A Venture Capital Primer for Small Business

Introduction

Venture capital financing is a method used for raising money, but less
popular than borrowing. Venture capital firms, like banks, supply you with
the funds necessary to operate your business, but they do it differently.
Banks are creditors; they expect you to repay the borrowed money. Venture
capital firms are owners; they hold stock in the company, adding their
invested capital to its equity base. While banks may concentrate on cash
flow, venture capital firms invest for long-term capital. Commonly, these
firms look for their investment to appreciate three to five times in five or
seven years.

One way of explaining the different ways in which banks and venture capital
firms evaluate a small business seeking funds is: Banks look at its immediate
future, but are most heavily influenced by its past; venture capitalists
look to its longer run future.

To be sure, venture capital firms and individuals are interested in many of
the same factors that influence bankers in their analysis of loan
applications from smaller companies. All financial people want to know the
results and ratios of past operations, the amount and intended use of the
needed funds, and the earnings and financial condition of future projections.

But venture capitalists look much more closely at the features of the product
and the size of the market than do commercial banks.

What Venture Capital Firms Look For

Banks are creditors. They’re interested in the product/market position of
the company for assurance that this product or service can provide steady
sales and generate sufficient cash flow to repay the loan. They look at
projections to be certain that owners/managers have done their homework.

Venture capital firms are owners. They hold stock in the company, adding
their invested capital to its equity base. Therefore, they examine existing
or planned products or services and the potential markets for them with
extreme care. They invest only in firms they believe can rapidly increase
sales and generate substantial profits. The reason for this is that venture
capital firms invest for long-term capital, not for interest income. A
common estimate is that they look for three to five times their investment in
five or seven years.

Of course, venture capitalists don’t realize capital gains on all their
investments. Certainly they don’t make capital gains of 300 to 500% except
on a very limited portion of their total investments. But their intent is to
find venture projects with this appreciation potential to make up for
investments that aren’t successful.

Venture capital is risky due to the difficulty of judging the worth of a
business in its early stages. Therefore, most venture capital firms set
rigorous policies for venture proposal size, maturity of the seeking company,
management of the seeking company, and “something special” in the plan that
is submitted. They also have rigorous evaluation procedures to reduce risks,
since their investments are unprotected in the event of failure.

Size of the Venture Proposal.

Most venture capital firms are interested in investment projects requiring an
investment of $250,000 to $1,500,000. Projects requiring under $250,000 are
of limited interest because of the high cost of investigation and
administration; however, some venture capital firms will consider smaller
proposals if the investment is intriguing enough.

The typical venture capital firm receives over 1,000 proposals a year.
Probably 90% of these will be rejected quickly because they don’t fit the
established geographical, technical or market area policies of the firm – or
because they have been poorly prepared.

The remaining 10% are carefully investigated. These investigations are
expensive. Firms may hire consultants to evaluate the product, particularly
when it is the result of innovation or is technologically complex. The
market size and competitive position of the company are analyzed by contacts
with present and potential customers, suppliers, and others. Production
costs are reviewed. The financial condition of the company is confirmed by
an auditor. The legal form and registration of the business are checked.
Most importantly, the character and competence of the management are
evaluated by the venture capital firm, normally via a thorough background
check.

These preliminary investigations may cost a venture firm between $2,000 and
$3,000 per company investigated. They result in perhaps ten to fifteen
proposals of interest. Then, second investigations, more thorough and more
expensive than the first, reduce the number of proposals under consideration
to only three or four. Eventually, the firm invests in one or two of these.

Maturity of the Firm Making the Proposal.

Most venture capital firms’ investment interest is limited to projects
proposed by companies with some operating history, even though they may not
yet have shown a profit. Companies that can expand into a new product line
or a new market with additional funds are particularly interesting. The
venture capital firm can provide funds to enable such companies to grow in a
spurt rather than gradually as they would on retained earnings.

Companies that are just starting or that have serious financial difficulties
may interest some venture capitalists, if the potential for significant gain
over the long run can be identified and assessed. If the venture firm has
already extended its portfolio to a large risk concentration, they may be
reluctant to invest in these areas because of increased risk of loss.

