Can You Really Land Venture Capital?

Last year, out of approximately 125,000 interested parties, just 2,939 "lucky winners" (that's just about 2.4 percent) split a venture capital pot of $21.7 billion. Let me do the math for you--each company reeled in about $7.4 million each. And that's how the venture capital community divided out the spoils last year to the very few companies they found to be "worthy." Were last year's results any better than in previous years? Just who were these lucky winners and what chances do you have of grabbing some of that money for your business?

Let's start with the good news--venture capital investing is picking up steam again. Last year saw the first overall increase in venture capital investing after three years of consecutive declines. But how does that help you figure out whether or not your chances are any better now than say, two years ago? To answer that question, you need to first understand how venture capital works and then we'll explore what areas appear to be "hot."

First, to truly comprehend just how the venture capital industry works, you need to know a little about the forces that drive it. Most venture capital funds are created to last for roughly ten years. The majority of their investments are made in the first three to five years, are expected to "mature" (or hit break even) by the seventh and then become "liquid" by the tenth, meaning via an IPO or the sale of the company.

When this cycle was interrupted, as it was in 2000 when the "dotcom" bubble burst and the IPO and mergers and acquisitions (M&A) market virtually disappeared, venture capitalists were forced to go into triage mode. Having lost their main vehicle for getting a return on their investment, the VCs desperately needed to conserve cash. Just imagine, if you will, what the typical VC portfolio looked like six years ago. Because of all the craziness of that period, many VCs had portfolios that were heavily invested in early-stage companies. To fully appreciate what that means to a VC, let's express it this way:

1. Each early-stage company invested in will require approximately $35 million and five years to mature (or approximately $7 million per year to support).

2. Each mezzanine-stage company--and that's a company that's been in the VCs' portfolio for approximately three to five years--will only require another one to two years of the $7 million maintenance investment described above.

3. Each later-stage company in the portfolio is (hopefully) self-sustaining and on a path that will lead to a major payback to the VC via an IPO or a sale.

Normally, a venture capital firm might try to keep its portfolio balanced with each company type taking up about one-third of the portfolio. But by the year 2000, the glut of investments into early-stage companies had many VC portfolios looking something like this: 60 percent, 30 percent and 10 percent. When the bubble burst and the IPO and M&A market dried up, the VCs were stuck with the worst possible scenario: a heavy burden of expensive companies to maintain with no hope of getting a liquidity event off their meager inventory of "ready" companies. Thus, they were forced to do the following:

1. They had to abandon some of their early-stage companies and write them off as losses. And VCs hate to do this!

2. With no IPO or M&A market, they had to budget to keep their remaining portfolio companies alive indefinitely.

3. By redirecting their funds to the more mature companies in their portfolio, they essentially stopped even thinking about investing in anything that resembled a startup.

This wholesale abandonment of the startup community has made life extremely tough for this sector over the past five years. We often refer to this period from 2000 to 2004 as the "nuclear winter" of VC investing. However, it also helped revitalize the angel community, as they began to recognize the really great investing deals VCs couldn't afford to look at.

Even today, with an average VC investment running around $7.4 million per company, the VC trend is still heavily focused on investing in the lower-risk, more mature companies. This makes it very difficult for an entrepreneur to get that first VC check. And since angels rarely invest more than $750,000 per deal, it's extremely hard to go from the angel level to being able to justify a check for $7.4 million. We call this the venture-"gap"-ital problem.

But let's suppose you've figured out a way to overcome the challenges outlined above and you clearly have the momentum to attract venture capital. What types of companies or industries are hot for VC investing? Well, according to PriceWaterhouseCoopers Moneytree 2005 report, the really hot sectors are software (840), biotechnology (357), medical devices and equipment (251), telecommunications (247), and semiconductors (210). (The numbers in parentheses are the VC deals funded in these industries in 2005.)

So if your company is well past the idea stage, is large enough that it can justify a $7.4-million investment and fits within one of the five industries shown above, you stand an excellent chance of getting funded.

If you don't fit that criteria, you might want to consider getting your company rated by a private equity rating service so they can help direct you into a strategy that would give your company the best chance of getting funded.