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Venture Capital: Strategies For Emerging Growth Companies
By Don Reinke - Partner, ReedSmith
Keiretsu Forum News January 2004
At some point in the growth of almost every entrepreneurial business, and particularly with emerging growth companies, the entrepreneur is faced with the need to obtain financing from outside sources. It is no secret that venture capital is a significant source of financing for emerging growth companies in the Bay Area. Although every company and every venture capital transaction is unique, it has been our experience that many similar legal and business issues arise in establishing a successful venture and structuring the terms of a venture capital financing. This article is intended to provide a brief overview of those legal and business issues encountered by the entrepreneur in successfully pursuing venture capital financing.
Since the percentage of equity that a venture capitalist will require is directly proportional to the risk involved, addressing the risks which most concern venture capitalists will significantly increase an entrepreneur’s chances of obtaining venture capital. Substantially all venture capitalists will principally be concerned with the “M&M’s” of a start-up company, its “Market” and “Management.”
Market
If a company’s product requires the creation of a new market or significant development of a currently very small market niche, for example, the risk to the venture capitalist is greater in this situation because of the larger expenditures normally required to determine if the “concept” is valid. A venture capitalist can always cut its losses at any time during the development of a new product if the product doesn’t meet expectations or technology barriers cannot be overcome. The creation of a new market, however, usually first requires that the product be fully developed before the market can be tested. If the market fails to materialize, the venture capitalist has often expended large sums of money developing a product that cannot be sold.
Management
Also critical to the success of any start-up company is the background and experience of its founders. The technical skills and managerial experience of the founders will often dictate whether a start-up company’s business plan is taken seriously and will attract the attention of venture capitalists. Have any of the founders had previous experience with entrepreneurial endeavors? Do the founders bring with them the skills necessary to implement at least the first several stages of the business plan? These are questions that the venture capitalist will ask in evaluating a potential investment in a start-up emerging growth company.
Revenue Size/ROI
Assuming your company has addressed the Market and Management issues satisfactorily, what else is the venture capitalist looking for in a start-up company? Most venture capitalists are looking for a company with the potential to grow $50 million to $100 million or more in revenues per year within a five to ten year (or shorter) time horizon. There are of course many exceptions. Generally, however, revenues less than this amount will make it difficult for the venture capitalist to obtain the return on its investment that it expects.
Venture Capital
Most of today’s venture capitalists raise their money from very wealthy individuals and institutional investors like pension funds and insurance companies through limited partnerships with terms of ten years. If the venture capitalist is striving for a 25% to 30% overall return to its limited partners, then it must return on its investment to offset the inevitable losses. Every venture capital fund finds itself saddled with more than one “puppy” in their portfolios, a term coined by Jane Morris, vice president of Venture Economics in Needham, Massachusetts, to describe emerging dogs. As a result, venture capitalists will always be very cautious investors despite their willingness to invest in start-up companies. If your company meets the venture capitalist’s criteria-experienced Management team and adequate Market potential with a viable or potentially viable product, it is then important to select the right venture capitalist.
Choosing the Venture Capitalist
The right venture capitalist should be familiar with your industry, knowledgeable of your product and market and someone with whom you and your management team feel comfortable with on a personal basis. With a venture capital investment you are associating with a partner that in many ways is similar to contemplating marriage. It is important that you and your investor have the same goals and expectations regarding this partnership. If the partnership doesn’t work out, your company may have to operate with investor imposed restrictions limiting your freedom to run your business. You may then find yourself spending more time responding to your investor’s demands than focusing on the growth of your company.
Obviously, to reach this point you must first locate potential venture capital investors. There are several excellent organizations and books available to get you started, including the National Venture Capital Association, the Western Association of Venture Capitalists, and Pratt’s Guide to Venture Capital Sources among many other sources.
The best source referrals, however, will be other entrepreneurs who have been funded by venture capitalists and your professional service providers such as lawyers and accountants who are familiar with the venture capital community. A typical venture capitalist may receive up to 100 business plans per month. If your business plan arrives without you first making personal contact with the recipient venture capitalist, your business plan may not receive the consideration necessary to attract the attention of that venture capitalist. An introduction of your company to the venture capitalist by someone who knows this individual will substantially increase the chance that you will receive meaningful feedback, (even if it is negative) and hopefully generate interest in your company.
Once you have successfully obtained the attention and interest from one or more venture capitalists, the issues of valuation and financing terms must be addressed.
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