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Understanding Traditional Professional Venture Capital

Professional venture capital firms have traditionally thought of their job as the early stage financing of relatively small, rapidly growing companies. Their primary objective is to make a sizeable return on their investment, and they take an active role alongside management, realizing that venture capital investing requires a long term investment discipline. Billions of dollars pour into these funds as the institutional investors (pension funds, insurance companies, major corporations, individuals and families, endowments and foundations, union and multi employer plans, and foreign investors) seek the 20 to 30 percent per annum returns that the venture fund traditionally make.

Today's professionally managed venture capital firms have proven their ability to evolve with the financial times. They endured the big time losses from their early stage investments in computer hardware companies in the late 70s and early 80s, (over 500 hardware companies initially, down to a handful today) and entered the biotech era with lots more trepidation. Today, they stay ontop of new industries and currently have a strong fasination with all companies that are net and web oriented. They have adjusted, readjusted, and continue to readjust their investment philosophies as they seek to improve the knowledge of the art and science of venture capital investment.

The traditional venture capital firms manage funds that range in size from ten million to over several hundred million dollars. Funds that manage over one hundred million are called megafunds. Besides coming in many different sizes, they also have a lot of different orientations. Some funds specialize in seed stage investments, while others only do advanced or bridge financings. Others concentrate their efforts on leveraged buyouts, and some only invest in specialized areas. These investment specially areas may be only medical, or retail; others may prefer manufacturing or just computer software. Some large funds run what is termed a balanced fund which invests over a broad spectrum of industries and company development stages.

For all funds, their prime criteria are solid, experienced management teams who have identified a creditable market niche with a large growth potential and the possibility of developing a hundred million dollar plus annual revenue company.

Very frequently, the partners in the fund will have prior experience and current knowledge in the areas in which the fund invests. This results in them being better equipped to take an active part in guiding the company in such areas as planning, marketing, developing supplier connections, finding new personnel, and bringing in additional financing sources.

Venture Capital in General

The formal organized venture capital community can generally be divided into two main groups: traditional private institutionally funded partnerships and corporate venture capital funds. Although they have different objectives for investing (private funds for a money return) and corporate (for gaining technology)--they have some similar operating policies and modus operandi.

Another item in common for both private and corporate funds is the minimum and maximum amounts they're willing to invest. On the minimum side, it's usually in the area of $100,000 to $500,000. While some may go as low as $50,000 for seed projects, others may not go below $500,000. Their line of reasoning regarding minimums is that it costs them just as much time and money for due diligence in making a $50,000 investment as it does for $500,000.

Regarding the maximum amounts, there really isn't any ceiling. Most funds are individually limited to x percent of their total funds. However, all funds are capable of putting together syndicates with other funds to provide almost unlimited financing for the right entrepreneurial projects.

More Venture Capital Insight

Here is some more insight into the formation and operations of venture capital funds. This insight should help you in understanding their investment motivation.

Each fund typically has several general partners as well as analysts, research and clerical personnel. The general partners have the responsibility to put the fund together and to solicit and obtain the actual limited partner institutional investors. These limited partner investors typically commit to a gross total dollar investment. The actual dollars will be invested in stages, commonly one third of the money when the fund is started, one third after the first year, and the balance during the second year. They are expecting that their investment will not be fully returned until the seventh through tenth year. They also expect to earn an annualized 30 percent compound interest on their money.

The general partners, on the other hand, receive an annual management fee to oversee the investment. They make all investment decisions without routine input or approval of the limited partners or passive investors. Additionally, although there are many different types of agreements, the general partners are entitled to receive a percentage of the profits after the initial investments are repaid, typically 20 percent. One can easily see that fund managers are under a large amount of pressure to perform, and those that do are justifiably rewarded. High performers are rewarded with increased commissions, salary, and even other perks including cars, airline tickets, and vacations.

Although most traditional venture capital funds orient their investments toward products, there are some that seek service type companies; Computer software and medical services are examples. When seeking product investments, and to some extent in the service, there are three categories to consider: revolutionary, evolutionary, and substitute.

There Are Three Categories to Consider

Revolutionary. Examples of revolutionary products would be cameras, televisions, or computers. Venture capitalists tend to shy away from the revolutionary deals. They take too much cash and they take too long to develop.

Evolutionary. Examples would be instant and auto focus cameras, color or portable television, and personal or laptop computers. These are the ideals for venture capital, the next generation or cheaper versions. To really merit consideration, the next generation should be 30 percent cheaper, 30 percent faster, or have a 30 percent improvement in quality. Better yet, all three.

