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Venture capital primer; where venture capitalists want to invest.

Venture Capital Primer

Where Venture Capitalists Want to Invest

Attracting investors to a young business is tough because of the risks involved. Young businesses fail at an alarming rate, so those with money usually are cautious and wary. The most risk-oriented financiers of all are venture capitalists. What they want--and how entrepreneurs should approach them--is the subject of this article.

Venture capitalists are a particularly hard-skinned bunch. Their business is putting money into hope-and-a-prayer-type, start-up, and growing businesses. It's no wonder there's a widely held view that venture capital is classic "risk capital"--capital invested in risky enterprises. These enterprises are risky because they are so new and unproven.

Venture capitalists also want an equity (ownership) stake in a firm. This differs from a bank that lends money (against collateral) and expects to get repaid, plus interest, on a predetermined schedule. Venture capitalists have no set schedule for getting their money back and lack collateral.

"We're not in the business of lending money," clarifies Donald H. Parsons Jr., an investment officer for The Centennial Funds, which manages nine venture capital funds from its Denver headquarters.

Not all venture capital is the same. VCs invest in companies depending on: (1) the company's stage of development, and (2) its industry.

Stage of Development

VCs break down development stages into two main classes of financing. Early-stage financing is the first. This contains seed, startup, and first-stage financing stages.

If all that exists of a business is a gleam in an entrepreneur's eye, and money is needed to prove the concept or start development of the product, then we're talking about seed financing. When final product development is at hand and it's time to create marketing strategies, then the firm is a startup in need of startup financing. At these stages, the company has no sales or commercial production. First-stage financing, the most advanced of the early stages, goes to firms ready to begin commercial production and commence sales.

The second main class is expansion financing. This, too, has three stages. The first, called second-stage financing, is for firms in production, whose sales are ramping up and who need working capital. Third-stage financing is for businesses on a growth curve that need to expand their manufacturing capacity, marketing efforts, working capital, and research and development efforts. The final or fourth-stage (also called bridge or mezzanine) financing, is to prime the business for going public, which is expected within six to 12 months. This stage is often repaid from the public offering's proceeds.

"Most venture capitalists target businesses depending on the stage they're at," says Mitt Romney, managing partner at the Boston venture-capital firm, Bain Capital. Some do just early-stage financing, even just seed or startup financing. Others invest only in the stages that come under expansion financing.

Who to Approach

A business owner with an established business who wants to push his firm onto fast-track growth wastes his or her time by going to VCs who specialize in early-stage financing. Likewise, those looking for money to start a business shouldn't bother to approach VCs interested in later-stage financing.

Most firms seeking venture capital in Utah are at a very early stage of development. "In this [Salt Lake] valley, you find deals in the raw," notes Orem Phillips, vice president of business and development for Ogden's Thiokol Corp.

Risk is a reason for venture capitalists to specialize. The earlier a company is in its development, the more risk. Some VCs are bigger risk takers than others. Also, the expertise required is different. Just like there are people adroit at conceptualizing and getting a business going, and others proficient at managing ongoing firms, there are VCs good at helping firms get started while others are adept at fully developing firms beyond the startup stage.

Further, the financial demands change with the stage. Seed financing is typically small, usually less than $1 million, often even under $100,000. But as a firm develops, usually its need for money grows. Its marketing efforts expand; its workforce increases; its manufacturing facilities need enlarging. VCs with deep pockets can better handle the latter financing stages than can VCs who are not as flush with cash or who lack the contacts to put together a syndicate of VCs.

Industry Specialists

Most venture capitalists specialize in one or a few industries, usually in high-tech areas. Much of the venture capital invested in the past decade went to such industries as computer hardware and software, biotechnology, and the like.

Not all, however, are plugged into high tech. Romney says his firm, Bain Capital, invests primarily in low- and medium-tech, including manufacturing, data processing, health care, retailing, and information-related businesses. His firm invested in Key Airlines that, at the time, was a Salt Lake City-based commercial jet charter company. Another Brain investment was a division of Hallmark Cards that manufactures photo albums and photo frames.

The entrepreneur looking for money must match his or her firm's business to the likes and interests of the VC (see the list of venture capital sources at the end of this article).

Many VCs wouldn't consider investing in a photo-album maker. They prefer new drug-delivery systems, for example.

Congratulations: You're Getting Married

In addition to matching a VC's risk and industry criteria to your business, consider that most VCs don't just put down their money and hope for the best. They become involved with the management of the business. Some become very active, others are more consultants. In all cases, the chemistry between the VC and the firm's management must be good if the relationship is to work.

