Venture Capitalists: Working With Business Capital Pros
Most companies raise outsider capital to support or stimulate economic growth. Capital comes from savings, loans, outside investors, discretionary company earnings and venture capitalists (VC). But just who are venture capitalists, what do they want and how can they put your fledging business on the fast track to profitability?
Venture capitalists are in the business of investing money in businesses - small businesses, mid-sized companies and global enterprises - any company that shows potential for significant growth over the short term.
Venture capital investment comes from a pool of funds raised by a VC firm. Outside investors, small and large, contribute to the fund and let the venture capital professionals determine where and how to invest those funds.
A VC firm is similar to a mutual fund. Private investors put money in the fund, and fund managers invest that money on the investor’s behalf. The VC group pools money from individuals, from companies, from pension funds, from university endowment funds, institutions like insurance companies or mutual funds - virtually any entity with investment capital.
The venture capital firm invests those funds in a number of different companies. Most VC firms focus on a particular geo-specific region, industry, type of technology or type of company. For example, some VC firms only invest in software companies. Others only invest in companies within a hundred mile radius of the home office. Still others invest in nano-caps - small companies with less than $1 million in earnings and/or assets. Each VC firm focuses on an economic sector or company type, so investors know precisely what types of investments are made with their money.
Venture Capitalists aren’t typically interested in long-term partnerships. Most expect to recoup their equity, plus appreciation and/or interest, in three to five years.
Some VC take a far horizon view and invest in a promising business for a 10-year term, so shop around and carefully study the investment guidelines of any VC firm you consider as a source of capital for your growing business.
How Venture Capitalists Choose the Right Companies
A business owner has a great idea for revenue expansion but needs money to implement her growth strategy. The company principals create a business model detailing plans and projections for the company, including how much money is required and how that money will be used to expand margins, grow staff, move into a different business space or, otherwise, increase profitability.
Company management presents the plan to the venture capitalists during a "pitch meeting," with the belief that the company presentation convinces the VC that your growing company is a great investment opportunity.
If the VC perceives earnings potential, they invest in a company after a detailed, sometimes lengthy due diligence. The initial investment is called the "seed" round, providing seed money to initiate implementation of the expansion plan. Subsequent investments, if necessary, are called "second" rounds, "third" rounds and so on. In return for its investment, your company issues stock to the VC firm, making these "outsiders" part owners in your business.
Company owners may also grant a VC a measure of managerial control over the company. You may give to the investor VC a seat or seats on your company Board of Directors. You may be required to bring on additional employees at the VC’s discretion, or you may have to obtain VC approval for certain spending or investment decisions before taking action.
In other words, you now have a partner - and one with clout backed up by a legal ownership document drawn up by the VC firm in conjunction with your company’s legal advisors who negotiate the best terms for you. Indeed, negotiations are possible so don’t accept the initial offer from a venture capital group unless it meets your business goals and operating criteria.
To obtain VC cash, you also give up a portion of company ownership for the term of the investment agreement. VC firms typically require from 10% to 50% ownership in the company, depending on the value of the company and the amount of money the VC invests. So, while you do acquire much-needed capital, your ownership stake is diluted.
The VC firm may also add non-cash assets to the mix including industry contacts, networking possibilities, or new skills, experience and perspectives that greatly benefit your company - and theirs.
Remember, VC owns a portion of your business and they have a financial interest in your company’s success so view these additional contributions as free consultation and new avenues to explore.
What Do Venture Capitalists Look For?
- Solid management. Consider this the "who" question. VCs want to invest in companies with experienced, confident, skilled executives and managers - a team of knowledgeable, innovative business pros.
- Unique products. VCs tend to avoid investing in companies that provide services. These investors look for companies that make products that deliver a competitive advantage.
If your company’s products have patents, proprietary protection, trademarks, copyrights or other ownership protections, a VC firm is more interested in helping you take your business to the next level based on these exclusive, proprietary products.
- Expanding markets. Is the market for your products growing or stagnant? Remember, VCs only invest in growth companies. If you can’t demonstrate significant market potential, venture capitalists move on to the next possibility.
- Solid operating plans. If your company is a start-up, your operating plan is simply your detailed, formatted business plan. If you oversee an existing company, an investment plan must be prepared, showing where and how the VC money will be used and what the projected returns on VC capital will be.
Venture capitalists see a lot of business plans and models and perceive growth potential where other lenders and outside investors may not. Your plan will be scrutinized at the microscopic level and all projected earnings will undergo testing under various scenarios.
- A reasonable exit strategy. Can your company grow quickly enough that an initial public offering (IPO) is a real possibility? Is it likely another company would acquire your company in the near future? VC firms expect to reap significant returns on their investments in exchange for the risk they assume.
No exit strategy? No VC money to grow your business. Period.
Demonstrating sustained quarter-to-quarter growth over several years is sure to pique the interest of a visionary VC firm. In fact, business growth is the basis for investing in your business. No growth? No capital.
Looking Good to Venture Capitalists
Aside from creating a solid business plan and pulling together a thorough set of financial documents and financial projections, there are other steps to make your business more attractive to potential VCs.
Convert debt to equity. Companies with owners who have equity stakes rather than significant debt, are more secure investments because owners are engaged in daily operations - a big plus in the eyes of VC firms.
If you can’t convert more company debt to equity, make sure you clearly list all debts outstanding, so VCs know exactly what they’re signing up for. Your presentation must be 100% transparent and 110% clear to professional investors, aka venture capitalists.
Maintain clear, easy-to-read accounting documents. Documenting revenues, expenses, inventory, capital and human assets equips VC to create a clear picture of the health and history of your business. Accounting docs also provide the basis for company valuation - something any VC wants to know. If your books are a mess, don’t expect VCs to assume risk they don’t understand.
It’s essential to keep your financial house in order to demonstrate competence and effective execution of business plans. VCs like well-run companies. That’s where they put their clients’ cash - the capital your company needs to grow. Make sure accounting is current, taxes paid regularly and debt under control to make your business the next big buy for your local VC.
Simplify complex contracts and agreements. As you grow your business, you may structure non-traditional agreements with vendors, clients/customers, angels and other investors - even the owner of your business work space. Complicated contracts and "iffy" agreements are red flags for VC firms, so clean up these agreements, get them in writing and keep things simple. You may be confident in a handshake agreement with a long-time supplier but VCs won’t be.
Eliminate potential conflicts of interest. If you run several businesses, VC firms believe your attention will spread too thin, or that you won’t put their company first. Investors want you focused on their investment. And VC have a responsibility to their clients so eliminate any conflicts that may create questions about your ability to manage VC capital.
Most of all, venture capitalists invest in companies that engage in open, straightforward communication. Be honest, share your plans, open your books, and view a VC, not just as a potential source of capital, but as a real partner in your company’s success.
Venture capitalists aren’t the answer for every company, but they may be the ideal source for cash, connections and some good advice based on decades of boots-on-the-ground experience.
Used wisely, VCs can solve numerous problems and bring new perspectives to a growing business.