Venture Capital

Venture capital is a type of equity investment usually made in rapidly growing companies that require a lot of capital or start-up companies that can show they have a strong business plan. Venture capital may be provided by wealthy individual investors, professionally managed investment funds, government-backed Small Business Investment Corporations (SBICs), or subsidiaries of investment banking firms, insurance companies, or corporations. Such venture capital organizations generally invest in private startup companies with a high profit potential. In exchange for their funds, venture capital organizations usually require a percentage of equity ownership of the company (between 25 to 55 percent), some measure of control over its strategic planning, and payment of assorted fees. Due to the highly speculative nature of their investments, venture capital organizations expect a high rate of return. In addition, they often wish to obtain this return over a relatively short period of time, usually within three to seven years. After this time, the equity is either sold back to the client-company or offered on a public stock exchange.

Venture capital is more difficult for a small business to obtain than other sources of financing, such as bank loans and supplier credit. Before providing venture capital to a new or growing business, venture capital organizations require a formal proposal and conduct a thorough evaluation. Even then, they tend to approve only a small percentage of the proposals they receive. An entrepreneur with a small start-up should not consider venture capital if, for example, her objective is to grow her fledgling graphic design service into a middle-size regional greeting card business. This profile does not fit with the venture capitalists' objectives. Venture capital firms usually look for investment opportunities with firms that offer rapid growth as well as something new: a new technology or technology application, a new chemical compound, a new process for the manufacture of a product, etc. Once an entrepreneur's venture has been determined to be of a kind that may interest venture capitalists, the next move is to start planning. The most important thing an entrepreneur can do to increase his or her chances of obtaining venture capital is to plan ahead.

Venture capital offers several advantages to small businesses, including management assistance and lower costs over the short term. The disadvantages associated with venture capital include the possible loss of effective control over the business and relatively high costs over the long term. Overall, experts suggest that entrepreneurs should consider venture capital to be one financing strategy among many, and should seek to combine it with debt financing if possible.

THE EVALUATION PROCESS

Since it is often difficult to evaluate the earnings potential of new business ideas or very young companies, and investments in such companies are unprotected against business failures, venture capital is a highly risky industry. As a result, venture capital firms set rigorous policies and requirements for the types of proposals they will even consider. Some venture capitalists specialize in certain technologies, industries, or geographic areas, for example, while others require a certain size of investment. The maturity of the company may also be a factor. While most venture capital firms require their client companies to have some operating history, a very small number handle startup financing for businesses that have a well-considered plan, something "new," and an experienced management group.

In general, venture capitalists are most interested in supporting companies with low current valuations, but with good opportunities to achieve future profits in the range of 30 percent annually. Most attractive are innovative companies in rapidly accelerating industries with few competitors. Ideally, the company and its product or service will have some unique, marketable feature to distinguish it from imitators. Most venture capital firms look for investment opportunities in the $250,000 to $2 million range. Since venture capitalists become part owners of the companies in which they invest, they tend to look for businesses that can increase sales and generate strong profits with the help of a capital infusion. Because of the risk involved, they hope to obtain a return of three to five times their initial investment within five years.

Venture capital organizations typically reject the vast majority—90 percent or more—of proposals quickly because they are deemed a poor fit with the firm's priorities and policies. They then investigate the remaining 10 percent of the proposals very carefully, and at considerable expense. Whereas banks tend to focus on companies' past performance when evaluating them for loans, venture capital firms tend to focus instead on their future potential. As a result, venture capital organizations will examine the features of a small business's product, the size of its markets, and its projected earnings.

As part of the detailed investigation, a venture capital organization may hire consultants to evaluate highly technical products. They also may contact a company's customers and suppliers in order to obtain information about the market size and the company's competitive position. Many venture capitalists will also hire an auditor to confirm the financial position of the company, and an attorney to check the legal form and registration of the business. Perhaps the most important factor in a venture capital organization's evaluation of a small business as a potential investment is the background and competence of the small business's management. For many venture capital firms the most important factor in their assessment is determining the capabilities of the management team, and not the potential product. Since the abilities of management are often difficult to assess, it is likely that a representative of the venture capital organization would spend a week or two at the company. Ideally, venture capitalists like to see a committed management team with experience in the industry. Another plus is a complete management group with clearly defined responsibilities in specific functional areas, such as product design, marketing, and finance.

