Venture Capital For Dummies
Navigating the world of venture capital as you seek to raise funds for your business can be scary and confusing because of the high stakes. After you identify whether venture capital is a good choice of funding for your company, you can begin to seek out investors. When seeking venture capital, you need to know who the venture investors are and where to find them. You also need to take certain steps to prepare yourself and your company for the scrutiny you’ll experience as potential investors strive to learn more about your company as they decide whether it is a good candidate for venture capital.
Determining Whether Your Company Is a Venture Company
It’s very important to figure out the type of company you’re building — a venture company or a lifestyle business — so that you can decide whether you should consider venture capital in your business growth strategies. Sometimes, determining which category you fall into is hard. Even though lifestyle businesses can make annual revenues into the millions, other things, like the type of business and/or the rate of growth, make them unsuitable for venture capital investment. The rate of growth and the ultimate size of the company are good indicators that can help you decide.
|Characteristics of Venture Companies||Characteristics of Lifestyle Businesses|
|Area in which you do business||National or global||Local or regional|
|Growth rate||Very fast (you plan to grow from a brand new company into a nationwide corporation in only a few years)||Slow (you plan to open only one new location of your business each year, for example)|
|Nature of business||Generally game changing businesses based on new technologies||Businesses that sell or deliver traditional or conventional products or services|
|Makes money for||Investors, founders, and owners||Founders and owners|
|Future plans||To be sold to another company or to go public, with founders leaving the business or assuming different roles, based on need and qualifications||To be kept in the family for generations or to be sold when the founder/owner retires|
Alternatives to Venture Capital Funding
Venture capital is a unique way of getting funding for your company. Because venture investors look for companies that are growing very quickly and can make several times the initial investment for the investors, venture capital isn’t right for every company. Fortunately, growing businesses have plenty of other ways to find funding. Here are just a few of the other ways you can get capital:
Debt: Many different kinds of debt are available for growing businesses: business loans, government-backed Small Business Administration (SBA) loans, and factoring loans that are backed by accounts receivable (in these loans, you sell the business’s accounts receivable to a third party at a discount).
Friends and family: Your friends and family are watching you create and grow your business. Chances are they are proud of you and want you to succeed. If they have the means, they may be interested in financially supporting your venture.
Angel investors: Angel investors are like venture capitalists in that they invest in early-stage companies to get a large return on investment. Unlike venture capitalists, who fund businesses by using other people’s invested money, angels work with their own money. As a result, angels have a lot more freedom to invest in non-standard ventures.
Crowdfunding: Crowdfunding is a great way to pre-sell your product before it’s ready to ship to customers. For businesses, crowdfunding doubles as a way to get paid to market your new company or product.
Growing organically: When you grow your company organically, you take out only what you need to survive and put the rest of your profits back into the company as an investment. The bigger you can grow your company, the more money it will return to you in the future.
Preparing to Seek Venture Capital
Investors want to put their money in companies that will succeed. To select such companies, an investor has the difficult task of predicting which companies will flourish and which will fail. Investors like to see companies with lowered risks. A business can lower the risk to success over time by developing the business strategically and creating powerful relationships with individuals and other businesses.
To make your business most attractive to investors, you must show that you've hit milestones and lowered the risks that are inherent to start-up companies. You don't need to have profits or even revenue yet. You just need to show venture capital investors that you are on your way.
Key tasks to building the business
Every business faces the risk that it will fail. Successful venture companies are founded, grown, and sold to another business, or they go public in an initial public offering (IPO). Between the day the business is founded and the day it is sold, a business faces several major risks that stand in the way of success. These risks are different for all businesses, but here are some examples:
Creating a product that is unique and that is (or will be) in high demand: A venture company must sell a product that solves a major problem for a lot of people or businesses. If your product is commonplace or needed only by a handful of people, you will have a great deal of difficulty connecting with venture capital.
Fulfilling all legal, tax, and government regulations required to sell the product: Venture capitalists are professional investors. They will not work with companies that have failed to build the business legally or without meeting all formal government requirements.
Selling the product for a profit: A popular product isn't valuable unless it can be sold for more than it costs to make. Making products profitable can be especially tricky in cases where manufacturing or materials are very expensive.
Hiring a management team that can grow the business: The team is probably the most important asset for a start-up company. A great team can change the product, redesign the marketing plan, and make new relationships with strategic partners. A great team can overcome most challenges to the business.
