Professional venture capital is defined by the National Venture Capital Association as “money provided by professionals who invest alongside management in young, rapidly growing companies that have the potential to develop into significant economic contributors.” Venture capital is, however, a viable alternative for only a limited number of small, growing companies.
Venture capitalists are individuals – or groups of people – whose primary aim is to purchase equity in growing companies and then sell that investment at a profit within a designated period. The primary institutional source of venture capital is a venture capital firm. Venture capitalists take higher risks by investing in an early-stage company with little or no history, and they expect a higher return for their high-risk equity investment.
Most venture capitalists prefer to purchase equity in ongoing businesses as opposed to start-ups (and generally specialize in high-tech companies). Venture capitalists search for high-growth firms with a new technology or product innovation. Because of the risk associated with the typical investment, the investor will require a 30-to-40 percent (or higher) projected annual rate of return. The most heavily negotiated issue in any venture capital investment is valuation. This will determine what percentage of the company the investor will receive in return for his cash outlay. Valuations are determined not only by the quality of the company but also by the supply of available funds.
The traditional venture capital investment is typically equity-based and may take the form of common stock, preferred stock, or convertible debt. The investment will not be structured to require a current payout in the form of interest or dividends. Instead, the venture capitalist expects to achieve the return upon liquidation of the investment. At the time of the initial investment, an exit strategy is usually devised to sell or bring the company public within three to five years. Venture capital is not the answer for a company desiring to remain private.
The advantages of acquiring venture capital financing are the minimal current costs and its availability to companies with a promising future but limited current profits. It may also reduce interest costs for debt financing since a lower-debt-to-equity ratio may result in more favorable borrowing rates. Finally, since many venture capitalists were once budding entrepreneurs, they are invaluable sources for advice. The basic disadvantage of this type of financing is the dilution of ownership interest and the difficulty in making a match between business and investor.
It is important to note that not all monies a venture capital fund has under management are available for current investments. In fact, some firms may have substantial assets under management, but not be active in terms of seeking new investments. The firm may have already invested in venture deals or may have the funds designated for the expansion of companies already in their portfolio. However, venture capital firms will often operate more than one fund. Although one fund may be closed to new investments, the firm may be in the process of raising capital for another fund. It is at this point that the venture capital firm will be most active in reviewing new investment opportunities.
While some firms are generalists and invest in a larger variety of companies, most venture capital firms limit the businesses they will invest in by determining their preference regarding geographic location, industry, and stage of funding. Regardless of these preferences, virtually all firms have a specified dollar value range they are willing to extend for investment.
Many firms consider how closely they will be able to monitor a given investment before agreeing to extend venture capital to a business. Some venture capital firms are now advertising themselves as more than financial resources for their investments and are offering experienced advice to help lead the company to success. In such a case, proximity to funds can be a great asset for a business seeking venture capital. Two percent of all venture capital invested in the United States is invested in North Carolina. Venture capital availability has increased dramatically in the past few years, and there are now more than fifty funds active in North Carolina (See list). North Carolina’s venture capital investments have tripled since 1997. Even though proximity can be an asset to obtaining venture capital, many non-North Carolinian investors are choosing to invest in North Carolina’s businesses. The Council for Entrepreneurial Development (CED) compiled in-state and out-of-state venture capital resources and found the Research Triangle region experienced a dramatic increase in funds from 1998 to 1999. The CED study identified significantly more investments than either PriceWaterhouseCoopers’ Money Tree report or the National Venture Capital Association (NVCA) report, and CED has noted that a goal for 2000 will be to work with the NVCA to reconcile their records throughout the year. It is undisputed that venture capital is rising in North Carolina, and there are more venture capital opportunities for funding now than there have ever been.
While all venture capitalists seek high-growth companies for investment, some concentrate their investments in specific industries. Leading industries in attracting venture capital are software, communications, and business services companies. According to the study, the business services sector’s strong performance was due to the strength of Internet-based businesses, including business-to-business, e-commerce, Internet consulting, web site development and hosting, and online advertising. Both business services and new media obtained more than five times the venture capital in 1999 than in 1998. In 1999 retail and distribution nearly quadrupled their funds, while consumer services, financial services, and communications each more than doubled their 1998 figures. Despite a movement to invest in complementary businesses, there are still numerous venture capital firms with diversified interests, meaning they take on companies in a variety of industries.