VENTURE CAPITAL PROPOSALS

In order to best ensure that a proposal will be seriously considered by venture capital organizations, an entrepreneur should furnish several basic elements. After beginning with a statement of purpose and objectives, the proposal should outline the financing arrangements requested, i.e., how much money the small business needs, how the money will be used, and how the financing will be structured. The next section should feature the small business's marketing plans, from the characteristics of the market and the competition to specific plans for getting and keeping market share.

A good venture capital proposal will also include a history of the company, its major products and services, its banking relationships and financial milestones, and its hiring practices and employee relations. In addition, the proposal should include complete financial statements for the previous few years, as well as pro-forma projections for the next three to five years. The financial information should detail the small business's capitalization—i.e., provide a list of shareholders and bank loans—and show the effect of the proposed project on its capital structure. The proposal should also include biographies of the key players involved with the small business, as well as contact information for its principal suppliers and customers. Finally, the entrepreneur should outline the advantages of the proposal—including any special and unique features it may offer—as well as any problems that are anticipated.

If, after careful investigation and analysis, a venture capital organization should decide to invest in a small business, it then prepares its own proposal. The venture capital firm's proposal would detail how much money it would provide, the amount of stock it would expect the small business to surrender in exchange, and the protective covenants it would require as part of the agreement. The venture capital organization's proposal is presented to the management of the small business, and then a final agreement is negotiated between the two parties. Principal areas of negotiation include valuation, ownership, control, annual charges, and final objectives.

The valuation of the small business and the entrepreneur's stake in it are very important, as they determine the amount of equity that is required in exchange for the venture capital. When the present financial value of the entrepreneur's contribution is relatively low compared to that made by the venture capitalists—for example, when it consists only of an idea for a new product—then a large percentage of equity is generally required. On the other hand, when the valuation of a small business is relatively high—for example, when it is already a successful company—then a small percentage of equity is generally required. It is quite normal for venture capital firms to value a company at below the valuation the company has for itself. It is best if the small business looking for venture capital prepare for such an outcome.

The percentage of equity ownership required by a venture capital firm can range from 10 percent to 80 percent, depending on the amount of capital provided and the anticipated return. But most venture capital organizations want to secure equity in the 30-50 percent range so that the small business owners still have an incentive to grow the business. Since venture capital is in effect an investment in a small business's management team, the venture capitalists usually want to leave management with some control. In general, venture capital organizations have little or no interest in assuming day-to-day operational control of the small businesses in which they invest. They have neither the technical expertise or managerial personnel to do so. But venture capitalists usually do want to place a representative on each small business's board of directors in order to participate in strategic decision-making.

Many venture capital agreements include an annual charge, typically 2-3 percent of the amount of capital provided, although some firms instead opt to take a cut of profits above a certain level. Venture capital organizations also frequently include protective covenants in their agreements. These covenants usually give the venture capitalists the ability to appoint new officers and assume control of the small business in case of severe financial, operating, or marketing problems. Such control is intended to enable the venture capital organization to recover some of its investment if the small business should fail.

The final objectives of a venture capital agreement relate to the means and time frame in which the venture capitalists will earn a return on their investment. In most cases, the return takes the form of capital gains earned when the venture capital organization sells its equity holdings back to the small business or on a public stock exchange. Another option is for the venture capital firm to arrange for the small business to merge with a larger company. The majority of venture capital arrangements include an equity position, along with a final objective that involves the venture capitalist selling that position. For this reason, entrepreneurs considering using venture capital as a source of financing need to consider the impact a future stock sale will have on their own holdings and their personal ambition to run the company. Ideally, the entrepreneur and the venture capital organization can reach an agreement that will help the small business grow enough to provide the venture capitalists with a good return on their investment as well as to overcome the owner's loss of equity.