"It's kind of like a marriage," notes Brad Bertoch, staff consultant for the Utah Small Business Development Center and executive director of the Wayne Brown Institute. "You're going to have ups and downs. When things get tough, how are people going to react? Are they [the VCs] going to be helpful, or are they going to cover their own tail?" You need to trust and feel comfortable with the VC.

What The VC Wants

Getting venture capital is like engaging in any negotiation. Hard and fast rules don't exist. How much of the company you have to give up, how much money you'll get, how much control goes to the VC--all of these are negotiable. Here are the things important to venture capitalists. Remember, when numbers are given, they are merely rules of thumb.

Profits: VCs are in this for the money; forget this at your peril. Notes Romney, "Everyone will tell you they look for management first. In reality, [the VC looks] to see whether there's an opportunity for a business to make you an enormous return on your investment." What's an enormous return? According to Romney, in the riskier early stages, VCs typically want 10 times their money within five years, which works out to about 58 percent a year, compounded. Later-stage investors look for about 25 percent annually, reflecting their lower risk exposure. This is why everyday businesses, like gasoline stations and manufacturers of common widgets, can't get venture capital--they have no chance of generating the enormous profit potential VCs require.

The reason VCs demand such high returns is the size of the risks they take. For early-stage financing, which is the riskiest, Romney estimates 10 to 25 percent of the firms that get funding are "very successful" and hit their goals, 25 to 35 are complete failures, with the rest in between. Therefore, on average, less than a quarter of a VC's investments reach their targeted returns.

Management: While management may not be priority No. 1, it is important, very important. "People who have been successful in the past or who are experienced in what they're setting out to do," are the types of people VCs want, says Richard Shanaman, special limited partner at Utah Ventures, the only venture-capital fund based in Utah. One Utah company that successfully attracted venture capital based on its management track record was Cardiopulmonics.

Growth: If the company has limited growth potential, likely it has limited profit potential. Bertoch says the VCs he meets want to see annual sales of $20 million to $25 million within five to seven years. Romney says it could be even higher, say $50 million in five years. Bertoch says Iomega and Wicat are examples of companies fitting this criteria.

Protected market position: Venture capitalists don't like to invest their time and money only to find competitors quickly moving into their newly developed market. When possible, VCs look for patent protection or proprietary technology. For low tech, Romney looks for a "defensible advantage." A chain of office supply superstores that quickly opens several outlets so it dominates a market, has created a defensible advantage. Newcomers will find it hard to establish a beachhead in that market.

Exit potential: The relationship between entrepreneur and venture capitalist differs from a marriage in one respect: it's not a lifelong commitment. Typically, VCs want to get out of their investment within seven years. "After seven years, they turn into pumpkins and die. The venture community doesn't get emotionally attached to the company. That's why they may want to leave while you want to stay," says Lee Smith who co-founded Symbion and Albion, both medical-technology firms that attracted venture capital.

The most common way for them to get out (so-called exit strategies) is selling the firm, selling their position in the firm, or taking the firm public. This is one reason rapid growth is essential. Going public isn't feasible for a firm with sales of a few hundred thousand dollars and little prospect for doing more. Nor is such a firm or the VC's position in the firm likely to be acquired. It also accounts for the focus VCs place on certain types of businesses. Some types, such as biotechnology, excite investors. This makes it easier for the VC to exit his or her investment and take home the big bucks. Smith says that many conventional businesses sell for one to two times their annual sales, while he's seen high-tech firms often get four to five times their annual sales. Entrepreneurs who can't provide the VC with a plausible exit strategy won't get the VC's money in the first place.

These are the most important points venture capitalists look for. Entrepreneurs need note a few other aspects of venture capital:

Be patient: Some banks promise they'll approve or not approve your loan within 24 hours. Don't count on your VC providing the same level of service. Most VCs say the norm is six to 12 months to get your money--assuming you get funding at all.

Line up other sources: Venture capital is nice when you can get it, but don't count on it. Romney estimates less than 5 percent of the firms seeking venture capital get it, and he says the number may be as low as 1 or 2 percent.

Don't be greedy: Entrepreneurs often get hung up when a VC asks for 40, 50 or even 60 percent of the firm, which is a common ownership share they seek. Romney makes the observation that in situations where investors put up all the money, they usually get all the company, such as with General Motors or IBM. If VCs put up all the money, they're often willing to give the entrepreneur 40 or 50 percent of the firm. The VC is actually being generous. Says Romney, "What entrepreneurs have to decide is not how much of the pie they're going to get, but how big the pie is going to be."

Alan S. Horowitz is a free-lance writer based in Salt Lake City.
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Title Annotation:includes related article
Author:Horowitz, Alan S.
Publication:Utah Business
Date:Feb 1, 1992
Words:1933
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