process of preparing and completing a public offering of stock.
Venture capitalists even invest in companies that are in trouble. These turnaround investments can be riskier than startups and therefore even more expensive to the entrepreneurs involved.
Venture capital isn’t for everybody, but it provides a very important financing option for some young firms. When you’re writing a business plan to raise money, you may want to consider venture capitalists and their unique needs.
What Venture Capitalists Want
While venture capitalists come in many forms, they have similar goals. They want their money back, and they want it back with a lot of interest and capital growth.
VCs typically invest in companies that they foresee being sold either to the public or to larger firms within the next several years. As part owners of the firm, they’ll get their rewards when such sales go through. Of course, if there’s no sale or if the company goes bankrupt, they don’t even get their initial money back.
VCs aren’t quite the plungers they may seem. They’re willing to assume risk, but they want to minimize it as much as possible. Therefore, they typically look for certain features in companies they are going to invest in. Those include:
- Rapid sales growth
- A proprietary new technology or dominant position in an emerging market
- A sound management team
- The potential to be acquired by a larger company or be taken public in a stock offering within three to five years
- High rates of return on their investment
Rates of Return
Like most financiers, venture capitalists want the return of any funds they lend or use to purchase equity interest in companies. But VCs have some very special requirements when it comes to the terms they want and, especially, the rates of return they demand.
Venture capitalists require that their investments have the likelihood of generating very high rates of return. A 30 percent to 50 percent annual rate of return is a benchmark many venture capitalists seek. That means if a venture capitalist invested $1 million in your firm and expected to sell out in three years with a 35 percent annual gain, he or she would have to be able to sell the stake for approximately $2.5 million.
These are high rates of return compared with the 2.5 percent or so usually offered by ten-year U.S. Treasury notes and the nearly 10 percent historical return of the U.S. stock market. Venture capitalists justify their desires for such high rates of return by the fact that their investments are high-risk.
Most venture-backed companies, in fact, are not successful and generate losses for their investors. Venture capitalists hedge their bets by taking a portfolio approach: If one in ten of their investments takes off and six do OK, then the three that stumble or fail will be a minor nuisance rather than an economic cold bath.
One key concern of venture capitalists is a way to cash out their investment. This is typically done through a sale of all or part of the company, either to a larger firm through an acquisition or to the public through an initial offering of stock.
In effect, this need for cashing-out options means that if your company isn’t seen as a likely candidate for a buyout or an initial public offering (IPO) in the next five years or so, VCs aren’t going to be interested.
A common way for venture capitalists to cash out is for the company to be acquired, usually by a larger firm. An acquisition can occur through a merger or by means of a payment of cash, stock, debt, or some combination.
Mergers and acquisitions don’t have to meet the strict regulatory requirements of public stock offerings, so they can be completed much more quickly, easily, and cheaply than an IPO. Buyers will want to see audited financials, but you—or the financiers who may wind up controlling your company—can literally strike a deal to sell the company over lunch or a game of golf. About the only roadblocks that could be thrown up would be if you couldn’t finalize the terms of the deal, if it turned out that your company wasn’t what it seemed, or, rarely, if the buyout resulted in a monopoly that generated resistance from regulators.
Venture capitalists assessing your firm’s acquisition chances are going to look for characteristics like proprietary technology, distribution systems, or product lines that other companies might want to possess. They also like to see larger, preferably acquisition-minded, firms in your industry. For instance, Microsoft, the world’s largest software firm, frequently acquires small personal computer software firms with talented personnel or unique technology. Venture capitalists looking at funding a software company are almost certain to include an assessment of whether Microsoft might be interested in buying out the company someday.
Going Public: Initial Public Offerings (IPOs)
Some fantastic fortunes have been created in recent years by venture-funded startups that went public. Initial public offerings of their stock have made numerous millionaires, seemingly overnight. For example, when Twitter made its initial public offering at a price of $26 in November 2013, the stock took off, gaining as much as 93 percent within a day and creating 1,600 millionaires. Wow! IPOs have made many millions for the venture investors who provided early-stage financing.
The 2012 passage of the Jumpstart Our Small Business Startups (JOBS) Act allows for confidential filing of IPO-related documents. This has made it easier for small business owners who do not want their numbers getting out to the public too soon. There was often concern about investors getting too much preliminary information that could influence their decision to commit to the company. Confidentiality has increased the number of IPO filings in the small business community.
Nonetheless, an IPO takes a lot of time. You’ll need to add outside directors to your board and clean up the terms of any sweetheart deals with managers, family, or board members as well as have a major accounting firm audit your operations for several years before going public. If you need money today, in other words, an IPO isn’t going to provide it.
An IPO is also probably the most expensive way to raise money in terms of the amount you have to lay out up front. The bills for accountants, lawyers, printing, and miscellaneous fees for even a modest IPO will easily reach six figures. For this reason, IPOs are best used to raise amounts at least equal to millions of dollars in equity capital. Venture capitalists keep all these requirements in mind when assessing an investment’s potential for going public. Keep in mind that the number of new businesses that go public is quite small.
The Truth About IPOs
Many entrepreneurs dream of going public. But IPOs are not for every firm. The ideal IPO candidate has a record of rapidly growing sales and earnings and operates in a high-profile industry. Some have a lot of one and not much of the other. Low earnings but lots of interest characterize many biotech and internet-related IPOs. These tech companies are usually the ones that generate the huge IPOs and instant millionaires we read about.
Potential Pitfall of VC Funding
Many VCs insist on placing one or more directors on the boards of companies they finance. And these directors are rarely there just to observe. They take an active role in running the company.
VCs also are reluctant to provide financing without obtaining an interest in the companies they back, sometimes a very significant and controlling interest. This can make them just as influential as if they had a majority of the directors on the board, or more so.
Buzzword: Rate of Return
Rate of return is the income or profit earned by an investor on capital invested in a company. It is usually expressed as an annual percentage.