Venture Capital

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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