Sources of Venture Capital

Executive Summary

• Sources of capital depend on whether it is an early-stage company or a rapidly expanding business that is seeking significant financing.

• Angel investors rather than venture capital funds usually provide seed capital for new companies.

• Use your network to get connected with sources of venture funding, and know your audience before you meet with them.

• Venture capitalists look for high rates of return and have a relatively short time horizon.

• These investors will assist the entrepreneurs with many aspects of their business besides capital.

Back to top

Introduction

There are many sources of venture capital. They include:

• friends and family;

• individual angel investors or angel investor groups;

• early-stage venture capital funds (VCs);

• expansion-stage and later-stage VC funds;

• community-based venture funds; these are often run by development agencies, which are usually funded or subsidized by local government funds designed to stimulate business growth.

This article answers a number of questions about obtaining venture capital. When is it appropriate to seek venture funding rather than bank financing? How do you go about finding these funding sources? How do they differ, and what drives their investment decisions? Entrepreneurs and their management team need to understand the role of these investors, what expectations they will have for return on their investment, and over what time frame they will expect to earn those returns.

Back to top

Early-Stage Companies

Companies are usually started by a single entrepreneur or a small group of entrepreneurs. These founders frequently work for no pay, a situation that is referred to as “sweat equity.”¹ The initial cash needed is likely to be provided by the founders, but may be supplemented by money from friends and family members who have a variety of reasons to want to be a part of what the founders are doing. This type of funding is sometimes referred to as “seed capital.”² The founders may also seek bank financing, but if the bank is willing to extend credit it will probably be based on their personal assets or borrowing capacity. Banks rarely lend to companies that do not have a track record of revenues and profits.

Venture capitalists generally expect to see that the founders have put in a combination of sweat equity and personal cash, and they prefer to see that they have raised some money from friends and family. After exhausting these sources, entrepreneurs may think it is time to approach VCs to raise the funds they need to grow their business. In fact, although VCs did invest smaller amounts in the 1970s and 1980s, they are now much larger funds and tend only to invest when companies need multiple millions. As this transition was taking place, angel investors began to fill the gap between friends and family and VCs.

Back to top

Angel Investors

Typically, angel investors are thought of as wealthy financiers who want to fund startup companies that have a change-the-world idea or invention. They do usually have some wealth, but it is not necessarily the case that they are extremely rich. Successful business men and women may be sought out by entrepreneurs for their particular expertise. These individuals may not have previously thought of themselves as angels, but they may become interested in the business and impressed by the entrepreneurs and decide to invest. On the other hand there are those who regularly look for such opportunities. Angels generally invest in companies in their local area so they can keep an eye on their money.

Beginning in the mid-1990s, angel investors began to realize that there were some disadvantages to being a lone investor. For example, it is unlikely that one or even a couple of people possess all the knowledge necessary to make wise investments. They may have knowledge of many aspects of the business they are considering, but they are not likely to understand everything about the business and how to structure the investment. Additionally, a single investor would have to put a fairly large sum in a single company to have any real say in the business. A group of angels is more likely to have a breadth of knowledge and, by pooling their funds, an impact on the company. Angel investment groups have been forming over the past 10 to 15 years, and there are now several hundred such groups in the United States and Canada.

A 2008 study of US angel investing³ showed that in 2007 some $26 billion was invested in over 57,000 entrepreneurial ventures and that the number of active investors totaled almost 260,000. It can readily be seen that individual angel investors still make up the lion’s share of investors, which creates a challenge for those entrepreneurs trying to connect with them.

Finding angels requires networking. Ask attorneys and accountants, especially those who frequently work with and specialize in startup companies. If your business is technical in nature, you might contact universities, and you should certainly try to make contact with current and retired executives who come from industries related to yours.

Back to top

Venture Funds

Some VCs focus on investing in particular industry sectors, or geographies, or stages of a company’s life. Some may restrict their investments to local businesses. Some will fund early-stage companies, but others may only entertain investments in what are known as expansion-stage and later-stage companies.

The definition of an early-stage business can vary widely and is not easily defined in terms of revenues. If, for example, it is a service business or software company, it may not require a lot of investment for the company to achieve positive cash flows. At the other extreme, a life sciences business (biotech, pharmaceutical, and medical devices), which involves substantial research and regulatory approval, may be years from any real revenues and will need significant funding along the way. As a general rule, before a company is ready for VC funding a number of events will have taken place, such as completion of proof of concept, development of prototype products, beta testing of the product or service, and, finally, generation of revenues. However, certain types of businesses—most notably life sciences or other large technical projects—require such large amounts of capital that they are well beyond the capacity of angels. These businesses tend only to be funded by the VC specialists. But for many new businesses there is an overlap between angels and “early-stage” VCs, and it is not uncommon that the two groups will coinvest.

What constitutes expansion- and later-stage companies? Expansion-stage companies have customers and proven revenue, and there are good reasons to believe that they are positioned to grow very rapidly, at rates of 30–100% annually. And later-stage companies already have substantial revenues, so the next round of financing is meant to grow the company to a critical mass and attract public financing, or result in a merger or acquisition by another company. In both situations it is likely that this will provide liquidity and at least a partial exit for founders and investors. Many young companies never get to the point of seeking expansion or later-stage VC funding, not because they fail, but rather because they determine that an earlier merger or acquisition makes more sense for both founders and investors.

