Reprint from "A Road Map to Financing Your Business" Conference

Preparing for Venture Capital

by Jeffrey M. Stoller, JD, CMA, MBA, MBT

"Venture capital" is defined by most people as money for start-ups and good ideas. Private investors or "angels" are the principal source of capital for most start-ups and good ideas. Most "venture capital companies," however, define venture capital as money for expansion of an existing business. Since there are many small to medium-sized businesses that would like to grow, many of them family-owned and operated, it is this latter definition that this article will address.

It is important to understand what venture capital companies look for and to decide whether your business realistically fits within those parameters. If it does not, you may not want to invest the time, energy, money and psychological stress that will be required to pursue venture capital sources.

Large venture capital companies are generally funded by clients who rely on the fund managers to make appropriate investments. Decisions are not made by the investors, themselves. Knowing this, you can better anticipate the motivation of fund managers and be able to give them what they are looking for.

Venture capital might be appropriate if…

You need additional capital to expand your existing business rapidly OR

You have a new and promising product to exploit

AND

You cannot obtain a conventional loan OR

If you can obtain a conventional loan, the repayment terms would create too great a burden during the period in which you are building to meet your potential OR

No underwriters are willing to take you public…yet

What kind of investments do venture capital companies look for?

3 to 5 Year Exit Businesses that have the potential to grow very quickly and to either go public in 3 to 5 years or be sold in that same period. In other words, venture capital companies look for investments they can be out of in 5 years. They may ultimately decide to stay in, but that’s something to be considered at a later date. If your goal is a closely-held business for your family and future generations, venture capital may not be appropriate.

5X - 7X Returns Within that 3 to 5 years, a venture capital firm wants to have the opportunity to make 5 to 7 times its investment from a combination of profits and appreciation realizable through a public offering or sale. If you have a retail store and you want to expand into the space next door so you can increase your sales by 15-20%, as satisfactory as this may be to you, venture capital may not be appropriate if neither the income nor the realistic potential to go public and generate a 500%-700% return in 3 to 5 years are present.

Good management This may sound obvious, but to a family owned and operated business, or a business operated by its founder, it may be a little unnerving to hear that the venture capital company wants different management. One of the most important and difficult transitions a family operated business can make is to professional management; and whether or not the owners want to make this transition is a key decision that should be made prior to seeking venture capital.

What can you expect from a venture capital company before it invests?

Lots of questions. That is, if they are interested. The job of the venture fund manager is to place investments for his clients in businesses that are, theoretically, riskier than other types of investments. Therefore, the manager must be very careful about his/her choices, to make sure they (the fund managers) do not get sued for negligence. This situation is understandable since many of us know that, when a friend or relative asks for investment advice, we are more cautious with their money than we would be with our own.

Most of the questions asked should have been answered in a detailed and well-prepared business plan. Do not make the mistake many small business owners make of assuming you know everything about your business or that your successful history should be good enough. You could be badly disappointed. Sit down with a consultant who is not your friend and who is not worried about hurting your feelings and let him/her drill you on the questions you may be asked. Note: What you think is a well-prepared business plan may not be what they think is a well-prepared business plan; which may significantly impact your credibility. The cost of consulting a professional will probably be minimal and the benefit considerable compared to the amount of investment you are trying to attract. You only have one chance to make a first impression.

Scrutiny of management. As suggested above, do not take this as a personal affront. For example, you began the business 10 years ago, have supported your family comfortably and are very proud of your accomplishments. Nevertheless, a venture fund manager may say to you, "What makes you think you can build this business to where we want it to be? You didn’t go to business school, you’re not a lawyer or accountant, you don’t have any graduate degrees…" Most people would react negatively to questions like this, but this is what is to be expected and planned for.

To give up a large share of your business. Sometimes demanding as much as 70% of your business, venture capitalists will generally give you the opportunity to succeed without interference until the situation seriously jeopardizes their investment. Also, success in achieving the established goals and standards could result in their interest being diminished and your regaining a larger share of the business. Why would you want to give up such a large share of your business? If your business truly does have the potential to yield a 500-700% return to the venture fund in 3 to 5 years, the return to you, even with 30-50% of the business, will be much more than you would have made by keeping 100% and not having the additional capital to grow.

To compromise. From the outset, keep in mind that your goals may not be the same as the venture capitalists. Your first and most important decision is to decide whether you can compromise what you want to satisfy them. Since venture capital companies have no shortage of businesses seeking their money and, as discussed above, do not want to expose themselves to suits for negligence, it is not likely the venture capital firm will compromise what they want.

The above points are intended to (a) enable you to better prepare in the event your business satisfies these criteria, and (b) save you time and effort in the event your business does not satisfy these criteria or give you some direction on how to re-formulate your business in order to succeed in obtaining venture capital. Remember that when dealing with venture capitalists, lawyers, bankers…anyone really, their primary interest is their own – their families, their jobs, their safety, their well-being – not yours; just as they recognize the same is true of you. It’s not selfishness or greed; just common sense and reality. Therefore, the more you can satisfy their interests, instead of simply relying on a contract or a "code of ethics", the better off you will be.

©Copyright 1997 Stoller & Associates, Inc. All Rights Reserved
1717 North Bayshore Drive, Suite 321
Miami, Florida 33132-1180
Tel: (305) 530-0046 Fax: (305) 350-6826
E-mail: exec@stollerassociates.com