A Quick Guide to Raising Venture Capital - PART 2
Wednesday, 3 March 2010 | Spin-Offs and Start-Ups
The Wall Street Journal Europe Future Leadership Institute invites international thought leaders and decision-makers to portray their work, research and findings. The chapter "Spin-Offs and Start-Ups" collects articles designed to help students and young entrepreneurs creating their own company. The article below was written for the Future Leadership Institute by Oliver Gajda, international renowned expert on venture capital, former Director of Europe Unlimited and member of The Future Leadership Institute Eagle Group.
2. Basic considerations
Finding sources of money is fairly easy, getting it is the difficulty. Before you spend long hours putting together your pitch for the venture capitalist you have read or heard about, let us consider the alternatives. For your start-up business, support is readily available from a variety of organisations. These include start-up coaches, accountants, lawyers, business consultants, friends, the chambers of commerce, business information centres or incubators, government support programmes and so on.
Depending on the stage of your start-up, your primary financing sources are family and friends. They usually come with limited resources and emotional attachment, which is risky if you should fail. Nonetheless, this is probably the starting point for you unless you have enough cash on your own bank account. Business angels are also a great source of funding, but make sure you pick one that understands your business and its industry, has plenty of contacts, the willingness to get involved and share - but no urge to be in charge.
If your business idea is a little straighter and revenue is on the doorstep, banks (overdrafts, short or medium-term loans), factoring, invoice discounting or preferable payment terms from suppliers and bootstrapping could be a very good solution to overcome funding gaps. However, these will in nearly every case not support stellar growth of your company. Lack of funding can also be tackled by reducing cost and expenditure, for example the purchase of second hand information technology, leasing and sharing of facilities. In some cases public support programmes (regional, national, European) can be used to drive the development of a specific technology or the exploitation of a new market. Still, most of these come with a bureaucratic burden, which needs to be managed.
Nevertheless, not all of these might be useful to you for your business right now and it is advisable to be aware of what is available where you are. Talk to relevant people you already know (business and corporate lawyers, for example, are often a great source of contacts). Of course, if your business will be the next success story we will be reading about in the Wall Street Journal, than a professional venture capital investor might be someone to consider. Call you contacts, use them to get an insight regarding suitable venture capitalists out there and get a personal introduction, if you can.
To simplify your work, I would advise carefully considering at least the following points.
* Define your roll-out plans. Do not be shy. Start talking about the roll out plans of your venture with business partners (if you have any) or other parties of interest as early as possible. Clearly define the preferred outcome of the company or technology development and focus on the most promising business activity. It is easy to envision different scenarios, but focus will help you in executing your plans with relevant support. Investors are not interested in opportunities as such, but in those opportunities that can be executed and achieved within an agreed time-frame by you and your team.
* Spell out the consequences of potential follow-up. Be very clear about the situation your business is in, the relationships that could support it and the abilities and limitations that define it. Ask yourself:
a) Which of your business partners are willing and capable to support the deployment phase?
b) Who has the intellectual property rights and the know-how and how can these be managed within your venture?
c) What is the business model you favour? Is it a direct sales concept, a reseller model, a services model in some form, including varieties such as Software as a Service, based on licensing and royalties, franchising, etc.? Will you make money with the first customer or will you first have to amass many users in order to make your product or service viable?
d) Which legal incorporation will be the most appropriate for the type of business you are launching? Consider liabilities.
e) How would you prefer to split responsibilities (leadership and management), investments and shares (paid-in or in kind) between you and your business partners?
f) Estimate your external funding needs and the percentage of shares that you are happy to pass on to third party investors.
Based on this, establish what will be the most appropriate and suitable investor for your business plan and risk profile. To do so, put together the following:
a) Characterise your business with regard to your business area, your potential customer base and staff as well as the anticipated investment horizon that is the duration which you believe you will need external investors on board.
b) Understand available funding schemes (equity, debt, quasi-equity etc.) that a venture capital fund might offer -often some of these go hand in hand in order to reduce the risk that the venture capitalists is exposed to.
c) Be aware of investors` funding strategies and ascertain which would be the most appropriate for your business model that answer the needs of your projected (or preferred) growth and revenue potential and speed. Be also very clear about the 3-7 year investment horizon with often exorbitant growth expectations that venture capital brings with it. Can your business match this and are you and your team good enough to execute this? If not, consider other options.
Once satisfied with your growth model, and it might take some reading, thinking and talking, make a decision with regard to your preferred investor type for your next step. Likelihood is that you will have to tap into different pots at different times, no matter what type of business you are trying to build. According to your choice your approach will have to vary significantly. Make sure that you fully understand what the appropriate requirements are or you will waste your time and money. For those business models that will generate revenues quickly and are expected to reach break even within a short period of time, say one to two years or less, more conservative funding models, such as loans, could well be favourable. Again, it depends on your own preference and the market for funding. Early 2010 will still be a difficult time for most forms of capital as the relevant industries come to grasps with the financial crisis and its impact on capital availability at investor level.
If you should think about raising venture capital, now or in two years, you are in for an interesting but challenging ride, but you also better have stellar growth prospects. Within the venture capital industry talk is mostly about those investments that have made headlines, not those that failed. And currently, it is about consolidation and who will be around to continue investing in 2011.
