From the March 1997 issue of Entrepreneur

The devil of getting venture capital lies in the semantics of the situation. While almost every emerging enterprise requires a dollop of venture capital to get to the next stage, venture capitalists are not the source of this funding about 99.44 percent of the time.

The fact is, the vast majority of venture capital comes from sources other than venture capitalists. Where most entrepreneurs err is in pursuing the latter rather than the former. The distinction wouldn't be so important if the six months to a year most entrepreneurs take learning this didn't kill as many companies as it did.

There just isn't enough venture capital to go around. The $7.4 billion or so the nation's venture capital partnerships started with last year is just a fraction of the $50 billion to $60 billion America's emerging high-growth companies need each year, says Jeffrey Sohl, director of the Center for Venture Research at the University of New Hampshire in Durham.

When you look at numbers like this, it becomes obvious that professional venture capitalists offer limited financing opportunities for a small population of companies. The question, then, is whether yours is among that small minority of enterprises a venture capitalist will finance.

To find out, run through the following seven-point diagnostic test from John H. Martinson, managing partner of Edison Venture Fund, a Lawrenceville, New Jersey, venture capital firm with more than $200 million under management. And to add more weight to the numbers we've been talking about, consider a typical year for Edison, according to Martinson: "We see 2,000 business plans, of which we might visit 300, seriously consider and conduct due diligence on 50, and invest in eight to 12." Here's the litmus test:

1. Are you a technology company? "In general, 80 percent of a venture capitalist's portfolio is in technology," says Martinson. Why the relentless focus on technology? Martinson says the key may lie in the answer to the next question.

2. Are you capable of being a market leader? "We rarely finance a company that is going up against a market leader with a similar product," says Martinson. The reason? "It's too difficult and too expensive to succeed." But here's where technology plays a role. Breakthroughs can shatter the established paradigm of existing markets or create vast new ones. With low-tech consumer products, such as plastic housewares, or ubiquitous services, such as restaurants, it's difficult to change the rules of the game.

3. Can the company be built inexpensively? In Martinson's nomenclature, that means about $10 million or less. "Venture capitalists like to build companies on the cheap," says Martinson, "to limit the downside risk and because they don't want to have to rely on other sources of capital to pitch in to help the company reach its goal."

4. Is there a clear distribution channel? Many times, entrepreneurs come up with great products, but there's no clear or easy way to sell them, says Martinson. And consistent with venture capitalists' focus on overall cost containment, they also want to know that the distribution channel can be accessed fairly inexpensively.

For instance, the existence of mass-market retailers appears to offer inexpensive and wide distribution for many consumer products, and even some technology products. However, there are often hidden costs that make these channels prohibitive, such as inventory requirements, the stores' right to return unsold product, "slotting" fees or mandatory cooperative advertising costs. Martinson says companies that have joint venture marketing opportunities--that is, the opportunity to move product through someone else's distribution channel--or otherwise have direct and proven access to the market are typically more attractive to venture capitalists than those that must invent their own distribution systems or pay high fees to use someone else's.

5. Does this product require significant support? Complex products or services usually require customer support organizations that are expensive and sometimes difficult to establish and maintain. For instance, a relatively low-tech home alarm system sold through mass-market distribution channels might seem appealing to an investor given Americans' rising concerns over security, says Martinson. But can customers install it themselves, or does a third party have to get involved? "If a third party is required, it's much less appealing because of the costs involved and their impact on the margins," he says.

But the need for customer support doesn't have to kill a deal. Sometimes a third party wants to get involved because it spells opportunity for them. For instance, SAP America Inc., a worldwide applications software company based in Germany, relies heavily on Big Six accounting firms to install and support its products. For SAP, funds that might otherwise go to a massive customer support organization go instead to the bottom line.

6. Can the product or service generate gross margins of more than 50 percent? "For business owners who are trying to carve out a salary and a living," says Martinson, "gross margins of 30 percent are fine." But for professional investors who need to make a return, 30 percent margins are too thin. Why? "First," says Martinson, "that margin leaves little room for error." Second, and more important, he says, "my return depends on an acquisition of the company or an initial public offering. With thin margins, the prospect for either becomes dimmer because the next owner of the company doesn't want to face all the attendant risks associated with trying to overcome those thin margins."

7. Can the company grow to $25 million in five years, with the prospect of growing to $50 million to $100 million? At $25 million in sales, a company is just beginning to generate the kinds of profits that make it worth enough so venture capitalists can get the kind of return they are looking for. Say, for instance, that a $25 million enterprise was bringing $5 million to the bottom line. Valuing the company as a multiple of its earnings--a standard benchmark--and using a multiple of 10 just to keep the math easy suggests a value of $50 million. If the venture capitalist invested $10 million, then the return on this hypothetical company would be five times the investment in five years--a middle-of-the-road target return for most venture capitalists.

On this final point, Martinson is firm. "If there's no possibility you're going to hit the $25 million benchmark within five years," he says, "it's simply a waste of time to pursue institutional venture capital." But once this hurdle is passed, Martinson offers encouragement: "If the business can really be cranked up fast, I would encourage entrepreneurs to give venture capitalists a try, because you just never know until you do."

Contact Sources

Edison Venture Fund, 997 Lenox Dr., Lawrenceville, NJ 08648, (609) 896-1900, ext. 18.

David R. Evanson, a writer and consultant, is a principal of Financial Communications Associates in
Ardmore, Pennsylvania.