THE IMPORTANCE OF PLANNING

Although there is no way for a small business to guarantee that it will be able to obtain venture capital, sound planning can at least improve the chances that its proposal will receive due consideration from a venture capital organization. Such planning should begin at least a year before the entrepreneur first seeks financing. At this point, it is important to do market research to determine the need for its new business concept or product idea and establish patent or trade secret protection, if possible. In addition, the entrepreneur should take steps to form a business around the product or concept, enlisting the assistance of third-party professionals like attorneys, accountants, and financial advisors as needed.

Six months prior to seeking venture capital, the entrepreneur should prepare a detailed business plan, complete with financial projections, and begin working on a formal request for funds. Three months in advance, the entrepreneur should investigate venture capital organizations to identify those that are most likely to be interested in the proposal and to provide a suitable venture capital agreement. The best investor candidates will closely match the company's development stage, size, industry, and financing needs. It is also important to gather information about a venture capitalist's reputation, track record in the industry, and liquidity to ensure a productive working relationship.

One of the more important steps in the planning process is preparing detailed financial plans. Strong financial planning demonstrates managerial competence and suggests an advantage to potential investors. A financial plan should include cash budgets—prepared monthly and projected for a year ahead—that enable the company to anticipate fluctuations in short-term cash levels and the need for short-term borrowing. A financial plan should also include pro-forma income statements and balance sheets projected for up to three years ahead. By showing expected sales revenues and expenses, assets and liabilities, these statements help the company to anticipate financial results and plan for intermediate-term financing needs. Finally, the financial plan should include an analysis of capital investments made by the company in products, processes, or markets, along with a study of the company's sources of capital. These plans, prepared for five years ahead, assist the company in anticipating the financial consequences of strategic shifts and in planning for long-term financing needs.

Overall, experts warn that it takes time and persistence for entrepreneurs to obtain venture capital. In the best of economic times, venture capital is difficult to secure. In slower economic times it becomes ever harder. It is not unusual to work on obtaining venture capital for years before an agreement is met, according to Brian Brus who studied the subject for his article "Starting a Business is Harder then Ever in the 21st Century." The hardest thing to communicate to enthusiastic entrepreneurs who come to venture capital firms looking for help, explains Brus, is that they can't just get started making their new product or service. Venture capitalists may be risk takers but for those lucky few with whom they invest, it may not feel that way once all the paper work is done and an agreement is in place.

see also Angel Investors; Financial Planning; Loans; Seed Money

BIBLIOGRAPHY

Bartlett, Joseph W. Fundamentals of Venture Capital. Madison, 1999.

Braunschweiger, Carolina. "Fundraising for Private Equity Hearty in First Quarter." Investment Management Weekly. 1 May 2006.

Clark, Scott. "Business Plan Basics: Why Most New Ventures Fail to Raise Capital." Houston Business Journal. 17 March 2000.

Davoudi, Salamander, Lina Seigol, and Peter Smith. "Why Private Equity Companies are Piling into Healthcare. Strong Cash Flows, Property and Demographics are Drawing them In." The Finanical Times. 26 April 2006.

Gimbel, Florian. "Venture Capitalists Shift Focus to India Technology." The Financial Times. 2 May 2006.

Gompers, Paul, and Josh Lerner. The Venture Capital Cycle. The MIT Press, 1999.

La Beau, Christina. "Growing in Size But Not in Equity: Women Businesses Still Lag in Venture Capital." Crain's Chicago Business. 13 December 2004.

National Venture Capital Association. "The Venture Capital Industry—An Overview." Available from http://www.nvca.org/def.html. Retrieved on 3 May 2006.

Parmar, Simon, J. Kevin Bright, and E.F. Peter Newson. "Building a Winning E-Business." Ivey Business Journal. November 2000.

                                Hillstrom, Northern Lights

                                  updated by Magee, ECDI

Seed Money

Seed money, or seed capital, is the first round of capital for a start-up business. It gets its name from the idea that early stage financing plants the seed that enables a small business to grow. Obtaining funding is one of the most critical aspects of starting a small business. In fact, many businesses fail or are prevented from even starting due to a lack of capital. Although obtaining financing can be difficult for any small business, it is particularly hard for new ventures. Since new ventures lack a track record, potential lenders and investors are often skeptical about their prospects for success. Nonetheless, the persistent would-be entrepreneur, if armed with a sound business plan and the necessary skills, can usually obtain funding for his/her dream eventually.

