When trying to raise VC funds for a small business, it really helps to understand how Venture Capital works, and what a VC firm expects. This article will give you, the entrepreneur – important insights into venture capital so you can develop an effective venture capital campaign. An entrepreneur with a small business can go after venture capital in any growth phase, and the VC firm expects to participate in equity through owning stock, options, warrants and convertible debt or stock.

To have a successful venture capital raise campaign, be sure you have solid Business Plans in place. As experienced Small Business Consultants with a background in private equity and business finance, I see many business plans, marketing plans and strategic plans that simply don’t meet muster. Give yourself the best chance possible by spending some time and effort in this area. Also, having a good Executive Summary and Investment Overview for an initial introduction to your business opportunity will serve you well. You need to make sure your Business Plan Process is up to snuff too.

Venture capital wants to balance control with the amount of investment risk in a deal. Here are two ways VC firms asses and determine investment risk.

The Risk / Return Evaluation

– At the Product or Service Level:

• Level 1:  Idea Stage.  Not Operable.  Market Assumptions.
• Level 2:  Pilot/ Test Stage.  Market refined.
• Level 3:  Fully Developed.  Few Customers.  Market defined.
• Level 4:  Satisfied Customers.  Market Established.

– At the Management Level:

• Level 1:  Entrepreneur.
• Level 2:  Few Founders.
• Level 3:  Partial Management Team.
• Level 4:  Full Management Team.  Highly Experienced.

Note:  The higher the Level from both Determinants (Product or Service & Management), the less Risk for a higher Return.  4/4 would be most desirable and cost the Entrepreneur the least.  1/1 would be the least desirable and cost the Entrepreneur the most.  A 2/2 or 3/3 are good Level Combinations to shoot for prior to approaching Venture Capital if financially practicable.

The Present Value / Future Value Evaluation

– Scenario:  Expected ROI is 35% per year, without inflation, over 5 years.  Present Value of Earnings is $4.5M.  Future Value Earnings in 5 years is $15M.

• VC Equity Share is calculated:  $4.5M divided by $15M = 30%.
• Maximum Investment is 10 times first year gross (expected) earnings, which in this example is about $500,000.
• Conclusions:  $5M maximum investment for 30% of the Company at 3/3 Level over a 3 year period.  A 1/1 Level, Seed/Start Up Investment would be a 45-50% Equity Stake, with an expected ROI of 60%.

Venture Capital Objectives

It is important to explore your potential Venture Capital Funds to determine exactly what they look for in an investment, what their parameters are and what they specialize in.  A VC Fund will have a detailed website which will layout their Fund’s Objectives.  You can also find this information in their Offering Prospectus/ Memorandum to their Investors.  Below is an outline of a VC firm’s Objectives to give you an idea what to look for.

Investment Objectives

• Rate of Return expectations.
• Long- term or short- term capital appreciation.
• Early, Middle or Late Stage Companies.
• Sectors concerned in.
• High growth potential.
• Liquidity Options.
• Expertise, Experience & repute of the Fund.
• Advisory Board Members.
• Members of the Fund.

Investment Criteria

• Evaluate in terms of Management, Product, Markets, Financials, and Business Stage.
• Highly competent and motivated management team.
• Proprietary Product or service that:  meets a strong market need:  Favorable price and cost relationship.
• A market which has a favorable mix of Size, Growth, Competitive Barriers and the potential for high volume sales.
• Management:
  • People are the most important ingredient in a Company’s success
  • Balanced Team
  • Superior Skills
  • Team leader with a track record
  • Ability to keep on and attract talent
  • Understands Planning & Control
  • Can make difficult decisions
  • Can work with professional advisors
  • Accept assistance from the Fund Members
  • committal to the Venture
  • Clearly understands the Funds’ expectation on liquidity, rate of return and investment objectives.
  • Above all, integrity, character, accountability and high business ethical motive

Product or Service

• Types of Products and Services in the Fund’s Sectors which are of interest.
• Competitive Edge:  Cost, Quality & Performance.
• Premium prices achievable?
• High Yield Profit Margins.
• Dominate or Control a significant market share.

Market

• Young, flourishing fast and provides opportunity
• Defined market niche.
• Dominance in that niche.
• Niche market should be small enough not to attract big company competitors, yet has a strong potential for expansion.
• Realistic Marketing Plan.
• Marketing Team Leaders should have encompassing industry contacts with sales people, sales reps and distributors.

Financial Outlook

(these are some example numbers that are based on a technology company)

• $20M in Sales & Earnings, after taxes, within 5 years.  Generate Return on Assets greater than 20%.
• Venture is not capital intensive.
• Project prices & profit margins that can cushion early round obstacles.
• Reaching Break Even in 2 years.
• If it is a capital intensive deal, should be capable of adding substantial value early on and attract later on rounds of financial backing at higher pricing.
• Maximum of 10 to 1 return on investment for startups.
• Liquidity in 5 years for startups.
• Later stage companies: ROI of 5 to 1 in 5 years or 3 to 1 in 3 years.

Stage

• Mostly early stage but will consider later stage with high growth opportunities.
• Consider small public companies as well as private.
• Spin offs as a result of re-structuring and rejuvenation.

Operating Policies

• Can change at the fund’s discretion
• Geography:
  • Any geographic area but most companies are in the West and Silicon Valley, China, Taiwan and Singapore.
• Monitoring Investments:
  • Free access to management
  • Fund receives Business Plan updates regularly
  • Fund will not seek majority ownership or run the venture
  • Help the venture attract Management to fill gaps and develop its business plan in the early stages of investment
  • Board Representation
  • Fund will provide expertise and assistance with securing key employees, filling management gaps, operational planning, key customer and supplier relationships, joint ventures, financing, security offerings, acquisitions and harvest strategies