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Venture Capital Strategy

June 10, 2010 by Frank Goley, Business Consultant

Understanding how Venture Capital works is crucial when you are trying to raise venture capital funds. This article gives you inside insights into venture capital so you can develop an effective venture capital strategy. This will go a long way toward the success or failure of your venture capital campaign. You can seek Venture Capital for any growth Phase. VC expects Equity Participation through the use of Stock Ownership, Warrants, Options and Convertible Securities/ Debt.A Venture Capitalist wants just enough Control to justify the investment risk.

Two of the important Risk Models VC Firms use to determine the Risk of an Opportunity are: 

1) The Risk / Return Evaluation

– Product or Service Level:

ü  Level 1:  Idea Stage.  Not Operable.  Market Assumptions.

ü  Level 2:  Pilot/ Test Stage.  Market refined.

ü  Level 3:  Fully Developed.  Few Customers.  Market defined.

ü  Level 4:  Satisfied Customers.  Market Established.

– Management Level:

ü  Level 1:  Entrepreneur.

ü  Level 2:  Few Founders.

ü  Level 3:  Partial Management Team.

ü  Level 4:  Full Management Team.  Highly Experienced.

Note:  The higher the Level from both Determinants (Product or Service & Management), the less Risk for a higher Return.  4/4 would be most desirable and cost the Entrepreneur the least.  1/1 would be the least desirable and cost the Entrepreneur the most.  A 2/2 or 3/3 are good Level Combinations to shoot for prior to approaching Venture Capital if financially feasible.

2) The Present Value / Future Value Evaluation

Scenario:  Expected ROI is 35% per year, without inflation, over 5 years.  Present Value of Earnings is $4.5M.  Future Value Earnings in 5 years is $15M.

ü  VC Equity Share is calculated:  $4.5M divided by $15M = 30%.

ü  Maximum Investment is 10 times first year gross (expected) earnings, which in this example is about $500,000.

ü  Conclusions:  $5M maximum investment for 30% of the Company at 3/3 Level over a 3 year period.  A 1/1 Level, Seed/Start Up Investment would be a 45-50% Equity Stake, with an expected ROI of 60%.

Venture Capital Don’ts

ü  Glossy Business Plans with lots of pictures and graphics, with little substance.  We call these “MBA Graduate Plans” – they look good but little teeth or substance.

ü  Relying too much on an intermediary or broker.  VC wants to know how you think.  Use a Business Plan Consultant to help you develop a Business Plan, VC Proposals, Investment Overviews, Loan Packages and a Financial Strategy.  Use an experienced Loan Broker, specializing in VC, to introduce you to VC networks.  But you approach and negotiate (with the help of a Private Equity Law Firm) with VC.  They are principally interested in you, the entrepreneur, the founders and management.

ü  Not confident.  Confidence in your opportunity shows character- a major deciding factor for VC.

ü  Shop the deal excessively.  Find 5 VC firms and approach 3.  Excessive shopping dilutes a deal’s attractiveness.

Venture Capital Do’s

ü  Hire an experienced Business Consultant from the very early stages of founding your Company.

ü  Develop a Financial Structure & Plan and correlate the Plan to a Strategy in identifying and approaching VC Firms.

ü  Find a VC Firm that will bring more than just money to the table:  Resources, connections, strategic partnerships, etc. in your Industry.

ü  Experienced Management Team, backed by solid track records and successes.  “Sell” your Team.

ü  Develop a Comprehensive Business Plan so your Business Concept is well developed.

ü  Be able to articulate your opportunity in 2 minutes.  Then VC might give an opportunity at an initial 30 minute presentation.

ü  Developed Product Plan, Marketing Plan and Strategic Plan so you can demonstrate realistic, quantitative data and projections.

ü  Highly defined, developed Market Niches.

ü  Demonstrate Competitive Edge and Barriers to Entry.

ü  Minimize Risks:  Strategic & Investment Risks.