Many entrepreneurs approach their family, friends, and colleagues for seed money after exhausting their own finances. Since these investors know the entrepreneur, they are more likely to take a risk on funding a new venture than are traditional financing sources, such as banks or venture capital firms. An entrepreneur must be committed and enthusiastic in pursuing seed money since he or she has little else with which to entice investors. Because it is almost impossible to predict how successful the project may eventually be, the only outsiders likely to invest in the venture are those who respect the entrepreneur's judgment and abilities. Those people are the ones who know the entrepreneur best. By getting in on the ground floor, the providers of seed money hope to participate in the entrepreneur's success and realize a healthy return as their investment appreciates over time. Nonetheless, seed money is a risky investment and most investors know this, or should. Investing seed money is, in many instances, more like buying a lottery ticket than making an investment.

Seed money usually takes the form of equity financing, so investors receive partial ownership of the fledgling company in exchange for their funds. As a result, it is important for the entrepreneur to take potential investors' personalities and business reputations into consideration when seeking seed money. Since these people will be part owners of the company-and may insist upon having some control over decision making-it is vital to ascertain whether their interests and personalities are compatible with those of the entrepreneur. Once suitable investors have been located, the entrepreneur must convince them that the new business venture has a good chance of success. The first step in this process is creating a formal, written business plan, including plausible projections of income and expenses.

Having a clearly defined purpose for seed money can be an important factor in securing these funds. The purpose of seed capital usually involves moving the business out of the idea stage—by building a prototype product or conducting market research, for example—and gathering concrete evidence that it can succeed. In this way, seed money helps the entrepreneur to prove the merit of his or her idea in order to attract the interest of formal investment sources.

As far as the amount of seed money the entrepreneur should try to obtain, experts recommend targeting only what is needed to accomplish the business's initial objectives. Given its risk, seed capital is usually more expensive for the firm than later stage financing. Thus, raising a small amount at a time helps the entrepreneur to preserve equity for later financing rounds. Ideally, an arrangement can be made that links seed money to launch financing, so the entrepreneur can go back to the same investors for future funding needs. For example, the entrepreneur might set goals for a successful market test of a new product. If the goals are met, then the original investors agree to provide additional funds for a product launch. This approach protects the entrepreneur against the possibility of having a successful test and then running out of money before being able to launch the product. Even if the original investors cannot provide additional funds directly, their vested interest may encourage them to help the venture succeed in other ways.

There are other sources of seed money available to entrepreneurs besides friends and family members. For example, some venture capital firms reserve a limited amount of capital for financing new ventures or business ideas. Since start-ups involve greater risks than established businesses, however, the venture capital investors generally require a larger equity position in exchange. On average, venture capitalists providing seed money will expect a 50 to 100 percent higher return on investment than in a standard venture capital arrangement. There are also nonprofit organizations dedicated to providing seed capital for new businesses. In many cases, these organizations will also assist the entrepreneur in creating a business plan or marketing materials, and establishing cash flow controls or other systems.

Angel Investors

Successful business owners looking to invest in new enterprises are a good potential source of start up capital or seed money. These people are often referred to as angel investors. They are known as "angels" because they often invest in risky, unproven business ventures for which other sources of funds—such as bank loans and formal venture capital—are not available. New startup companies often turn to the private equity market for seed money because the formal equity market is reluctant to fund risky undertakings. In addition to their willingness to invest in a startup, angel investors may bring other assets to the partnership. They are often a source of encouragement, they may be mentors in how best to guide a new business through the startup phase and they are often willing to do this while staying out of the day-to-day management of the business.

Although angel investors usually work on an individual basis there has been a trend towards the formation of angel investor groups within the last decade. An article in Fortune Small Business (FSB) discusses the trend towards angle investment groups. According to the author, Jennie Lee, "Last year [2005] some 227,000 angles in the U.S. pumped $23 billion into startups, up about 3 percent from 2004…. One reason for the growth: the void left by venture capitalist, who have started to favor larger, later-stage investments."