Substitute. These are products that can develop niche or substitute markets, like fast food chicken or hamburger, or regional spinoffs on automobile fast or quick lubes. Venture capital firms have differing opinions about substitutes. Some really like them if the niche is well defined, has an easy market entry, and what seems to be a broad appeal. Others beg off on substitutes, feeling they need too much marketing and advertising, both of which are hard to quantify when tracking the expense outlays.

Regardless of the categories, the uppermost consideration for traditional venture capital partnerships is the potential monetary return. This may not be the top criterion for corporate venture capital funds.

Corporate Venture Capital

Many corporations form venture capital subsidiaries for a variety of reasons, one of which is not to make a large return on their initial investment. This doesn't mean that they don't want to make money or that the entrepreneur should avoid exploring corporate venture capital as a source of financing. In fact, in many cases, corporate venture capital can be a better deal for the entrepreneur than the traditional firms. The corporate firms tend to overfund their portfolio companies in an attempt to drive the realization of the project to a faster conclusion; because large corporations typically don't have an entrepreneurial mindset, they tend to overstaff and overequip all areas of operations. Consequently, where the entrepreneur is striving hard to produce results over a shortened time period, corporate venture capital makes a great fit.

What Corporate Venture Capital Seeks.

If corporations aren't seeking large returns, what are they after? A good start is strategic alliances in one form or another. It could be from a basic or applied research basis, one where they can support a patent or invention. It could also be a marketing alliance where they can obtain exclusive marketing rights. Or it could be a manufacturing agreement where the entrepreneuring company manufactures private label products for the corporation. Ofttimes they are trying to find new talent or teach practical entrepreneuring to existing personnel. At other times they may be doing some public relations posturing or supporting a philanthropic desire.

They look for start ups where there will be a need for large capital contributions. As the company grows and expands, they are prepared to invest sums in excess of $5,000,000, on up to tens of millions. They seek projects that can utilize multiple locations or plant sites, including foreign locations. With this size of investments, it's obvious that they are looking for projects that have very large market potential where their long term vision means that the company will have revenues in excess of half a billion dollars in 10 years or so, which also means that one product companies won't do. They need to have multiple product spinoffs that allow for secondary products and licenses for international exploitation.

Why They Need Big Projects.

The reasons they need such big projects is that they are hunting for alliances to incubate future acquisitions that they can grow and support to become whole new corporate divisions. They are seeking to provide work for any plants that they may have which will have unused manufacturing capacity. They need projects in which they can invest excess cashflow and teach entrepreneurial thinking to their middle-management layers. They realize that many new technologies come from smaller companies. Consequently, if they can establish strategic partnerships during the early stages of a company's development, they can gain an insight into the windows of these new technologies and markets.

When one realizes that large companies like IBM or Exxon spend in excess of three billion dollars annually for just research and development--a sum equal to the whole traditional venture capital industry--then one can see that initial returns on their venture capital investments are not the prime motivator. Traditional venture capital firms are seeking to turn or liquefy their investments in three to seven years, whereas the corporate venture firms have longer timeframes of ten to twenty years to grow new ideas into mature industries.

The Negatives of Dealing with Corporate Venture Capital.

With all these positive points in favor of corporate venture capital, assuming the entrepreneurs project is large enough, what could be negative? The biggest negative is the unstable nature of corporate venture capital. This type of fund has a history of being the in thing to do and just as suddenly falling out of favor. Large corporations are ruled by the economic times of Wall Street and its obsession with quarterly profits. This means that when the corporate venture capital firm is plush with excess cashflow, it has a keen interest in making venture type of investments. When things get tight, when pressure is put on budgets, invariably corporate venture capital gets slashed since expenditures of hard cash get sliced first.

Additionally, some corporate venture fund managements are restricted as to the final decisions to invest. They may have to obtain approval from corporate hierarchy to exceed predetermined investment levels or to invest in what may be considered fringe product areas. Since many new entrepreneurial ideas cross common product lines, or even combine technologies from different industries, it's not uncommon that corporate venture capital is not appropriate in the earliest stages. Even though venture capital is supposed to be entrepreneurial in style, corporate bureaucracies don't necessarily end at the door of corporate venture funds. It can take an excruciatingly long time to get upper level approval for the entrepreneur who is depending on staying on a fast development track. Be sure you clear this point prior to getting too far downstream with corporate funds. Be sure the fund management has the authority to not only approve your project, but also to write the check.

Watch Out for Management Changes.