Although most venture capital firms will not consider a great many proposals
from start-up companies, there are a small number of venture firms that will
do “start-up” financing. The small firm that has a well thought-out plan and
can demonstrate that its management group has an outstanding record (even if
it is with other companies) has a decided edge in acquiring this kind of seed
capital.

Management of the Proposing Firm.

Most venture capital firms concentrate primarily on the competence and
character of the management. They feel that even mediocre products can be
successfully manufactured, promoted, and distributed by an experienced,
energetic management group.

They look for a group that is able to work together easily and productively,
especially under conditions of stress from temporary reversals and
competition problems. Obviously, analysis of managerial skill is difficult.
A partner or senior executive of a venture capital firm normally spends at
least a week at the offices of a company being considered, talking with and
observing the management to estimate their competence and character.

Venture capital firms usually require that the company under consideration
have a complete management group. Each of the important functional areas –
product design, marketing, production, finance, and control – must be under
the direction of a trained, experienced member of the group.
Responsibilities must be clearly assigned. And, in addition to a thorough
understanding of the industry, each member of the management team must be
firmly committed to the company and its future.

The “Something Special” in the Plan.

Next in importance to the excellence of the management group, most venture
capital firms seek a distinctive element in the strategy or
product/market/process position of the company. This distinctive element may
be a new feature of the product or process or a particular skill or technical
competence of the management. But it must exist. It must provide a
competitive advantage.

Elements of a Venture Proposal

Purpose and Objectives

Include a summary of the what and why of the project.

Proposed Financing

You must state the amount of money you will need from the beginning to the
maturity of the project proposed, how the proceeds will be used, how you plan
to structure the financing, and why the amount designated is required.

Marketing

Describe the market segment you’ve got or plan to get, the competition, the
characteristics of the market, and your plans (with costs) for getting or
holding the market segment you’re aiming at.

History of the Firm

Summarize the significant financial and organizational milestones,
description of employees and employee relations, explanations of banking
relationships, recounting of major services or products your firm has offered
during its existence, and the like.

Description of the Product or Service

Include a full description of the product (process) or service offered by the
firm and the costs associated with it in detail.

Financial Statements

Include statements for both the past few years and pro forma projections
(balance sheets, income statements, and cash flows) for the next three to
five years, showing the effect anticipated if the project is undertaken and
if the financing is secured. (This should include an analysis of key
variables affecting financial performance, showing what could happen if the
projected level of revenue is not attained.)

Capitalization

Provide a list of shareholders, how much is invested to date, and in what
form (equity/debt).

Biographical Sketches

Describe the work histories and qualifications of key owners and employees.

Principal Suppliers and Customers, Problems Anticipated and Other Pertinent
Information

Provide a candid discussion of any contingent liabilities, pending
litigation, tax or patent difficulties, and any other contingencies that
might affect the project you’re proposing. List the names, addresses and the
telephone numbers of suppliers and customers; they will be contacted to
verify your statement about payments (suppliers) and products (customers).

Provisions of the Investment Proposal

What happens when, after the exhaustive investigation and analysis, the
venture capital firms decides to invest in a company? Most venture firms
prepare an equity financing proposal that details the amount of money to be
provided, the percentage of common stock to be surrendered in exchange for
these funds, the interim financing method to be used and the protective
covenants to be included.

This proposal will be discussed with the management of the company. The
final financing agreement will be negotiated and generally represents a
compromise between the management of the company and the partners or senior
executives of the venture capital firm. The important elements of this
compromise are: ownership, control, annual charges, and final objectives.

Ownership.

Venture capital financing is not inexpensive for the owners of a small
business. The partners of the venture firm buy a portion of the business’
equity in exchange for their investment.

This percentage of equity varies, of course, and depends on the amount of
money provided, the success and worth of the business, and the anticipated
investment return. It can range from perhaps 10% in the case of an
established, profitable company to as much as 80 or 90% for beginning or
financially troubled firms.

Most venture capital firms, at least initially, don’t want a position of more
than 30 to 40% because they want the owner to have the incentive to keep
building the business. If additional financing is required to support
business growth, the outsiders’ stake may exceed 50% but investors realize
that small business owner/managers can lose their entrepreneurial zeal under
those circumstances. In the final analysis, however, the venture firm,
regardless of its percentage of ownership, really wants to leave control in
the hands of the company’s managers because it is really investing in that
management team in the first place.