So what is venture capital? Broadly speaking, it is a form of equity capital provided to companies that are not quoted on a stock market. Usually, it is used for product or technology development, as an expansion of working capital or to make acquisitions of products or companies. In some cases it is used to resolve ownership or management issues, but overall, it aims to provide long-term share capital for hopefully high growth.
Venture capital is frequently understood as a sub-set of private equity, especially in Europe. Overall we can distinguish between early stage, later- or expansion stage and buyouts. The term private equity is often applied as an overall category for investments in unquoted equity, but a more common use for it is to describe buyout investments or M&A.
Venture capital, as a sub-set of private equity, is particular as an investment, because it is supposed to be aimed at speeding up value creation through growth, not through financial engineering. That is, of course, not necessarily always the case, but admittedly in general the intention. Therefore, the venture capitalist should be expected to take a very active and hands-on part in helping you to grow your business during launch, early development, or expansion of your business. Venture capital is about the active combination of equity, expertise and contacts in the market. This combination is what makes a good investor.
For our purposes, venture capital or early stage investments are those we will focus on. They are made in start-ups. However, the field is diverse by size and by type of investors. Early stage investments are also not singular events. Any given start-up is likely to receive multiple investment rounds from different kind of investors as the business develops, often more than four or five. You can easily identify three investment areas that venture capital investors might consider; they are seed, start-up or growth.
A seed investment will be appropriate for a company launch and the development of its product or product testing. Usually the seed round will be a modest amount of funding as it will carry the company through the first stages of product development, the creation of a prototype and/or the preparation of a sophisticated business plan. Typically, the seed capital comes from family, friends or so-called business angels. Some specialised or regional venture capital funds also pursue this type of funding as part of their overall business strategy. This will be followed by a start-up investment, which is appropriate at a later stage when the business will already make some revenue, though no or limited profits, and have a product that can be launched into the market.
This is the point where venture capital investors become more interested and many technology-focused funds specialise in this area. Other, non-specialised venture capital funds invest only a small percentage of their capital in start-up companies, as they do not have the capacities of managing the risks associated with start-ups in specific industries. These funds focus on businesses already operating and seeking to grow into new markets. Only when a business generates profits, or is distinctly set to generate profits, will larger funds, especially those operating at a pan-European level, start to become interested. In order to reduce risk, a venture capitalist usually will provide capital in steps according to a company's development, sometimes even single investment rounds are structured in tranches over time.
To be able to fully comprehend how a venture capitalist chooses a specific investment strategy - which will define all investment decisions - you need to understand their own position. They most often manage private money on behalf of institutional investors, such as banks, insurance companies and pension funds, or of wealthy families - but are requested to invest some part of their own money, too. Their value proposition is to return interest well above other investment opportunities, such as the stock market, over a period of usually up to ten years. The structure of these funds is such that the venture capitalist will receive a small management fee to pay for his running cost (somewhere between one and a half and three percent on assets under management), and will participate in the upside at the end of the fund. The venture capitalist is therefore concerned to make as much money as possible within the time he as been given -or faster. In reality, the venture capitalist is just an entrepreneur like you, active in financial services. He will benefit from the growth of his company and also feel the pain of decline.
Add to this the fact that not all investments turn out to be profitable for the venture capitalist. On average there might be only one or two companies in a venture capitalist's portfolio out of maybe fifteen that make a significant win when they are sold. Many will be written off over time, others will just repay the investment, and a number will make a modest profit to the investor. Let us be clear about this, the venture capitalist must make decisions based on expected return at all times. This can lead to your company not receiving initial or follow-on investment, it can lead to the venture capitalist pulling out of your company if things are not going well or even forcing you to liquidate. It can also mean that you that will be pressured to sell your business at a time that is convenient to the venture capitalist, but not to you or the development of your company. For example, when the stock markets are good, a venture capitalist will push portfolio companies to the market when valuations are high, not when the companies are ready to move on.
The venture capitalist will therefore only invest in companies that have a strong business model, and like you will only spent effort on companies that have a strong market potential. It is this potential of extremely high growth that will make the venture capitalist interested in your business, and the fact that it can be sold within three to seven years at a substantial profit. The high growth expectations of the venture capitalist exclude many very good business ideas from receiving venture capital, only because their growth potential does not match the expectations of the investors. Therefore, not having been able to raise venture capital is absolutely no value judgement on the business as such. However, there are also venture capital funds that manage public (or less profit driven) money, often with a specific regional or industry focus, which provide money on partly less strict terms.
Now, before approaching a venture capital fund make sure that your business is in the right industry, that is has realistic high growth expectations and that you and your management are prepared to work hard for the money they might give you. To satisfy a venture capitalist's expectations and to get funding is not simple - but if it should be, then that investor might not be the right one for you. Be careful to make your own due diligence. You need not only understand the venture capitalist's business and goals, but need to match them with your own. Once you know what you are going to do and how, select those investors that are investing in exactly this (seek out information on their existing portfolio, their past investments and success - read their blogs, articles and interviews, talk with people who have already worked with them) then prepare for a potential venture capital pitch. In real life, of course, always expect the unexpected.
