About Venture Capital Investors

About Venture Capital Investors

Starting or growing a business with the goal of selling products or services to national or global markets nearly always requires the founder-entrepreneur to attract investment capital from outside the company. An entrepreneur and management team planning their success around the availability of sufficient and timely outside capital will have carefully thought through the following questions:

How should we position our company for successful rounds of investment?

What categories of investors should we want as our partners and, therefore, who should we approach?

How much money do we need and how much equity should we expect to "pay" for the investment dollars? What terms will investors expect to help them reduce their investment risk?

Once those questions are answered, usually with the help of an attorney and an accountant experienced in advising companies on these issues, the entrepreneur is ready to approach investors or partners. Still, it helps to understand how the equity investment market works before taking that step.

Many companies whose business plans call for relatively modest amounts of outside capital, usually from $500,000 to a $1 million can succeed in attracting all their equity capital from three kinds of individual investors: the founders themselves, friends and family of the founders, and local "deep pocket" individual venture investors.

Start-up ventures with business plans that require extensive pre-profit product development costs and/or market development costs will need to look beyond individual investors to venture capital firms and Small Business Investment Companies that are seeking to get in on the ground floor of new companies. Firms needing up to several million dollars in outside capital should be closely attuned to meeting the criteria most often used by institutional investors.

To appreciate the investment criteria of most institutional investors in small companies, it is important to understand the measures of success these funds are held to by their own investors.

Virtually all venture capital firms and SBICs are investing "other peoples' money" -- money raised from pension funds, banks, university endowments, insurance companies investment arms, and so forth.

To be attractive investment vehicles themselves, these venture capital firms must be able to promise, and deliver, a rate of return more attractive than those available in markets for publicly traded stocks and other securities.

In the past three years, especially, competing successfully with the rates of return available on the public markets has been challenging. Since venture investments are riskier and most such investments are illiquid -- the investment is tied up for many years before there is any opportunity to cash out of the venture -- the expected rates of return must be very high.

While there are no useful rules of thumb, most venture firms will look to yield between 10 and 50 times their original investment, based on their own evaluation of the company's need for capital and the levels of success and profitability the company can achieve.

Keep in mind that not every venture investment will yield a rate of return, let alone an exit opportunity to its investors. Even the best venture investors experience a total loss on one or two out of every ten investments made. Another four or five deals will require significantly more capital than was initially projected, and may join the ranks of the "walking dead" companies that plateau before achieving any significant market share and, therefore, never attract either an acquiring larger company or an IPO underwriter.

So, the venture fund's rate of return must be earned from the remaining two or three investments out of the original ten. There are, of course, spectacular venture success stories. These tend to overshadow the "might have beens" that weigh down the fund valuations and rates of return on venture firm financial statements.

Despite the challenge of return rate and the recent extraordinary performance of public equity markets, there is a favorable climate today for attracting venture capital. Why?

First, a sustained and robust public market for initial public offerings (IPOs) of both high technology and non-technology equities has provided a ready and profitable exit opportunity for venture investors.

Second, the robust IPO market has enabled many venture firms to turn in very attractive rates of return to their investors, and has helped them to attract unprecedented amounts of new money from their own investors for new venture deals.

In short, there is a lot of venture money chasing a limited number of attractive new deals.

Venture capital investment criteria are quite straightforward.

Does the company serve a market that is large enough and is fast growing enough to be interesting and promising?

Does the company's product or service have a clear, differentiated advantage in its marketplace?

Does the company, through intellectual property or other means, have sufficient barriers to the entry of other competitors who can duplicate their advantage?

Does the company have a skilled, honest, realistic, seasoned management team with the ability to carry out the business plan and with the ability to responsively weather unanticipated problems and opportunities that arise along the voyage to success?

Are the company's customers pleased with the product or service, or with its early versions, and are they likely to become repeat customers?

Is the valuation of the company and the terms of the offered equity investment attractive enough to warrant the risk involved in the investment?

Of all of the above, the need for a strong management team is by far the most critical. For a venture opportunity to be attractive, there must be a positive answer to all of these questions. But venture investors will spend most of their effort verifying the quality of the team of managers who will be spending their money.

Once you have traversed all of these hurdles, you're ready to focus on the terms and methods of closing the deal. Once again, a company will turn to its expert legal and financial advisers for help with terms, documents, and closing.