These angel investment groups usually meet on a regular basis and invite prospective entrepreneurs to present their business ideas for consideration. David Worrell discusses what such a presentation may involve in his article entitled "Taking Flight: Angel Investors are Flocking Together to Your Advantage." If invited to present ideas before an angel investor group, "expect to be one of two or three presenters, each given 10 to 30 minutes to showcase an investment opportunity. Speak loudly, as most groups mix presentations with a meal."

Despite the potential for funding through an angel investor group, according to Worrell, individual angels are still likely to be the best source of seed and early stage money for a small business or startup. "Angel groups can bring more money and other resources, which makes them more effective at later stages."

see also Angel Investors; Financial Planning; Venture Capital

BIBLIOGRAPHY

"About ACA." Angel Capital Association, Available from http://www.angelcapitalassociation.org/. January 2006,

Benjamin, Gerald A., and Joel Margulis. The Angel Investor's Handbook. Bloomberg Press, January 2001.

Chung, Joe. "Panning Out." Technology Review. October 2004.

Lee, Jeannie. "How to Fund Other Startups and Get Rich." FSB. June 2006.

National Venture Capital Association. "The Venture Capital Industry—An Overview." Available from http://www.nvca.org/def.html. Retrieved on 3 May 2006.

Phalon, Richard. Forbes Greatest Investing Stories. John Wiley & Sons, April 2004.

"Where the Seed Money Is." Industry Standard. 26 February 2001.

Worrell, David. "Taking Flight: Angel Investors are Flocking Together to Your Advantage." Entrepreneur. October 2004.

                                 Hillstrom, Northern Lights

                                   updated by Magee, ECDI

Venture Capital Networks

Venture capital networks, or clubs, are groups of individual and institutional investors that provide financing to risky, unproven business ventures. Like other providers of venture capital—which may include professionally managed investment funds, government-backed Small Business Investment Corporations (SBICs), or subsidiaries of investment banking firms, insurance companies, and corporations—members of these networks generally invest in private startup companies with a high profit potential. In exchange for their funds, the venture capitalists usually require a percentage of equity ownership of the company, some measure of control over its strategic planning, and payment of assorted fees. Due to the highly speculative nature of their investments, venture capitalists hope to achieve a high rate of return over a relatively short period of time.

The main difference between venture capital networks and other venture capital providers is their degree of formality. Venture capital networks are informal organizations that exist to help entrepreneurs and small businesses connect with potential investors. Before the advent of networks, it was extremely difficult for entrepreneurs to gain access to wealthy private investors, also known as "angels" or "adventure capitalists." The networks—which may take the form of computer databases or document clearing-houses—basically provide "matchmaking" services between people with good business ideas and people with money to invest. In contrast, formal venture capital firms are professionally managed organizations that exist to earn a high return on funds by investing in new and growing companies. These firms are typically highly selective about the companies in which they invest, meaning that venture capital from these sources is not available to the vast majority of startup businesses.

According to Nation's Business, wealthy private investors provided American small businesses with $10 to $20 billion annually during the mid-1990s. In the early 2000s the venture capital market slowed dramatically. However, according to Second Venture Corporation, a venture capital network dedicated to helping entrepreneurs find funding with which to start businesses, "The current venture capital market [in early 2006] is rebounding nicely, from the past setbacks of the dot com bubble. Venture capital remains a viable source of funding for startups, which are able to deliver the necessary growth that investors are looking for. Past events should certainly not discourage entrepreneurs who have genuine winning ideas and business plans from looking for funds."

The membership of venture capital networks consists primarily of wealthy entrepreneurs who recognize both the financial potential of new businesses and the importance of capital in the early stages of a business's life. In many cases, these investors wind up sitting on the boards of the companies they fund, where they can provide valuable, firsthand management advice based on their own experiences.

HOW NETWORKS WORK

In the past, it was extremely difficult for entrepreneurs to find and make contact with private investors. In response to this problem, many business groups and universities created networks to help entrepreneurs gain access to interested investors. One of the earliest such efforts was the Venture Capital Network, a computer database that was established by a professor at the University of New Hampshire. This and other computerized networks are similar to computer matchmaking services. Each entrepreneur posts a business plan and a set of financial projections on the network, while each investor submits information describing his or her interests and investment criteria. Due to their previous business experience, different investors may be most interested in investing in companies of a certain size, in a certain industry, or with certain capital requirements. The computer then provides participants with a list of possible matches. Interested parties are left to make contact with one another and try to reach an agreement.

