Venture Capital Law and Legal Definition
Venture capital is money used to support new or unusual commercial undertakings; equity, risk or speculative capital. This funding is provided to new or existing firms that exhibit above-average growth rates, a significant potential for market expansion and the need for additional financing for business maintenance or expansion.
Companies who seek venture capital are willing to exchange equity in the company in return for money to grow or expand the business. Those who provide venture capital generally seek a greater degree of control in the company affairs and quicker return on their investment than standard investors.
Venture capital is a type of equity investment usually made in rapidly growing companies that require a lot of capital or start-up companies that can show they have a strong business plan. Venture capital may be provided by wealthy individual investors, professionally managed investment funds, government-backed Small Business Investment Corporations (SBICs), or subsidiaries of investment banking firms, insurance companies, or corporations. Such venture capital organizations generally invest in private startup companies with a high profit potential. In exchange for their funds, venture capital organizations usually require a percentage of equity ownership of the company (between 25 to 55 percent), some measure of control over its strategic planning, and payment of assorted fees. Due to the highly speculative nature of their investments, venture capital organizations expect a high rate of return. In addition, they often wish to obtain this return over a relatively short period of time, usually within three to seven years. After this time, the equity is either sold back to the client-company or offered on a public stock exchange.
Venture capital is more difficult for a small business to obtain than other sources of financing, such as bank loans and supplier credit. Before providing venture capital to a new or growing business, venture capital organizations require a formal proposal and conduct a thorough evaluation. Even then, they tend to approve only a small percentage of the proposals they receive. An entrepreneur with a small start-up should not consider venture capital if, for example, her objective is to grow her fledgling graphic design service into a middle-size regional greeting card business. This profile does not fit with the venture capitalists' objectives. Venture capital firms usually look for investment opportunities with firms that offer rapid growth as well as something new: a new technology or technology application, a new chemical compound, a new process for the manufacture of a product, etc. Once an entrepreneur's venture has been determined to be of a kind that may interest venture capitalists, the next move is to start planning. The most important thing an entrepreneur can do to increase his or her chances of obtaining venture capital is to plan ahead.
Venture capital offers several advantages to small businesses, including management assistance and lower costs over the short term. The disadvantages associated with venture capital include the possible loss of effective control over the business and relatively high costs over the long term. Overall, experts suggest that entrepreneurs should consider venture capital to be one financing strategy among many, and should seek to combine it with debt financing if possible.
THE EVALUATION PROCESS
Since it is often difficult to evaluate the earnings potential of new business ideas or very young companies, and investments in such companies are unprotected against business failures, venture capital is a highly risky industry. As a result, venture capital firms set rigorous policies and requirements for the types of proposals they will even consider. Some venture capitalists specialize in certain technologies, industries, or geographic areas, for example, while others require a certain size of investment. The maturity of the company may also be a factor. While most venture capital firms require their client companies to have some operating history, a very small number handle startup financing for businesses that have a well-considered plan, something "new," and an experienced management group.
In general, venture capitalists are most interested in supporting companies with low current valuations, but with good opportunities to achieve future profits in the range of 30 percent annually. Most attractive are innovative companies in rapidly accelerating industries with few competitors. Ideally, the company and its product or service will have some unique, marketable feature to distinguish it from imitators. Most venture capital firms look for investment opportunities in the $250,000 to $2 million range. Since venture capitalists become part owners of the companies in which they invest, they tend to look for businesses that can increase sales and generate strong profits with the help of a capital infusion. Because of the risk involved, they hope to obtain a return of three to five times their initial investment within five years.
Venture capital organizations typically reject the vast majority—90 percent or more—of proposals quickly because they are deemed a poor fit with the firm's priorities and policies. They then investigate the remaining 10 percent of the proposals very carefully, and at considerable expense. Whereas banks tend to focus on companies' past performance when evaluating them for loans, venture capital firms tend to focus instead on their future potential. As a result, venture capital organizations will examine the features of a small business's product, the size of its markets, and its projected earnings.
As part of the detailed investigation, a venture capital organization may hire consultants to evaluate highly technical products. They also may contact a company's customers and suppliers in order to obtain information about the market size and the company's competitive position. Many venture capitalists will also hire an auditor to confirm the financial position of the company, and an attorney to check the legal form and registration of the business. Perhaps the most important factor in a venture capital organization's evaluation of a small business as a potential investment is the background and competence of the small business's management. For many venture capital firms the most important factor in their assessment is determining the capabilities of the management team, and not the potential product. Since the abilities of management are often difficult to assess, it is likely that a representative of the venture capital organization would spend a week or two at the company. Ideally, venture capitalists like to see a committed management team with experience in the industry. Another plus is a complete management group with clearly defined responsibilities in specific functional areas, such as product design, marketing, and finance.
VENTURE CAPITAL PROPOSALS
In order to best ensure that a proposal will be seriously considered by venture capital organizations, an entrepreneur should furnish several basic elements. After beginning with a statement of purpose and objectives, the proposal should outline the financing arrangements requested, i.e., how much money the small business needs, how the money will be used, and how the financing will be structured. The next section should feature the small business's marketing plans, from the characteristics of the market and the competition to specific plans for getting and keeping market share.
A good venture capital proposal will also include a history of the company, its major products and services, its banking relationships and financial milestones, and its hiring practices and employee relations. In addition, the proposal should include complete financial statements for the previous few years, as well as pro-forma projections for the next three to five years. The financial information should detail the small business's capitalization—i.e., provide a list of shareholders and bank loans—and show the effect of the proposed project on its capital structure. The proposal should also include biographies of the key players involved with the small business, as well as contact information for its principal suppliers and customers. Finally, the entrepreneur should outline the advantages of the proposal—including any special and unique features it may offer—as well as any problems that are anticipated.
