Published August 1, 1998

Venture Capital 101: Raising Venture Capital Guide

Why should I raise Venture Capital?

Most companies seek to raise venture capital to support or stimulate economic growth. Other companies raise venture funding to establish credibility or to access resource networks which their venture capital partners have developed through years of experience. A seasoned venture partner often becomes a valuable confidant, advisor and sounding board for an otherwise lonely chief executive or founder.

Certainly, venture capital financing is not a prerequisite for success. Many companies, both private and public, have achieved success absent venture funding (e.g. United Parcel Service and Microsoft Corporation). in fact, only 276 companies received their first round of institutional venture funding in.

Today's global business environment is increasingly competitive requiring decisiveness, broader relationship networks, abundant financial resources, and a global presence in order to compete effectively. The venture capital relationship can often bring that exact mix of support in addition to financial funding. Examples of such beneficial partnerships abound among prominent companies e.g., Nextel Communications, Compaq Computer, Powersoft, Staples Office Supply, Wellfleet Communications and others.

What alternatives exist?

For those companies which do not seek or are unable to attract venture funding, many alternatives exist:

Boot Strap: More than half of all funding for early and expansion stage companies is provided by company founders in the form of personal investment and foregone salary (sweat equity). Contributions by friends and family, coupled with earnings from operations are sufficient to support many companies through initial phases of development. Cash advances on purchases or development contracts from customers and strategic partners is another cheap substitute for equity financing, when available.

Angels: Angels, or wealthy individuals, are another important source of financing. In many instances, angels have earned their money as successful entrepreneurs and business managers, and are capable of providing business counsel and advice in addition to capital. Angels have a reputation for making quick investment decisions but their resources are typically limited. Accordingly, angels are often less tolerant of losses and have a shorter investment horizon than most venture capitalists.

Private Placement: Investment banks and agents raise equity capital for emerging companies by "placing" unregistered securities with accredited investors. Private placements usually result in less equity dilution for existing shareholders than venture financing. Fees and expenses are high relative to funding from venture or angel investors, and the timetable for completing a private placement is often long and uncertain. Private investors generally offer little or no business counsel, and tend to have minimal tolerance for losses and under-performance.

Initial Public Offering: Few companies are able to access public equity markets. The public market is attractive for its high valuations, abundant capital supply and liquidity characteristics. Transaction costs are high, including ongoing legal expenses associated with public disclosure requirements. Companies often chose to fund long term strategic initiatives with venture funding instead of public equity to avoid legal exposure and the public market's focus on near term quarterly performance.

How do I find venture capital?

Begin by identifying a list of venture capitalists whose investment preferences match your needs and company profile with regards to size of investment, stage of development, industry and geographic location. Over 600 active institutional venture capital firms manage over $35 billion of capital available for investment in early, expansion and late stage growth companies. "Pratt's Guide to Venture Capital Sources" is a valuable resource for any company seeking to raise venture funding. It is a list of active venture firms published annually by Venture Economics including each firms' location, investment preferences, contact persons and capital pool.

Make contact with prospective investors through a respected referral such as an attorney, accountant, consultant or business broker. As a rule, over one hundred investment proposals are reviewed for every one company that receives venture funding. Most venture capitalists will respond to a cold call or business plan which arrives "across the transom", but a respected referral will usually establish a higher standard of quality and accelerate a response.

Limit your search to a manageable number of investor candidates, preferably six or less. Educating investors requires substantial senior management time and distracts attention from day to day business operations. Choosing venture firms located in close geographic proximity will expedite initial meetings and screening.

A business plan and executive summary should be developed by the CEO with input from senior management. Allow ample time to complete fund-raising, usually two to six months, and budget the maximum time for business planning purposes to avoid negotiating from weakness. Investment banks will assist companies raising $5 million or more for a fee, which helps to mitigate distraction from business operations. Smaller financings are routinely completed independently by management without outside assistance. Accountants, lawyers and business brokers frequently act as advisors or agents on small financings, and can facilitate the process, particularly for managers who are new to fund-raising.

Seek advice from entrepreneurs in the community who have previously raised venture capital. Venture capital sponsored fairs, seminars and panel discussions are an ideal forum to gain exposure to entrepreneurs and service providers with experience in fund-raising.

Finally, maintain a list of venture contacts and communicate regularly through quarterly newsletters or press releases. Do not assume that your most recent venture funding will be your last. Use frequent written communications to develop relationships with appropriate investor candidates over time.

Which industries attract venture capital?

Above all, venture capitalists seek industry segments poised for rapid growth and exceptional profits. Sustained growth and profitability beyond a five year horizon is essential to create a premium exit value in a public offering or sale. Ordinarily, emerging markets and industry segments offer these characteristics. Occasionally, a new segment within a mature market, or a new method of solving an existing problem, creates a sustained, rapid growth opportunity. For instance, a new distribution model developed by Staples Office Supply created buying efficiencies which enabled Staples to capture market share from then existing "mom & pop" operations.

Venture capitalists seek markets sufficiently large to achieve $100 million or greater in value. Market critical mass is necessary to produce liquidity in a public offering or sale. Small markets may not attract attention from stock analysts or strategic buyers sufficient to generate premium values.

Occasionally, niche markets with unusually high barriers to entry will drive profitability sufficient to build substantial value and liquidity.

