Private Equity as an Option for Raising Capital
The words, "venture capital," are used quite frequently in discussions of entrepreneurial finance, but to different people, they mean different things. It is essential that the first-time entrepreneur knows the differences and uses the term correctly. But "venture capital" is a generic term that the man-on-the-street uses to describe all forms of private equity that might be invested, on some basis, in privately held, smaller firms. Quite often, the person using this term is referring to angel, or individual investors.
Private equity investing may broadly be defined as investing in securities through a negotiated process. It entails providing equity capital to develop new products and technologies, to increase working capital, to make strategic acquisitions, or to strengthen a companyís balance sheet. Venture capital is a subset of the larger private equity asset class. The private equity asset class includes venture capital, buyouts, and mezzanine investment activity. Venture capital focuses on investing in private, young, fast growing companies. Buyout and mezzanine investing focuses on investing in more mature companies.
"VENTURE CAPITAL" is professionally managed investment capital targeted for new and emerging companies in which investments have the potential to yield extraordinary returns. Venture capitalists are professional investors who specialize in funding and building young, innovative enterprises. Venture capitalists are long-term investors who take a hands-on approach with all of their investments and actively work with entrepreneurial management teams in order to build great companies.
So whatís the difference between a bank and a venture capitalist? Banks provide term loans and working capital to companies. The company has to make interest payments and pay back the principal within a stipulated timeframe. In comparison a VC subscribes to the equity shares of a company for a stake in the company at a negotiated valuation.
What does a Venture Capitalist look for?
Venture capitalists are higher risk investors and, in accepting these higher risks, they desire a higher return on their investment. The venture capitalist manages the risk/reward ratio by only investing in businesses that fit their investment criteria and after having completed extensive due diligence on each candidate.
Venture capitalists have differing operating approaches. These differences may relate to the location of the business, the size of the investment, the stage of the company, industry specialization, and structure of the investment and involvement of the venture capitalists in the company's activities. The entrepreneur should not be discouraged if one venture capitalist does not wish to proceed with an investment in the company. The rejection may not be a reflection of the quality of the business, but rather a matter of the business not fitting with the venture capitalist's particular investment criteria.
Venture capital is not suitable for all businesses, as a venture capitalist typically seeks:
Venture capitalists look for companies with superior products or services targeted at fast-growing or untapped markets with a defensible strategic position. Alternatively, for leveraged management buyouts, they are seeking companies with high borrowing capacity, stability of earnings and an ability to generate surplus cash to quickly repay any outstanding debt.
Quality and Depth of Management
Venture capitalists must be confident that the firm has the quality and depth in the management team to achieve its aspirations. Venture capitalists seldom seek managerial control; rather, they want to add value to the investment where they have particular skills including fundraising, mergers and acquisitions, marketing and networks.
Corporate Governance and Structure
In many ways the introduction of a venture capitalist is preparatory to a public listing. The venture capitalist will want to ensure that the investee company has the willingness to adopt modern corporate governance standards, such as non-executive directors, including a representative of the venture capitalist. Venture capitalists are put off by complex corporate structures without a clear ownership and where personal and business assets are merged.
Appropriate Investment Structure
As well as the requirement of being an attractive business opportunity, the venture capitalist will also be seeking to structure a satisfactory deal to produce the anticipated financial returns to investors.
An Exit Plan
Lastly, venture capitalists look for clear exit routes for their investment such as public listing or a third-party acquisition of the investee company.
Stages in the Venture Capital Investment Process
A recurring theme throughout this
series of articles has been to encourage you to make the most efficient use of
your time. In fund raising, that means only pursue sources that are
viable providers of capital to you. The corollary to that is you need to
understand the investment objectives of the investors you approach and make
sure that the investment you pitch to them is something in which they are
For you to do this with regard to VENTURE CAPITAL, you need to understand what makes them tick. I hope to provide you with some of that insight in this month's column.
Let's look at a typical activity sequence for a professional venture capital firm. (To more sophisticated readers, I apologize in advance for this oversimplification). A VC firm will create a ten-year limited partnership with the venture capital firm as the general partner. Raise money from investors. [Yes, just like you, a venture capitalist is an entrepreneur who needs to raise money.] Invest the capital in opportunities that meet its investment criteria, AND pass the internal approval process. Work with the portfolio companies to help them build value and move them toward an attractive exit. Achieve exits when possible and distribute the proceeds to its investors. And finally, do it all again.
Once the appropriate investment opportunity is identified, the following process outlines the typical deal flow stages.††
Deal Origination in which potential investments come to the attention of venture capitalists.