Most venture firms determine the ratio of funds provided to equity requested
by a comparison of the present financial worth of the contributions made by
each of the parties to the agreement. The present value of the contribution
by the owner of a starting or financially troubled company is obviously rated
low. Often it is estimated as just the existing value of his or her idea and
the competitive costs of the owner’s time. The contribution by the owners of
a thriving business is valued much higher. Generally, it is capitalized at
a multiple of the current earnings and/or net worth.

Financial valuation is not an exact science. The final compromise on the
worth of the owner’s contribution in the equity financing agreement is likely
to be much lower than the owner thinks it should be and considerably higher
than the partners of the capital firm think it might be. In the ideal
situation, of course, the two parties to the agreement are able to do
together what neither could do separately: 1) the company is able to grow
fast enough with the additional funds to do more than overcome the owner’s
loss of equity; and 2) the investment grows at a sufficient rate to
compensate the venture capitalists for assuming the risk.

An equity financing agreement with an outcome in five to seven years which
pleases both parties is ideal. Since the parties cannot see this outcome in
the present, neither will be perfectly satisfied with the compromise reached.

It is important, though, for the business owner to look at the future. He or
she should carefully consider the impact of the ratio of funds invested to
the ownership given up, not only for the present, but for the years to come.

Control.

Control is a much simpler issue to resolve. Unlike the division of ownership
over which the venture firm and management are likely to disagree, control is
an issue in which they have a common interest. While it is understandable
that the management of a small company will have some anxiety in this area,
the partners of a venture firm have little interest in assuming control of
the business. They have neither the technical nor the managerial personnel
to run a number of small companies in diverse industries. They much prefer
to leave operating control to the existing management.

The venture capital firm does, however, want to participate in any strategic
decisions that might change the basic product/market character of the company
and in any major investment decisions that might divert or deplete the
financial resources of the company. They will, therefore, generally ask that
at least one partner be made a director of the company.

They also want to be able to assume control and attempt to rescue their
investment if severe financial, operating or marketing problems
develop. Thus, they will usually include protective covenants in their
equity financing agreements to permit them to take control and appoint new
officers if financial performance is very poor.

Annual Charges.

The investment of the venture capital firm may be in the final form of direct
stock ownership which does not impose fixed charges. More likely, it will be
in an interim form – convertible subordinated debentures or preferred stock.
Financings may also be straight loans with options or warrants that can be
converted to a future equity position at a pre-established price.

The convertible debenture form of financing is like a loan. The debentures
can be converted at an established ratio to the common stock of the company
within a given period, so that the venture capital firm can prepare to
realize their capital gains at their option in the future. These instruments
are often subordinated to existing and planned debt to permit the company
invested in to obtain additional bank financing.

Debentures also provide additional security and control for the venture firm
and impose a fixed charge for interest (and possibly principal) on the
company. The owner/manager of a small company seeking equity financing
should consider the burden of any fixed annual charges resulting from the
financing agreement.

Final Objectives.

Venture capital firms generally intend to realize capital gains on their
investments by providing for a stock buy-back by the small firm, by arranging
a public offering of stock of the company invested in or by providing for a
merger with a larger firm that has publicly traded stock. They usually hope
to do this within five to seven years of their initial investment. (It
should be noted that several additional stages of financing may be required
over this period of time.)

Most equity financing agreements include provisions guaranteeing that the
venture capital firm may participate in any stock sale or approve any merger,
regardless of their percentage of stock ownership. Sometimes the agreement
will require that the management work toward an eventual stock sale or
merger. Clearly, the owner/manager of a small company seeking equity
financing must consider the future impact upon his or her own stock holdings
and personal ambition of the venture firm’s aims, since taking in a venture
capitalist as a partner may be virtually a commitment to eventually sell out
or go public.

Types of Venture Capital Firms

Traditional Partnerships are often established by wealthy families to
aggressively manage a portion of their funds by investing in small companies.

Professionally Managed Pools are made up of institutional money and
which operate like the traditional partnerships.

Investment Banking Firms usually trade in more established securities,
but occasionally form investor syndicates for venture proposals.

Insurance Companies often have required a portion of equity as a
condition of their loans to smaller companies as protection against
inflation.

Manufacturing Companies have sometimes looked upon investing in smaller
companies as a means of supplementing their research and development
programs.

