Pursuing Venture Capital
This article has been excerpted from Financing Your Small Business, available fromSmallBizBooks.com.
Does your business qualify for institutional venture capital? Run through this diagnostic test developed through an interview with John Martinson. He's the managing partner of the Edison Venture Fund, a Lawrenceville, New Jersey venture capital firm with $420 million under its management.
1.Are you a technology company? Technology is the stuff of gods for venture capitalists. With proprietary technology, a company can dominate a market and protect its profit margins. Institutional venture outfits do invest in low- or no-tech deals, just not as often. This means that competition among nontechnology companies is keener than among technology companies.
2.Can you be a market leader? Martinson says institutional venture capital firms are hesitant to throw money at a company that is going up against a market leader with a me-too product or service. It's too difficult and too unlikely to succeed simply by stealing market share from the leader. There are exceptions, however. In particular, this is where technology can play a role by shattering the existing paradigm of how a product or service is offered, as well as by providing entree for an upstart.
3. Will it be cheap to make this company? Of course, what's expensive to one is cheap to another. But in most venture capitalists' terms, cheap is a company that can be put together and establish significant profitability on $10 million to $15 million. According to Martinson, this preference stems from the fact that most institutional venture capitalists do not want to rely on other sources of capital to make the venture work. Rather, they want to be able to help the company reach a profitable plateau with the funds they are able to commit to the deal.
4. Is there a clear distribution channel? Entrepreneurs often come up with great products and services but no clear or easy way to sell them, Martinson says. It's important to ask whether 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, hidden costs often make these channels prohibitive, such as the need to supply thousands of stores with inventory, the right to return unsold product, "slotting" fees or mandatory cooperative advertising costs. Companies that have joint-venture marketing opportunities--that is, the chance to move product through someone else's distribution network or take advantage of someone else's direct and proven access to the market--are typically more attractive to venture capitalists than those that must invent their distribution or pay high fees to use someone else's resources, Martinson says.
5. Can this product be distributed without significant support? Complex products or services usually require customer-support organizations that are expensive and sometimes difficult to establish and maintain. For instance, given rising concern over security, a relatively low-tech home alarm system sold through mass-market distribution channels might appeal to an investor. But can customers install the system themselves, or must a third party be involved? If so, says Martinson, "it's a much harder business to orchestrate and much less appealing because of the involved costs and their impact on the margins." But the need for customer support need not kill a deal. Sometimes a third party wants to get involved because it smells opportunity. For instance, SAP, one of the world's largest applications software companies, relies heavily on Big Five 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? Gross margins are defined as sales less cost of sales. If that number is less than 50 percent, it's a turnoff for most institutional venture investors. Why? Because it's difficult to pay all the selling, general and administrative expenses and generate a healthy profit at this level. It's much more likely that a company will deliver the required high-operating or net margins if its gross margin is above 50 percent to begin with.
7. Can the company go public or be acquired? If neither of these events occur, there's little chance of a real payday for the venture capitalists. The requirement also represents a double-edged sword. First, are the company's founders willing to go this route? People who want to run family businesses don't go public or get acquired. Second, does the company have the ability to go public? A desire to do so is just that, but actually getting such a deal done requires a great business, guts, some luck and a lot of money upfront.
8. Can the company achieve $25 million in sales, and are there prospects for $50 million to $100 million in sales? With $25 million in sales, a company can generate the level of profits that makes the business worth enough so that a venture capitalist can become involved. Let's say, for instance, that a $25 million business brings $5 million to the bottom line and that the VC invests $10 million and owns 50 percent. Let's assume that the company goes public at 20 times its earnings, suggesting a value of $100 million. The VC who owns 50 percent of the company--hence 50 percent of the value, or $50 million--records a return of five times the original investment. That is generally considered a successful investment for most venture capitalists.
If you answered "no" to any of the preceding questions, with possible exceptions for numbers 1 and 6, institutional venture capital is probably not an option for your company. Edison Venture Fund's Martinson is particularly firm on question 8. "If there is no possibility you will hit the $25 million benchmark within five years, pursuing institutional venture capital is simply a waste of time," he says.
Given these kinds of hurdles, it's no wonder few companies land institutional venture capital. The supplicants beating a path to Edison Venture Fund's door seem to bear this out. "We see 2,000 plans each year," Martinson says. "We might visit 300, seriously consider and conduct due diligence on 50, and invest in eight to 12."
If your plan does qualify for venture capital, by all means start looking.
For information on more ways to raise money for your venture, check out Financing Your Small Business, available from SmallBizBooks.com.