Screening is a step in which the venture capitalist reaches an initial decision to investigate further the investment (or not). The initial screen is a cursory glance at the business plan to determine whether or not the proposal fits within the investor's areas of expertise. If warranted, the investor reads the plan more thoroughly as part of the generic screen to assess potential of the product or idea to obtain first impressions of management.
Evaluation, during which the venture capitalist conducts a detailed analysis of the venture. Criteria that venture capitalist apply are:
- Assessment of concept;
- Assessment of the principals; and
- Assessment of returns.
Due Diligence, if warranted, is the second phase of the evaluation step. This step may include formal market studies, reference checks, consultation with third parties. The investor outlines basic contract terms and discusses pricing. Your ability to respond quickly and completely to due diligence inquiries and to complete disclosure schedules and other required documentation, will largely dictate the timetable for closing.
Negotiation is a step in which the investor and the principals iron out the framework for a deal. The deal closes once the parameters are acceptable to both parties.
Post-investment activity relates to how the venture capitalist monitors the firm and takes part in major decisions. This phase largely involves monitoring, control, and intervention only as needed. Many entrepreneurs and managers of closely held companies run their businesses on a rather autonomous basis and are not used to gaining consensus. If you close a VC transaction, youíll be expected to adhere to established and regular reporting and oversight functions. This will likely include monthly information gathering and sharing, submitting specific tracking reports showing the companyís progress concerning agreed development milestones and many times quarterly board meetings.
Tips to Improve Chances of Securing Venture Financing
Do define the business clearly.
In particular, identify the "competitive advantage" that the product or service embodies. This attribute is what makes the business opportunity unique and provides the edge over the competition. Exclusivity by means of copyright or patent is useful.
Do identify clearly the target market for the product or service and present the marketing strategy that supports financial projections.
The marketing strategy should stress how the product or service will provide a value added benefit to the purchaser. The findings of independent market research should provide further reasoned estimates of the market potential and penetration.
Do demonstrate a thorough understanding of the industry sector in which the product or service will compete.
Show the investor that you have a position in the industry conducive to rapid growth.
Do outline the management abilities of the business' principals.
These capabilities should demonstrate proven marketing expertise and fiscal responsibility. VCís generally subscribe to the view that they donít invest in companies or products, they invest in people. Emerging companies should have in place a well-planned and implemented compensation scheme whereby key management is rewarded based on the successful growth and development of the business.† In addition, you should be prepared to identify the key employees who will be critical to the investment transaction and/or the companyís continued success.
Do outline a proposed financial framework for the deal.
The business plan presented to a venture capitalist should specify the financial return, identify sources of risk, make provision for profitable exit, and propose how to structure the deal. Depending on risk, venture capitalists expect the value of their investment to grow from fivefold (for low risk firms) to twenty-fold (for high risk firms). The business plan should identify how to include other investors, if any, in the deal.
Don't advance market projections that are unrealistic.
One reason venture capitalists specialize is to develop expertise in given sectors. Investors have a good sense of what constitutes a realistic market forecast. The best defense against this error is to provide projections or strong historical facts based on independent market research.
Don't ignore sources of risk and uncertainty.
All businesses are subject to external uncertainty and have internal shortcomings. Show the investor that you recognize such risks and that you have developed contingency plans to address them.
Advantages of Venture Capital
Venture capital has a number of advantages over other forms of finance, such as:
- The venture capitalist injects long-term equity financing, which provides a solid capital base for future growth. The venture capitalist may also be capable of providing additional rounds of funding should it be required to finance growth.
- The venture capitalist is a business partner, sharing the risks and rewards. Venture capitalists are rewarded by business success and the capital gain.
- The venture capitalist is able to provide strategic, operational and financial advice to the company based on past experience with other companies in similar situations.
- The venture capitalist also has a network of contacts in many areas that can add value to the company, such as in recruiting key personnel, providing contacts in international markets, introductions to strategic partners and, if needed, co-investments with other venture capital firms when additional rounds of financing are required.
Facilitation of Exit
- The venture capitalist is experienced in the process of preparing a company for an initial public offering (IPO) and facilitating in trade sales.
Karl Buettner (610-560-4700 x 101) is a partner and Christopher Jansen (610-560-4700 x112) is a Managing Director at Gatehouse Ventures, LP.
Gatehouse Ventures, LP, is a private equity firm specializing in leveraged buyouts and leveraged buildups in partnership with qualified management teams. Gatehouse focuses on companies with market values between $5 - $20 million and where our principals can leverage their expertise to drive value for our partners.
For more information, please visit: www.gatehouseventures.com