Small Business Investment Corporations (SBIC’s) are licensed by the
Small Business Administration (SBA) and may provide management assistance as
well as venture capital. When dealing with SBIC’s, the small business
owner/manager should initially determine if the SBIC is primarily interested
in an equity position, as venture capital, or merely in long-term lending on
a fully secured basis.

In addition to these venture capital firms, there are individual private
investors and finders. Finders, which can be firms or individuals, often
know the capital industry and may be able to help the small company seeking
capital to locate it, though they are generally not sources of capital
themselves. Care should be exercised so that a small business owner deals
with reputable, professional finders whose fees are in line with industry
practice. Further, it should be noted that venture capitalists generally
prefer working directly with principals in making investments, though finders
may provide useful introductions.

The Importance of Formal Financial Planning

In case there is any doubt about the implications of the previous sections,
it should be noted that it is extremely difficult for any small firm –
especially the starting or struggling company – to get venture capital.

There is one thing, however, that owner/managers of small businesses can do
to improve the chances of their venture proposals at least escaping the 90%
which are almost immediately rejected. In a word – plan.

Having financial plans demonstrates to venture capital firms that you are a
competent manager, that you may have that special managerial edge over other
small business owners looking for equity money. You may gain a decided
advantage through well-prepared plans and projections that include: cash
budgets, pro forma statements, and capital investment analysis and capital
source studies.

Cash budgets should be projected for one year and prepared monthly.
They should combine expected sales revenues, cash receipts, material, labor
and overhead expenses, and cash disbursements on a monthly basis. This
permits anticipation of fluctuations in the level of cash and planning for
short term borrowing and investment.

Pro forma statements should be prepared for planning up to three years
ahead. They should include both income statements and balance sheets.
Again, these should be prepared quarterly to combine expected sales revenues;
production, marketing and administrative expenses; profits; product, market
or process investments; and supplier, bank or investment company borrowings.
Pro forma statements permit you to anticipate the financial results of your
operations and to plan intermediate term borrowings and investments.

Capital investment analyses and capital source studies should be
prepared for planning up to five years ahead. The investment analyses should
compare rate of return for product, market, or process investment, while the
source alternatives should compare the cost and availability of debt and
equity and the expected level of retained earnings, which together will
support the selected investments. These analyses and source studies should
be prepared quarterly so you may anticipate the financial consequences of
changes in your company’s strategy. They will allow you to plan long term
borrowings, equity placements, and major investments.

There is a bonus in making such projections. They force you to consider the
results of your actions. Your estimates must be explicit; you have to
examine and evaluate your managerial records; disagreements must be resolved
– or at least discussed and understood. Financial planning may be burdensome
but it is one of the keys to business success.

Now, making these financial plans will not guarantee that you’ll be able to
get venture capital. Not making them will virtually assure that you won’t
receive favorable consideration from venture capitalists.

Bibliography

Bartlett, Joseph W., Venture Capital Law, Business Strategies and
Investment Planning, John Wiley and Sons, Inc., New York, 1988.

Burrill, Steven G., The Arthur Young Guide to Raising Venture
Capital, Liberty House, Pennsylvania 1988.

Gaston, Robert J., Finding Private Venture Capital for Your Firm,
John Wiley and Sons, Inc., New York, 1989.

Gladstone, David, Venture Capital Investing, Prentice Hall, New Jersey, 1988.

Hosmer, LaRue T., and Roger Guiles, Creating the Successful Business Plan for
New Ventures, McGraw Hill, New York, 1985.

McGarty, Terrence P., Business Plans That Win Venture Capital,
John Wiley and Sons, Inc., New York, 1989.

We hope this publication has met your business needs.

SBA has a number of other programs and services available. They include
training and educational programs, advisory services, financial programs, and
contract assistance. Our offices are located throughout the country. For
the one nearest you, consult the telephone directory under U.S. Government or
call the Small Business Answer Desk at 1-800-8-ASK-SBA.

All of SBA’s programs and services are extended to the public on a
nondiscriminatory basis.

“A Venture Capital Primer for Small Business” was written by LaRue Tone
Hosmer, Professor and Chairman of the Corporate Strategy Department, Graduate
School of Business Administration, University of Michigan.

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