Not surprisingly, the information technology and health care industries attracted over two thirds of venture capital dollars disbursed in 1993. Most segments within these two industry categories are large and growing rapidly. They have high barriers to entry and attract premier management talent from around the world. Consumer and retail attracted another 10% of venture dollars disbursed in 1993.

Does my company qualify for venture capital?

Provided your company is in one of the industry segments attractive to venture capitalists, most evaluation criteria deployed are under management's control. Consequently, the due diligence process will focus on assessing management's strengths and weaknesses.

A demonstrable track record of success by the existing managers, preferably as a team, is essential. Experience in the same or a related industry is an advantage. Management will be graded on their maturity, creativity, commitment, leadership skills and communication skills. The ability of top management to attract, develop and retain new talent is imperative. Senior management should have an objective view of their own weaknesses.

Finally, management's goals and objectives must be consistent with the investor's. Chemistry between the venture capitalist and management should not be underrated, as both parties will be entering into a long term and professionally intimate relationship.

Other factors which will be evaluated by prospective investors include the following:

  • How compelling is the competitive advantage of the company's product or service?
  • What investment level is required to sustain this advantage?
  • How is the company's market positioning unique and differentiated?
  • Is competition well established or entrenched and what is their philosophy.?
  • Does your company have adequate access to existing distribution channels?
  • Does the economic model generate sufficient operating leverage?
  • How does employee productivity, re-investment rate and capital intensity compare to similar companies?
  • What is price and valuation relative to comparable private companies?
  • Are existing customers satisfied and committed to your product or service?
  • Is sales momentum building?

What should I expect from the due diligence process?

The due diligence process will comprise between four and ten weeks of rigorous analysis. It will involve multiple meetings and interviews with management, at both the investor's and company's offices. The investor will conduct numerous telephone interviews with existing and prospective customers. An on-site visit with a key customer may be requested.

Management credentials will be verified through references supplied by the company and the investor's own contacts. A technical consultant may be retained to assess strengths and limitations of proprietary technology. A marketing consultant may be hired to evaluate market dynamics and to augment market research conducted by the venture capitalist, including periodical searches and interviews with market gurus, editors and competitors. Financial analysis will test the economic model's sensitivity to key sales and expense assumptions.

The primary objectives of this process are to:

  • Understand how management approaches problems, issues and decisions.
  • Confirm management's representations and the investor's own perceptions regarding the company's technology and market opportunity.
  • Identify key vulnerabilities and risks so that the risk/reward outlook can be quantified.
  • Gain an intimate understanding of the company and its market so that as a partner, the venture capitalist is prepared to counsel management to anticipate and manage change.

Concurrent with the due diligence process, the venture capitalist and management will negotiate terms of a transaction. Valuation expectations should be discussed early in the process in the context of a range. Valuation is not likely to be resolved until the investor has identified all risks and vulnerabilities through due diligence.

How will a venture capitalist value my company?

Valuation methods are different depending on your company's stage of development. Early stage companies are valued based on management's investment or contribution in the form of hard dollars, sweat equity, opportunity cost and intellectual value. Prior demonstrable success in a venture backed company will increase management's appeal and negotiating strength considerably.

Expansion stage companies are ordinarily valued based on comparable company multiples of sales, while late stage companies are valued based on comparable earnings multiples. In all cases, valuation will correlate directly with potential growth and earnings.

Venture investors seek to earn between 5 and 10 times their initial investment within a 5-8 year investment horizon. Venture capitalists seldom charge fees or require current income (i.e. interest or dividends) on investments. Capital appreciation is the primary goal and is usually realized through a sale of the company to a strategic buyer or an initial public stock offering. Contrary to popular misconception, an IPO is not necessarily a preferred exit vehicle. A sale or merger may provide a more rapid exit and avoid exposure to unpredictable public market volatility.

How will an Investment be structured?

Convertible preferred stock is the most customary structure used by the venture community. Other equity securities, or combinations of debt and equity (i.e., subordinated notes and warrants) can be structured to mirror the economics of convertible preferred, but may be unnecessarily complex.

Investors will require priority ("preference") on the value of their principal investment over management's "sweat equity" in the event of a liquidation or sale of the company.

An accruing dividend of 8%-12% is typical, and provides a "minimum return" on top of the preference on principal. If the company performs well, investors will convert their preferred stock to common stock to participate in capital appreciation. Investors purchasing a minority ownership position will require certain rights and protective covenants to restrict management from taking unilateral action detrimental to investors.

Is there a "top ten" list on how to improve my odds of securing venture capital?

The following list applies equally to raising both equity and debt.

  • Regardless of your company's stage of development or capital needs, start developing relationships with potential investors as soon as practicable.
  • Qualify potential investors based on their preferences and availability of capital - not all venture capital funds have moneys available for new investments.
  • Prepare a concise business plan and update it regularly.
  • Be realistic in financial projections. Unrealistic projections may impair credibility on a first impression.
  • Do not be secretive or suspicious. Encourage all members of the management team to communicate freely and openly with potential investors.
  • Develop an in-depth knowledge of your market and competition before seeking investors. Contact opinion leaders in your market before investors begin their due diligence.
  • Encourage customer references early. Customers have already invested in your product and have a vested interest in your company's success.
  • Travel to the investor's office to secure an initial meeting.
  • Seek advice from venture capitalists even if they reject your initial proposal. Change your business plan or approach based on feedback if appropriate.
  • Don't be discouraged - perseverance is often a key ingredient to your success.

Tom Smith, Partner, Mid-Atlantic Venture Funds, (703) 904-4125