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.
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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."
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