Non-computerized venture capital networks operate in basically the same way. A central clearinghouse solicits business plans from companies seeking capital, then distributes profiles of the companies to private investors who belong to the network. If a certain investor wants to know more about a particular company, he or she might arrange for a formal presentation. In many cases, both business and investor profiles are distributed anon-ymously—without names attached—until both parties express an interest in proceeding further. Another similar type of arrangement can be found in a private investment club. These are community-based organizations in which several individuals pool their resources to invest in new and existing businesses on a local level. Such clubs generally solicit business plans and then distribute them to members, but then invest as a group.

The financing provided through venture capital networks can range dramatically in size from investments of $25,000 to more than $1 million (the majority of financing deals are under $100,000). Entrepreneurs searching for venture capital assistance usually pay a small fee to participate in a network—typically less than $500 annually—and institutional investors may pay a somewhat higher fee. Although venture capital networks are usually better sources of funding for startup companies than formal venture capital firms, merely joining a network does not guarantee that a small business will obtain financing. There are usually at least two companies for every one investor listed in databases. In addition, even if a match is made, the entrepreneur still must sell the investor on the proposal and negotiate a mutually beneficial agreement.

see also Angel Investors; Financial Planning; Loans; Seed Money

BIBLIOGRAPHY

Bartlett, Joseph W. Fundamentals of Venture Capital. Madison, 1999.

La Beau, Christina. "Growing in Size But Not in Equity: Women Businesses Still Lag in Venture Capital." Crain's Chicago Business. 13 December 2004.

"Raising Venture Capital? Looking for Angel Investors?" Second Venture Corporation. Available from http://www.ventureworthy.com/. Retrieved on 2 May 2006.

"Venture Capital Clubs or Groups." Venture Associates. Available from http://www.venturea.com/clubs2.htm. Retrieved on 2 May 2006.

                                Hillstrom, Northern Lights

                                 updated by Magee, ECDI

Venture Capital

Venture capital refers to money that is invested in companies during the early stages of their development. Such funds may come from wealthy individuals, government-backed Small Business Investment Companies (SBICs), or professionally managed venture capital firms. Since investing in an unproven business venture is highly speculative, venture capitalists generally target companies that they believe offer significant potential for growth, and therefore an opportunity to earn a high rate of return in a relatively short period of time. In exchange for providing capital, as well as a source of management assistance and industry contacts for growing firms, the investors usually require a percentage of equity ownership in the company, some measure of control over its strategic direction, and payment of assorted fees. “Private equity provides capital and access to a network that can transform a company into an industry player,” Karen E. Klein noted in Business Week. “But the price is high: a chunk of your business.” According to Klein in another article, “Attracting Venture Capital in 2008,” the venture capital market will be heading in two converse directions: in one direction, financial institutions that offer venture capital will thrive; in the other direction, firms that tend to make their business primarily on venture capital investments will cave in on themselves due to unpaid loans on risky investments that collapsed, resulting in thousands of defaulted loans.

Like other sources of equity financing, venture capital offers both advantages and disadvantages. The main advantage is that the business is not obligated to repay the money. For a start-up company, this frees up important cash flow that might otherwise be needed to service debt. The involvement of high-profile investors may also help increase the credibility of a new business. The main disadvantage to venture capital financing is that the investors become part owners of the business, and thus gain a say in business decisions. The company's founders face a dilution of their ownership positions and a possible loss of autonomy or control.

Even for business owners willing to make the tradeoff, venture capital is scarce and often difficult to obtain. Venture capitalists tend to be highly selective in choosing investments. Some will only consider investments in specific technologies, industries, or geographic areas. In fact, the larger venture capital firms typically reject more than

90 percent of the requests for funding that they receive. Conversely, venture capitalists can be a great alternative for startup companies that represent too significant of a risk for banks and other more traditional lending institutions. Capitalists that are willing to take greater risks can be handsomely rewarded for their faith and financial investment and often do well in rapidly growing sectors like technology, communications, and healthcare.