ü  Grants of Stock may be the structure which Investors prefer; however, this structure can dilute your ownership significantly, while giving up some control in your Company’s decisions (depending on the amount of stock granted).  By contrast, options can be used to combat the dilution and control factors, yet still make an Investor happy.  Options are just as valuable as stock; can be issued in agreed amounts; and the Investor participates after the money is invested based on the agreed option price- this aligns the Investors returns with performance.

ü  Be flexible with negotiations.  Have your Private Equity Law Firm do a run through VC Role Negotiation Session to prep your negotiating skills.

ü  Look for a VC’s good track record and research their funded companies.  Does this meet your expectations and requirements?

Venture Capital Objectives

ü  It is important to research your potential Venture Capital Funds to determine exactly what they look for in an investment, what their parameters are and what they specialize in.  A VC Fund will have a detailed website which will layout their Fund’s Objectives.  You can also find this information in their Offering Prospectus/ Memorandum to their Investors.  Below is an outline of a VC firm’s Objectives to give you an idea what to look for:

Investment Objectives

ü  Rate of Return expectations.

ü  Long- term or short- term capital appreciation.

ü  Early, Middle or Late Stage Companies.

ü  Sectors interested in.

ü  High growth potential.

ü  Liquidity Options.

ü  Expertise, Experience & Reputation of the Fund.

ü  Advisory Board Members.

ü  Members of the Fund.

Investment Criteria

ü  Evaluate in terms of Management, Product, Markets, Financials, and Business Stage.

ü  Highly competent and motivated management team.

ü  Proprietary Product or service that:  meets a strong market need:  Favorable price and cost relationship.

ü  A market which has a favorable mix of Size, Growth, Competitive Barriers and the potential for high volume sales.

ü  Management:

–People are the most important element in a Company’s success

–Balanced Team–Superior Skills

–Team leader with a track record–Ability to retain and attract talent

–Understands Planning & Control–Can make difficult decisions

–Can work with professional advisors

–Accept assistance from the Fund Members

–Commitment to the Venture

–Clearly understands the Funds’ outlook on liquidity, rate of return and investment objectives.

–Above all, integrity, character, accountability and high business ethics

Product or Service

ü  Types of Products and Services in the Fund’s Sectors which are of interest.

ü  Competitive Edge:  Cost, Quality & Performance.

ü  Premium prices achievable?

ü  High Yield Profit Margins.

ü  Dominate or Control a significant market share.

Market

ü  Young, growing fast and provides opportunity

ü  Defined market niche.

ü  Dominance in that niche.

ü  Niche market should be small enough not to attract big company competitors, yet has a strong potential for expansion.

ü  Realistic Marketing Plan.

ü  Marketing Team Leaders should have extensive industry contacts with sales people, sales reps and distributors.

Financial Outlook (these numbers are based on a technology company):

ü  $20M in Sales & Earnings, after taxes, within 5 years.  Generate Return on Assets greater than 20%.

ü  Venture is not capital intensive.

ü  Project prices & profit margins that can cushion early round obstacles.

ü  Reaching Break Even in 2 years.

ü  If it is a capital intensive deal, should be capable of adding substantial value early on and attract later rounds of funding at higher pricing.

ü  Maximum of 10 to 1 return on investment for startups.

ü  Liquidity in 5 years for startups.

ü  Later stage companies: ROI of 5 to 1 in 5 years or 3 to 1 in 3 years.

Stage

ü  Mostly early stage but will consider later stage with high growth opportunities.

ü  Consider small public companies as well as private.

ü  Spin offs as a result of re-structuring and rejuvenation.

Operating Policies

ü  Can change at the fund’s discretion

ü  Geography:

–Any geographic area but most companies are in the West and Silicon Valley, China, Taiwan and Singapore.

ü  Monitoring Investments:

–Free access to management

–Fund receives Business Plan updates regularly

–Fund will not seek majority ownership or run the venture

–Help the venture attract Management to fill gaps and develop its business plan in the early stages of investment–Board Representation

–Fund will provide expertise and assistance with securing key employees, filling management gaps, operational planning, key customer and supplier relationships, joint ventures, financing, security offerings, acquisitions and harvest strategies

Here is a Video on How to Get Funded in a Recession

See this video on Vator.tv »

Posted in Business Finance.