Back to top

What Venture Capitalists Look For

It makes little difference if it is an angel investor or an early-stage VC, they expect to see a business plan with a detailed description of the business model, marketing plans, competition, etc. This includes financial statements showing past results and a forecast for the next three to five years. Considerable emphasis will be placed on the cash flow forecast, as cash flow is a primary concern with any relatively new business. Investors will want to know how their investment will be put to use—often referred to as “use of proceeds.” They tend to look unfavorably on large portions of their funds being used for accrued and unpaid expenses, particularly founders’ salaries, or to pay down accounts payable. The prospective investors will perform considerable due diligence, which will include such areas as product reviews; speaking with customers, vendors and distributors; and examining any patent filings and pending legal matters. Primary among their assessments will be evaluating the management team.

The review performed by expansion-stage and later-stage VCs does not differ much from that outlined above; however, their investigations will look more closely at areas such as market conditions. Since at this point the business has a proven market for its product or services, it is far easier to assess future growth projections than when the company was just entering the market. Thus, a reasonably accurate assessment can be made of how fast the business can be scaled up and its ultimate potential. VCs will also reevaluate the company’s management. Often the skills needed to launch a business differ from those required to grow it.

All venture investors have one question in common: When will they see a return on their investment? In other words, when will there be a liquidity event—a sale of the company or a public offering of the stock? This is called the exit strategy.⁴ Venture capital is not generally meant to be long-term in nature. Most funding assumes that there will be an exit in three to seven years.

Back to top

Return on Investment Sought by Venture Capitalists

The earlier in a business’s life cycle the investment is made, the greater the risk. Thus, the higher the potential return on investment the venture capitalist will seek. Because there is a risk of total loss on at least some their investments, VCs must be able to see the potential for significant returns on each new investment. This means either quick returns or, if the time frame will be longer, large multiples of their investment. So company founders should not be surprised to learn that venture capitalists would like the opportunity to earn 10 or even 25 times their investment. That means that most venture investors have little interest in businesses that do not have excellent growth and profit prospects.

The terms of the investment will include the financial structure and the “pre-money value,”⁵ which is the value placed on the business before the new investors put their cash into the company. Thus, pre-money value is the amount assigned to all investors who have invested in the equity of the company thus far. This determines what percentage the new investor will own. If the pre-money value is $3 million and $1 million is newly invested by VCs, they own 25% of the company.

There are also many considerations as to what security the venture investors will own. They usually require a form of a security that is “senior” to the equity held by founders and small investors. This provides legal protection and authority, even though they may be minority investors (in terms of their ownership share of the company). The instrument often used for this purpose is preferred stock, with a variety of provisions attached that allow some level of control over major business decisions.

For the venture investors to have an opportunity to earn handsome returns on their investment, they focus not only on the pre-money valuation, but also on how many future rounds of fundraising the company might need as it grows. Even if future investments are made on the basis of an increased valuation, the additional capital will dilute prior investors’ ownership stake. So while the need for additional funding may be a good indication that the company is growing and needs more working capital to expand, that must translate to a much higher ultimate liquidation value if each investor group is to see healthy returns on the capital they put at risk. Historically, venture capital internal rates of return (IRR)⁶ have averaged between 20% and 30%.

Back to top

Case Study

Example of the Actual Results of an Early-Stage VC

The investors put in $120 million between 1998 and 2002, which is a typical funding period. This was invested in 31 companies and—although the fund has not yet exited all of these companies—reported results to date, plus a reasonable projection of ultimate exits, show these results:

The internal rate of return (IRR) to the investors will be about 23% on an annualized basis. This table illustrates how results vary by investment, indicates the degree of risk, and demonstrates why the VC must have the potential (often unrealized) to earn very large returns on each investment. In this case, without the three deals that produced very large returns, the overall results would not have been very attractive.

Back to top

The Role of Venture Capitalists After They Invest

Venture investors are not passive financiers; rather, they foster growth in companies by becoming actively involved with the management team, and in developing strategic and operational plans, marketing plans, etc. They will hold one or more positions on the company’s board of directors. VCs see themselves as entrepreneurs first and financiers second.

Back to top

Making It Happen

Companies will encounter lots of competition when seeking venture funding. So be sure to take the right steps to increase your company’s chances of success:

• Where should I be looking for investors? Be certain to look for help from local organizations that foster new business development in your area, such as local development agencies and funds established to encourage innovation and new technologies, and universities.

• How do I get connected to the right funding sources? Talk to all your contacts, ask lots of questions, and remember that it is far better to arrive at a source via a referral.

• How do I prepare to meet with prospective investors? Consider getting someone to coach your management team, prepare a first-class, focused business plan, understand your cash flow, and prepare realistic financial projections.

• What should I know about my audience? They will be assessing the management team as much as the business. VCs do not invest in businesses that do not have significant growth potential, but you must be realistic and prepared to defend your numbers. They will also be interested in knowing that there are multiple exit strategies.

• How do I sell our management team? Show the investors that you are the right people to run the business, and address areas where you need to add missing skills. Remember that founders may not be the best people to run the company, and consider supplementing the team with an advisory board, or ask the VC to assist in identifying advisers.

Back to top

Notes

1 See “Sweat equity” at www.businessfinance.com/sweat-equity.htm

2 See “Seed capital” at www.businessfinance.com/seed-capital.htm

3 Center for Venture Research. “The angel investor market in 2007: Mixed signs of growth.” Online at: wsbe.unh.edu/files/2007_Analysis_Report_0.pdf

4 See “Exit strategy: Business plan basics” at www.bizplanit.com/vplan/exit/basics.html

5 See “The pre-money value of a pre-revenue startup” at www.matr.net/article-25906.html

6 For a basic explanation of IRR and a downloadable spreadsheet example, see www.solutionmatrix.com/internal-rate-of-return.html

Back to top

Back to Table of contents