If you have a great idea for a start-up — or if you have an existing business that needs money to grow — the main options are to borrow from friends and family, borrow from a bank, or seek equity funding from a venture capital firm. Banks are skittish about lending to small businesses in the current economic climate. And if you need more than $100,000, borrowing from your friends and family is not likely an option.
While venture capital funding availability has decreased since the boom years in the late 1990s, if you have a solid product or idea you can still attract a VC investor. Before you embark on searching for venture capital (VC), consider that the firm becomes a part owner, not a creditor, and wants long-term revenue. Most VCs are limited partnerships that have a fund of pooled investments. They vary in size from boutique firms that manage a few million dollars to VCs that have billions of dollars invested in companies worldwide. They usually take preferred stock in the company and want at least one seat on the board of directors. They sometimes want the CEO position if they believe that existing management needs bolstering.
Return on Investment
While some VCs look for a return that is ten times their investment, others look for three-to-five times. Generally, seed and early stage — “angel” and “A round” VC funding — investors will seek the higher return because of greater perceived risk and smaller investment amounts. But mid-stage investors may want five times. Late stage investors may settle for three times their investment if the start-up is already cash-flow positive.
Prerequisites for Funding
Does a market exist for your idea? While you may think your product or idea is a stroke of genius, there may not be a market for it. VCs want commercial viability. If a market exists, can you manufacture the product or market the service cost-effectively?
Big market. The industry must be large enough to achieve a substantial return. This generally means a market that can generate $100 million in revenue by all competitors. Potential investors will want to see an assessment of the overall market over a five-year period and an overview of the competition.
Competitive advantage. Is the idea or product unique and is that uniqueness sustainable or can it be easily copied?
A solid management team. This is much more important for later stage investments. While VCs nearly always emphasize this, if you look at their portfolios they have often invested in companies started by college students — Yahoo! and Facebook are good examples — with no business experience.
Can You Let Go?
Generally, VCs want to get a return on their investments in five-to-seven years. So you will need to think about an exit strategy at the beginning of the discussion. VCs need to provide a return to their limited partners and move on to the next investment opportunity. You will have to either sell or merge your company or go public. Either way, you will be relinquishing some or all control. If this is something you feel you cannot do, look for a different funding option.
Venture capital firms typically look for deals of at least one million dollars and most prefer an initial amount between three and five million dollars. They may invest another three-to-ten million in future rounds. If you need less than one million dollars, other resources — such as micro-financing sources, investments from a strategic business partner or customer, or angel investors — could be good alternatives.
The financing evolution typically involves the following categories.
- Seed. If you have an idea but no product or company yet, you would be looking for seed capital. VCs usually avoid this stage.
- Start-up. This would be early-stage firms that need funding for expenses associated with research and product development.
- First round (series A). This covers recruitment of key management, additional market research, and finalizing of the product or service for introduction to the marketplace.
- Second round (series B). This provides working capital for early-stage companies that are selling a product, but not yet turning a profit.
- Mezzanine financing. Also called “late stage” financing, this is expansion money for a company successfully selling products or services at a profit.
Your Due Diligence
Just as the VC firm evaluates your business, you should assess potential investors. Do they have a long-term record of success? Do you feel comfortable with their personalities and approach to business? Remember, one of these people may take an operational or management role in your company and you may spend years working together. So a good fit is imperative.
A directory of VC firms by state can be found at Gaebler.com’s Resources for Entrepreneurs. An alphabetical venture capital list is at VentureChoice. The websites of individual VC firms will tell you what industries are in their portfolios and how much they invest and at what stage.
Current Economic Conditions
The bad economy is causing jitters in the investment community. Mark V. Cannice, a professor at University of San Francisco, conducts a quarterly survey of Silicon Valley VCs and publishes “Silicon Valley Venture Capitalist Confidence Index” in PDF form. That index has declined considerably since from the first quarter 2011 to the second.
However, good news exists for established small businesses. Joe Mandato of De Novo Ventures — a VC firm — told Cannice, “Funds are reluctant to commit to early stage deals and many are altering their investment objectives and are looking for later stage deals.”