Firms often evaluate requests thoroughly, and at considerable expense, before selecting a few that closely match the investors' areas of expertise and offer the best earnings potential. As a result, private equity financing is more likely to be an option for existing businesses with a solid track record and good prospects for future growth than for start-up companies that pose a much greater risk. It is a particularly good choice for fast-growing companies that have few tangible assets to use financing as collateral for loans.

For a business owner, the process of obtaining venture capital begins with a formal proposal. The most important element of this proposal is a detailed business plan describing the company's goals and strategies on a timeline. The proposal should also include recent financial statements, projections of future growth, a brief history of the company, biographies of key managers and executives, the amount of capital requested, and a description of how the funds will be used. Experts recommend that companies seeking equity financing evaluate several venture capital firms before entering into a deal. Managers should also hire professionals to help them understand the terms of the agreement before signing to avoid giving away too much control.

On receiving a proposal of interest, a venture capital firm usually follows up with a thorough investigation of the company's investment potential. This process might include analyzing financial statements, interviewing employees, customers, and suppliers, and meeting with the management team. If the venture capital firm remains interested following the evaluation phase, it usually responds with a proposal of its own, known as a term sheet. The term sheet acts as a blueprint for the investment deal, with provisions covering such issues as the valuation of the investment, voting rights, and liquidation options.

The final terms are decided through negotiations between the business managers and the venture capital firm, generally through the legal counsel of both parties. One of the most important factors in the negotiation process is agreeing upon the valuation of the business, which determines the amount of equity in the company that is required in exchange for the venture capital (a business with a low valuation must provide a high percentage of equity, and vice versa). As a general rule, venture capital firms seek to control between 30 and 40 percent of equity in the companies in which they invest. This amount allows the venture capital firm to exercise influence without assuming control or eliminating the management team's incentive to grow the business. The venture capital firm usually hopes to achieve a return of three to five times the original investment within five years, by selling its equity either to the company's management and executives or on the public stock markets.

Overall, venture capital can provide a valuable source of financing for growing businesses. Many analysts suggest that the nature of venture capitalism is cyclical—that it experiences waves of popularity in varied industries and with businesses of various sizes before becoming problematic for both lenders and recipients who both eventually retreat, causing traditional lending channels to again become the popular choice. This cycle repeats throughout good and bad economic times, giving companies in need of a lender an option regardless of the financial climate.

Because of the risks associated with venture capital, experts generally suggest that it be viewed as one of a number of potential sources of financing and be used in combination with debt financing whenever possible. “Private equity isn't for the faint of heart,” Klein acknowledged. “But then again, entrepreneurs aren't known for being timid.”

SEE ALSO Due Diligence; Entrepreneurship; Financial Issues for Managers; Financial Ratios

BIBLIOGRAPHY

“Attracting Venture Capital in 2008.” Available from: http://www.businessweek.com/smallbiz/content/dec2007/sb20071226_721429.htm.

Bartlett, Joseph W. Fundamentals of Venture Capital. Lanham, MD: Madison Books, 1999.

Cardis, Joe, et al. Venture Capital: The Definitive Guide for Entrepreneurs, Investors, and Practitioners. New York: Wiley & Sons, 2001.

Klein, Karen E. “A Private Equity Affair: Getting the Most from Venture Capital.” Business Week, 1 November 2004, 47.

Lerner, Josh, F. Hardymon, and A. Leamon. “Venture Capital and Private Equity: A Casebook.” New Jersey: John Wiley & Sons, 2008.

McKimmie, Kathy. “Funding Fundamentals: Where to Turn for Startup and Expansion Capital.” Indiana Business Magazine, January 2004, 24–27.

Stancill, James McNeill. Entrepreneurial Finance: For New and Emerging Businesses. Mason, OH: Thomson/South-Western, 2004.

Weiss, Jeffrey M. “Venture Capital Tips.” Detroiter, May 2002, 19.

Worrell, David. “Raising Money: All in the Delivery.” Entrepreneur, May 2004.