Finding and meeting investors
When your company is ready, you can begin to connect with investors. Venture capital investors can be hard to find. When you are ready, look for them in the following places:
Talk with your service providers. Bankers, lawyers, and accountants can often connect their clients with local venture capital firms.
Network and attend pitch events. Pitch events are formalized conferences designed to connect founders with investors.
Tap into the resources of business incubators (groups that concentrate resources in one place and often provide discounted services and free advice to young businesses) and mentors who have raised capital in the past. These groups will be able to point you to the right investors for your company. To find business incubators, go to the National Business Incubator Association at http://www.nbia.org/.
Reach out to venture capitalists through their websites. To find more about venture capitalists online, visit the National Venture Capital Association at http://www.nvca.org. Remember, venture capitalists need you just as much as you need them.
Crafting a Venture Capital Agreement That Benefits Entrepreneurs and Investors
A venture capital investment is a partnership between an investor and a growing company. To create a productive relationship that supports a rapidly growing company, the partnership has to be good for both the entrepreneur and the venture capitalist. To ensure that the agreement is fair and promotes the interests of both parties, pay particular attention to the term sheet and to your company's valuation.
A term sheet is a legal document that outlines the agreements made between the investors and the company founders. When both sides agree on the terms in a term sheet, the deal can close, and the investors effectively purchase stock in the company. The term sheet contains multiple terms, but the most negotiated are these:
The type of investment (stock or convertible debt): Convertible debt is a hybrid type of investment. The agreement begins as debt and then converts to a purchase of stock if the money is not paid back. Generally, both sides assume that the debt will convert to stock at an agreed-upon time. A regular stock purchase is a transaction in which an investor purchases a number of shares in a company for a predefined price.
The price of the stock, which is defined by the valuation of the company. Determining the price of stock for a start-up company is not a simple task. Many ways exist to determine a company's value. No matter how much a founder calculates his or her company's valuation, the true price of stock is the price that an investor is actually willing to pay.
Liquidation preferences for investors: Investment agreements are not all created equal. One of the biggest factors that affect an investor's final payout when your company sells is the liquidation preference. The liquidation preference describes who gets paid first when the company is sold. Liquidation can also occur when the company is dying, and assets are sold to cut losses. People holding preferred stock typically get their invested money back before everyone else.
Definitions for who controls the company: Investors can be given voting rights so that they make executive decisions for the company as a group. Also, investors can sit on the board and have a major impact on decision making. Determine up front how much power you want your investors to have.
The price of your company's stock is defined by the valuation of the company and the number of stock shares that make up the company.
Risk is a key determiner of your ultimate valuation. The value of your company is low when you first start up, because you face many future milestones that have yet to be accomplished. Over time, you decrease your risk by accomplishing these milestones. As you do so, the value of your company grows — a situation that is reflected in the cost of your company shares. Investors will have to put more dollars into the company to buy the same number of shares.
Because no perfect formula exists to determine the valuation of an early-stage (pre-revenue) company, expect to spend time negotiating with investors to make sure everyone is on the same page about valuation and risk (both the risks your company faces and those it has already overcome) when investments are made.
Pitching Your Deal to Venture Capital Investors
Talking with venture capital investors about your company is different than having a discussion with potential clients or customers. Investors want to know how you will make money for your company and subsequently for them. To impress these investors, be prepared with sophisticated materials that communicate your company, product, and plans for the future. In short, you have to get across that you are the founder that investors want to work with for the next three to seven years. Your task is to show that your team is capable of driving your company to success through integrity, hard work, and adaptability. You do that by creating a pitch deck.
The pitch deck is the visual slide presentation that acts as a backdrop to your oral presentation. When you are presenting your deal in person, the pitch deck should be clean and nearly wordless. After all, the images (typically infographics) serve to reinforce your oral presentation. However, you may not present your deal in person. In that case, a pitch deck can also be a PowerPoint file that you e-mail to investors. For this pitch deck, the slides must be self explanatory. (Yes, plan on creating more than one deck!)
All investor pitch decks for early-stage companies should include information about these topics:
Company overview and the problem your product or service solves
Your business model
Your target market and marketing strategy
The risks and barriers to entry your company must overcome
The size of your industry and your company's growth potential
Your exit strategy
Your valuation story
The ask, when you ask for investment from those in the audience