Venture capital firms generally prefer a certain stage of investments; some specialize in seed capital or early expansion, while others focus on greater expansion or exit financing.
Early-stage financing is defined as the first capital that an entrepreneurial company receives. It usually refers to seed capital or first-stage financing. At the seed stage, a small amount of capital is provided to prove a concept or qualify for start-up capital. First-stage deals provide financing to companies who have expended their initial capital and require funds to initiate full-scale manufacturing and sales. Financing is usually in the form of private equity because most of these companies do not have assets, cash flow, or profits to support bank loans or public stock offerings. Many entrepreneurial companies, particularly those that are technology-intensive, are seriously compromised in their early development by the shortage of seed-stage capital. Due to the high risk involved, new companies have their greatest difficulty raising the initial $1 to $2 million of start-up funding. However, once a company is able to prove that the idea in fact makes a good business, significantly more capital is available. The National Venture Capital Association report states that in the first quarter of 2000, early-stage (the stage after seed) companies received more than 20 percent of total venture capital investments.
Later-round financing is used to satisfy a growing company’s expansion needs. These stages include companies that are already profitable. Early or second-stage financing provides working capital for the expansion of a company that has growing receivables and inventories. Third-stage or mezzanine financing provides for major expansion of a company with increasing sales that is breaking even or becoming profitable. Fourth stage or bridge financing fund companies going public within six months, and are repaid with IPO proceeds. Venture capital is much easier to procure at these stages, as risk has diminished significantly.
The National Venture Capital Association reports that in the first quarter of 2000, more than 60 percent of all investments focused on these growth phases. Profitable venture-backed companies enjoy a broader range of funding alternatives than companies at any other stage of development. In addition to being able to finance growth through retained earnings, many of these companies are attractive candidates for corporate partnering, acquisition, and initial public offerings.
RAISING VENTURE CAPITAL
Pratt’s 1998 Guide to Venture Capital Sources estimates that only 30 of 100 businesses submitting plans will be invited to the crucial first meeting with a venture capital firm, and only one of the 30 is successful in obtaining venture capital financing. An estimated 60 percent of the proposals to venture capitalists are usually rejected after a brief scanning, and 25 percent are discarded after a lengthier review. Only the remaining 15 percent are examined in more detail.
Despite the influx of new venture capital funds, recent indicators show that the percentage of plans examined is actually diminished. A small business can substantially increase its chances of a more thorough review if it can get a direct introduction to a venture capitalist through a professional advisor, such as a lawyer or accountant. The approval and suggestion of a well-respected source will often cause the venture capital firm to consider a company’s business plan thoroughly. Companies submitting business plans absent such support are rarely successful in securing such funding.
Venture capital seekers can greatly improve their chances of receiving venture capital by presenting a well-organized and detailed business plan with realistic and yet impressive financial projections. Entrepreneurs should emphasize their managerial capability, the market size and evidence of demand, as well as the potential to sell the business for a hefty profit. The business plan, however, will only lead to a meeting. At the meeting, the company must be prepared to make a formal, persuasive presentation that will give the venture capitalist a positive impression of the product and management team.
Companies seeking to raise venture capital should allot a substantial amount of time to identifying potential suitors. While there are a number of venture capital firms operating within North Carolina, there are many sources available outside the state. Although these sources have traditionally been difficult to access, the company seeking venture capital financing should, in the initial stages, consider all the possibilities. The prospects for procuring funding from out-of-state sources are actually becoming more favorable due to the growing national awareness of attractive opportunities in the region, and use of the World Wide Web to connect North Carolina’s entrepreneurs with outside venture capitalists.
Most venture capital funds operate as “blind pools” in which investors’ monies are combined and then invested by the venture capital fund managers. Some offer an added twist in which investors have varying degrees of discretion in picking and choosing among the deals in which the funds invest.