Another negative is the fact that the upper management of corporate venture funds don't stay around long. The good ones leave for higher personal payouts with the private funds which tend to leave portfolio companies as orphans. These frequent personnel changes add to the confusion for the entrepreneur, since one of the many side benefits of making a venture capital connection is that the venture capital management itself has the ability to bring other players into the game. The fund manager that inherits the portfolio orphan may not have the enthusiasm, knowledge, or additional contacts that the original manager had who pushed the entrepreneur's deal through to begin with. The result is an orphan company, running low on money and time, without valuable industry contacts, and left without a dedicated lead venture fund.

Finally, corporate venture funds tend to want to establish the maximum values of a deal at the time of original investment. This tends to "cap" the harvest potential for the entrepreneurial team. Bad blood can develop if the team loses its high profit incentive, especially if the project runs into some snags. This is bound to happen when the entrepreneurial team is in a bad renegotiation position and they become susceptible to diluting their total package to compensate for the addition of more dollars or time.

The prime motivation of corporate venture capital is an interest in growing their own acquisition candidates. They tend to make initial investments based on an arrangement that enables them to acquire the entrepreneur's equity at some future time. They are ideal capital partners for entrepreneurial companies that will require large sums of investment, who require longer time periods for development, and who can benefit from teaming up with a large corporate partner in research, development, manufacturing, and market distribution.

How to Find and Qualify a Venture Capital Firm

How to Find a Venture Capital Firm

Identifying venture capital firms is a fairly simple process. There are numerous directories available, and the bible for the industry is Pratt's Guide to Venture Capital Sources. Pratt's, as well as others (including state and regionally sponsored guides) are available in any good city library. These guides furnish name, address, and contact information as well as the size of investments they prefer, and in many cases the particular industries in which the firm prefers to invest.

How to Qualify Them

Qualifying a venture capital firm is a little more difficult than finding one. It requires that the entrepreneur use some common sense and recognize some of the ground rules. This includes not approaching a firm that clearly states that it does not invest in biotech if you're a biotech development company. It's surprising the number of companies that spend a lot of dollars sending plans by overnight delivery to venture funds that plainly state in their published information that they refuse investment in a particular industry. Most funds have a list that shows their areas of interest as well as areas in which they do not invest.

While many funds invest in companies located all over the United States, some prefer only projects located within two or three hundred miles or two or three hours from their headquarters. If you identify a firm that likes your industry, but you're located outside their preferred geographical investment area, place a call to them and ask if they know of a firm in your area. Many funds participate in investments with other firms if there is a "lead" investor who will agree to monitor a portfolio company. These lead investors are usually geographically located relatively close to the investment When a fund indicates that it has a preference for a particular industry, it usually means that one or more of the general partners has some background in that industry. This can be especially helpful to the entrepreneurial team because they don't have to spend a lot of time getting the venture capitalists up to speed on industry knowledge. It's also helpful because the venture capitalist can pick up the phone and get quick answers to due diligence questions, and after making an investment is usually able to bring a lot of their industry contacts into the deal to help it grow and sometimes even staff the portfolio company.

How to Get in the Venture Capitalist Door

All venture capital firms will tell you that their best deals come from the companies in which they have already invested. The second best way to get in the door is to have someone who has some preestablished creditability with the fund make an introduction.

If you can't find such a person, your legal counsel, accounting firm, or banker can make an initial contact on your behalf. If they are unable or unwilling to do so, don't hesitate to make it yourself. The best approach is to place a phone call to the designated person listed in the guides. When they finally return your call, simply outline your project and ask if you could send them your Special Executive Summary. If after reviewing your summary they have an interest, they will request your complete business plan.

It is very difficult, not to mention a waste of valuable time and money, to send numerous plans out blindly to numerous funds. Every venture capital firm in the country receives two or three plans per day, some thirty or forty. While they may get around to briefly reading them, it may take two or three months. Even then, so many plans are so poorly written that they don't even deserve a reply. With this many plans coming in the door, you can also see that sending your plan by overnight delivery, or faxing your summary, simply is a waste of dollars. It's suggested you ask, and if they request fast delivery, by all means, do so. Most times, they won't have the time to look at your project for a week or two, so save the fast delivery bucks.

Again, the best avenue is someone who can front you in the door. When they have made the initial contact, simply send your plan with a brief cover letter and keep your fingers crossed. If you haven't had a reply in two or three weeks, a progress call is appropriate. Calling every few days will only alienate the initial screener of your project and assure that your plan will fall deeper into the bottom of the pile. However, don't get discouraged after all this discussion about how hard it is to get a receptive ear. Remember, venture capital firms need product, too; it's just the realization of the old axiom that "entrepreneurs run and money walks."

