In the book, Write Your Business Plan, the staff of Entrepreneur Media offer an in-depth understanding of what’s essential to any business plan, what’s appropriate for your venture and what it takes to ensure success. In this edited excerpt, the authors offer some clues to what venture capitalists are looking for in the companies they invest in.
When many entrepreneurs write a business plan, obtaining venture capital backing is what they have in mind. That’s understandable -- venture capitalists (VCs) are associated with business success and can provide large sums of money, valuable advice, priceless contacts and considerable prestige by their mere presence. Just the fact that you’ve obtained venture capital backing means your business has, in their eyes at least, considerable potential for rapid and profitable growth.
The following are the major types and sources of venture capital, along with distinguishing characteristics of each:
Seed money. Seed money is the initial capital required to transform a business from an idea into an enterprise. Seed money is usually a relatively small amount of cash, up to $250,000 or so, that's used to prove a business concept has merit. It may be earmarked for producing working prototypes, doing market research, or otherwise testing the waters before committing to a full-scale endeavor.
Venture capitalists aren't as likely to provide seed money as some other, less tough-minded financing sources, such as family investors. However, VCs will back seedlings if the idea is strong enough and the prospects promising enough. If they see something new and exciting (usually an aspect of technology) and foresee rapid growth (and a strong potential for high earnings), they may jump in and back a fledgling startup.
VCs, however, are less likely to provide equity capital to a seed-money-stage entrepreneur than they are to provide debt financing. This may come in the form of a straight loan, usually some kind of subordinated debt.
Startup capital. Startup capital is financing used to get a business with a proven idea up and running. Venture capitalists frequently are enthusiastic financiers of startups because they carry less risk than companies at the seed-money stage but still offer the prospect of the high return on investment that VCs require.
Later-round financing. Venture capitalists may also come in on some later rounds of financing. First-stage financing is usually used to set up full-scale production and market development. Second-stage financing is used to expand the operations of an already up-and-running enterprise, often through financing receivables, adding production capacity, or boosting marketing. Mezzanine financing, an even later stage, may be required for a major expansion of profitable and robust enterprises. Bridge financing is often the last stage before a company goes public. It may be used to sustain a growing company during the often lengthy process of preparing and completing a public offering of stock.
While VCs come in many forms, they have similar goals. They want their money back, and they want it back with a lot of interest and capital growth.
VCs typically invest in companies that they foresee being sold either to the public or to larger firms within the next several years. As part owners of the firm, they’ll get their rewards when such sales go through. Of course, if there’s no sale or if the company goes bankrupt, they don’t even get their initial money back.
VCs are willing to assume risk, but they want to minimize it as much as possible. Therefore, they typically look for certain features in companies they're going to invest in. Those include:
- Rapid sales growth
- A proprietary new technology or dominant position in an emerging market
- A sound management team
- The potential to be acquired by a larger company or be taken public in a stock offering within three to five years
- High rates of return on their investment
Like most financiers, venture capitalists want the return of any funds they lend or use to purchase equity interest in companies. But VCs have some very special requirements when it comes to the terms they want and, especially, the rates of return they demand.
Venture capitalists require that their investments have the likelihood of generating very high rates of return. A 30 to 50 percent annual rate of return is a benchmark many venture capitalists seek.
One key concern of venture capitalists is a way to cash out their investment. This is typically done through a sale of all or part of the company, either to a larger firm through an acquisition or to the public through an initial offering of stock. In effect, this need for cashing-out options means that if your company isn’t seen as a likely candidate for a buyout or an initial public offering (IPO) in the next five years or so, VCs aren’t going to be interested.
Venture capitalists assessing your firm’s acquisition chances are going to look for characteristics like proprietary technology, distribution systems or product lines that other companies might want to possess. They also like to see larger, preferably acquisition-minded firms in your industry. For instance, Microsoft, the world’s largest software firm, frequently acquires small personal-computer-software firms with talented personnel or unique technology. Venture capitalists looking at funding a software company are almost certain to include an assessment of whether Microsoft might be interested in buying out the company someday.
Some fantastic fortunes have been created in recent years by venture-funded startups that went public. Initial public offerings of their stock have made numerous millionaires, seemingly overnight.
Nonetheless, an IPO takes lots of time. You’ll need to add outside directors to your board and clean up the terms of any sweetheart deals with managers, family or board members as well as have a major accounting firm audit your operations for several years before going public. If you need money today, in other words, an IPO isn’t going to provide it.