If, after careful investigation and analysis, a venture capital organization should decide to invest in a small business, it then prepares its own proposal. The venture capital firm's proposal would detail how much money it would provide, the amount of stock it would expect the small business to surrender in exchange, and the protective covenants it would require as part of the agreement. The venture capital organization's proposal is presented to the management of the small business, and then a final agreement is negotiated between the two parties. Principal areas of negotiation include valuation, ownership, control, annual charges, and final objectives.
The valuation of the small business and the entrepreneur's stake in it are very important, as they determine the amount of equity that is required in exchange for the venture capital. When the present financial value of the entrepreneur's contribution is relatively low compared to that made by the venture capitalists—for example, when it consists only of an idea for a new product—then a large percentage of equity is generally required. On the other hand, when the valuation of a small business is relatively high—for example, when it is already a successful company—then a small percentage of equity is generally required. It is quite normal for venture capital firms to value a company at below the valuation the company has for itself. It is best if the small business looking for venture capital prepare for such an outcome.
The percentage of equity ownership required by a venture capital firm can range from 10 percent to 80 percent, depending on the amount of capital provided and the anticipated return. But most venture capital organizations want to secure equity in the 30-50 percent range so that the small business owners still have an incentive to grow the business. Since venture capital is in effect an investment in a small business's management team, the venture capitalists usually want to leave management with some control. In general, venture capital organizations have little or no interest in assuming day-to-day operational control of the small businesses in which they invest. They have neither the technical expertise or managerial personnel to do so. But venture capitalists usually do want to place a representative on each small business's board of directors in order to participate in strategic decision-making.
Many venture capital agreements include an annual charge, typically 2-3 percent of the amount of capital provided, although some firms instead opt to take a cut of profits above a certain level. Venture capital organizations also frequently include protective covenants in their agreements. These covenants usually give the venture capitalists the ability to appoint new officers and assume control of the small business in case of severe financial, operating, or marketing problems. Such control is intended to enable the venture capital organization to recover some of its investment if the small business should fail.
The final objectives of a venture capital agreement relate to the means and time frame in which the venture capitalists will earn a return on their investment. In most cases, the return takes the form of capital gains earned when the venture capital organization sells its equity holdings back to the small business or on a public stock exchange. Another option is for the venture capital firm to arrange for the small business to merge with a larger company. The majority of venture capital arrangements include an equity position, along with a final objective that involves the venture capitalist selling that position. For this reason, entrepreneurs considering using venture capital as a source of financing need to consider the impact a future stock sale will have on their own holdings and their personal ambition to run the company. Ideally, the entrepreneur and the venture capital organization can reach an agreement that will help the small business grow enough to provide the venture capitalists with a good return on their investment as well as to overcome the owner's loss of equity.
THE IMPORTANCE OF PLANNING
Although there is no way for a small business to guarantee that it will be able to obtain venture capital, sound planning can at least improve the chances that its proposal will receive due consideration from a venture capital organization. Such planning should begin at least a year before the entrepreneur first seeks financing. At this point, it is important to do market research to determine the need for its new business concept or product idea and establish patent or trade secret protection, if possible. In addition, the entrepreneur should take steps to form a business around the product or concept, enlisting the assistance of third-party professionals like attorneys, accountants, and financial advisors as needed.
Six months prior to seeking venture capital, the entrepreneur should prepare a detailed business plan, complete with financial projections, and begin working on a formal request for funds. Three months in advance, the entrepreneur should investigate venture capital organizations to identify those that are most likely to be interested in the proposal and to provide a suitable venture capital agreement. The best investor candidates will closely match the company's development stage, size, industry, and financing needs. It is also important to gather information about a venture capitalist's reputation, track record in the industry, and liquidity to ensure a productive working relationship.
One of the more important steps in the planning process is preparing detailed financial plans. Strong financial planning demonstrates managerial competence and suggests an advantage to potential investors. A financial plan should include cash budgets—prepared monthly and projected for a year ahead—that enable the company to anticipate fluctuations in short-term cash levels and the need for short-term borrowing. A financial plan should also include pro-forma income statements and balance sheets projected for up to three years ahead. By showing expected sales revenues and expenses, assets and liabilities, these statements help the company to anticipate financial results and plan for intermediate-term financing needs. Finally, the financial plan should include an analysis of capital investments made by the company in products, processes, or markets, along with a study of the company's sources of capital. These plans, prepared for five years ahead, assist the company in anticipating the financial consequences of strategic shifts and in planning for long-term financing needs.
Overall, experts warn that it takes time and persistence for entrepreneurs to obtain venture capital. In the best of economic times, venture capital is difficult to secure. In slower economic times it becomes ever harder. It is not unusual to work on obtaining venture capital for years before an agreement is met, according to Brian Brus who studied the subject for his article "Starting a Business is Harder then Ever in the 21st Century." The hardest thing to communicate to enthusiastic entrepreneurs who come to venture capital firms looking for help, explains Brus, is that they can't just get started making their new product or service. Venture capitalists may be risk takers but for those lucky few with whom they invest, it may not feel that way once all the paper work is done and an agreement is in place.
SEE ALSO Angel Investors; Financial Planning; Loans; Seed Money
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Hillstrom, Northern Lights
updated by Magee, ECDI