How to Present to Venture Capitalists

Assume a venture capitalist, after what seems an eternity to review your business plan, expresses a further interest in your project. What is likely to happen next?

A phone conversation with a request for some more information will most likely occur and include the subject of a face to face meeting. There's always the chance that it will be held at your facilities, but again, the most likely scenario is that you will be requested to visit them in their offices.

This initial meeting is a get acquainted session and the venture capitalist's first "size up the management" opportunity. First impressions count; be prompt, have clean fingernails, suit and tie, be relaxed, smile, and come well rehearsed. This presentation should be 15 to 30 minutes and modeled after your business plan. The venture capitalists simply want to hear your business story in your own words. They will have read your plan thoroughly, a couple of times, and will have prepared numerous questions. But first off, they want to size you up.

Don't Bring Your Attorney Along. Don't--I repeat, do not--bring your attorney or accountant along. They talk too much about the wrong things. No intermediaries at all is preferable; remember, the venture capitalists want to become intimately familiar with the management team. If there is going to be a wedding, they are going to marry the bride, not the bride's father or mother.

You're seeking to impart your basic philosophy and display the capabilities and skills of your management team. You can do this by making a straight forward presentation that is clear cut, having the technical aspects simplified. Venture capitalists need to understand the nature of technology and the current and future stages of entrepreneurial development. Discuss practical applications and substantiate the size of your markets. You must indicate an in depth knowledge of your competition by discussing their strengths and weaknesses, followed by why you can replace them and how you are going to do it.

When talking about your management team, describe specific experience that makes each of you uniquely qualified, especially as to what is applicable during the last five years. Note where and how your team has been assembled, how you have worked together in the past, and how you see individual skills complementing each other on your project If you have a missing management link, discuss it frankly and suggest that you're open for recommendations from them. All venture capital firms have a vast knowledge and network to identify and obtain key management players.

Be Realistic about Your Financials. Regarding the financial aspects of your project, the keys are truthfulness and reality. If your operations are existing, discuss the good and bad points. Talk about where you made mistakes and blew some time and dollars and where you're really proud of belt-tightening; give some examples of the ingenious methods you used to economize. Be realistic in your projections. Keep in mind that the venture capitalists probably have some practical experience in your industry area. If not, they definitely have seen many more optimistic projections that resulted in bad start ups than you have. Worst, best, and most likely scenarios aren't bad, but every projection has got to be backed with detailed assumptions. Assumptions can make or break the creditability of any projections. Be sure yours are well grounded.

In summary, the venture capitalist has the following objectives:

Second Round Venture Capital

Finding that second round of venture capital can truly be a challenge. Many entrepreneurs have found it to be almost impossible. Facing workforce reductions or even thinking about closing down are not pleasant experiences. Venture investing runs in cycles and the drought of second round financing is very real after the Internet frenzy of 1999 and early 2000. More scrutiny and more caution have been applied to all business models. Due diligence again takes months instead of weeks. Smaller dollar amounts at lesser valuations become the norm. What follows are some hints that you should heed when seeking second round financing.

Qualify Your Financing Source. You don't make critical sales calls without finding out as much information as possible about your prospect. The same applies to financing sources. Research the history of investments of your targeted venture firms to determine if they invest in your industry area and also check if they invest in your geographical area. Be sure they have current funds to invest. Time is your most valuable commodity and time spent raising money is time away from building your business.

Obtain an Intro. Venture capital firms see thousands of deals a year and invest in several dozen. Almost every completed venture capital deal comes from a referral. Find an attorney, accountant, board member, industry advisor or existing portfolio company to arrange an entrée. Referrers screen deals for VCs.

Have Existing Investor Commitments. Nothing indicates the strength of a deal as much as having ongoing commitments from existing investors. Even if the VC ultimately turns these investors down, they like to see a vote from other pocketbooks.

Tight Use of Proceeds. A lot of money was spent foolishly during the hot Internet era. Be sure you have a close focus on your proposed spending and can justify every dollar. This applies to each square foot of space and capital purchase. Establish milestones and describe just how you will achieve them for product development, customer acquisition, and management team expansion. Do this analysis proactively upfront and not during due diligence.

Don't Get Hung Up on Valuations. When investment dollars are scarce, valuations are lower. Although valuation is important, being penny-wise and pound-foolish by holding out for the last dollar or percentage point is not the smart way to get the bucks. The old adage of a smaller piece of a bigger pie applies to getting the deal done.

Second round funding, even in tough economic times, is always there for good companies with smart management. Work smarter on your financing the second time around.
(Extracted from Red Herring-Michael Frank, General Partner, Advanced Technology Ventures)


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2/02-2/16