Venture Capital

What It Means

Venture capital is money that serves as financial backing for new, generally unproven business enterprises, typically known as start-up companies, or start-ups. Because venture capital is used to fund companies that have little to no history of success, it is also known as risk capital. Venture capital is usually invested in companies seeking to launch innovative new products or services. In the late twentieth century venture capital was often used to finance emerging technology companies.

Individuals or groups who provide venture capital for new businesses are known as venture capitalists. Venture capitalists can be wealthy individuals, corporations, subsidiaries (companies owned by other companies), or other business entities.

In exchange for giving unproven entrepreneurs (self-employed individuals who own and manage their own businesses) the opportunity to start their own businesses, venture capitalists often demand a high level of return once the business has become established. Venture capitalists generally expect to earn a return of between three and five times the amount of their initial investment. They also expect to see this return in a relatively short period of time, typically between five and seven years after funding the venture. Venture capitalists can also be involved in shaping the policies of new companies, and they often assume the role of partial owner of the company.

When Did It Begin

Throughout history, up-and-coming entrepreneurs have depended on some form of venture capital to finance a growing business. Traditionally, early venture capitalists were wealthy individuals or families. The modern venture capital industry emerged in the United States during the 1930s, when the federal government imposed tighter restrictions on the ways that banks lent money to corporations. In response to these regulations, business leaders began to develop new systems of investing in emerging companies.

In 1946 American businessman Georges Doriot (1899–1987) founded American Research and Development Corporation (ARD), the first publicly owned company dedicated to providing venture capital to new businesses (a company is said to be publicly owned when the public is invited to buy shares in it). One of its most significant venture capital investments came in 1957, when it financed the founding of the Digital Equipment Corporation, or DEC, the first company in the world to manufacture minicomputers (the prototypes for the personal computer). ARD’s initial investment totaled $70,000; by the time DEC went public (selling shares in the company on the stock market) in 1968, ARD’s investment had grown to $37 million.

More Detailed Information

In order to acquire venture capital, start-up companies will usually submit a detailed business proposal to a venture capital firm or entity. This proposal typically includes a description of the start-up company’s products or services; an overview of the company’s goals (along with a timetable for achieving those goals); an outline of possible financing arrangements (including the amount of money needed, a schedule for repayment of the investment capital, and the projected gains on the venture capitalist’s returns); and a marketing strategy (a plan describing how the company intends to build consumer awareness about its product or service). If a venture capital firm accepts the prospective company’s proposal, it will usually submit a counterproposal outlining its own set of terms and timelines.

There are several potential sources of venture capital. In some cases, venture capitalists are wealthy individuals looking for an investment opportunity with a potentially high rate of return. These individuals can be enterprising investors, successful business entrepreneurs, or heirs to private fortunes. Because individual investors generally have less venture capital than larger investment firms, their investments are often used to finance relatively small companies.

Professional investment funds are entities that pool resources from various interests in order to raise large amounts of investment capital. Because they have more extensive financial resources, investment funds have a greater capacity for risk than individual investors, and so are able to finance more ambitious venture capital enterprises. On the other hand, securing venture capital from an investment fund tends to be highly competitive, because investment funds have a more formal and rigorous application process than other venture capitalists and invest a great deal of time and money in analyzing the new company’s prospects for success.

The U.S. government supports the founding of small businesses with the Small Business Investment Company (SBIC) program. SBICs are government-sponsored private firms that assist entrepreneurs with the financing and management of their emerging companies. SBICs are licensed and financed by the Small Business Administration (SBA), a federal agency founded in 1958 to provide financial, legal, and administrative support to small businesses.

Other potential sources of venture capital include large corporations, investment-banking companies, and insurance companies.

Recent Trends

Although the venture capital industry has always been most prevalent in the United States, the practice increasingly became an international phenomenon toward the end of the twentieth century. At the start of the twenty-first century venture capitalism in Europe was growing rapidly: in 2005 more than 12.6 billion euros were devoted to venture capital enterprises throughout Europe, an increase of 44 percent over the previous year.

With the emergence of powerful economies in Asia in the late 1990s and early twenty-first century, venture capitalism began to acquire a truly global reach. Venture capital investments in China more than doubled between 2002 and 2003, from $420 million to $1 billion, while in 2005 venture capital levels in India approached $9 billion.