Investors are the most expensive form of financing because of the return on investment required (higher than the interest rate on a loan) and in some cases the amount of ownership in the business that the entrepreneur will lose. Bellow are the most popular equity financing options:
Venture Capital Overview
One of the most talked-about forms of financing, venture capital was popular in the nineties. Venture capitalists raise money from investors in order to manage a portfolio of privately held companies. In short, they are intermediaries. Venture capitalists fund companies that are in early-stage development, expansion, or for special cases such as turnarounds or leverage buyouts.
According to the National Venture Capital Association (http://www.nvca.org), venture capitalists look to:
- Invest in new companies or in companies that are experiencing rapid growth.
- Buy equity securities.
- Help companies develop products and services by contributing experience or capital.
- Advise a company’s management on business operations and strategy.
- Gain higher returns in exchange for taking a higher risk on their investments.
Venture capitalists tend to have a long-term outlook and take more risks than other types of financiers, such as banks. They manage that risk by investing in portfolios of young companies either by themselves or with other venture capital funds. Moreover, they actively work with the companies in their portfolio, assisting management with strategic decisions and business expertise gained by helping other companies with similar problems.
Is Venture Capital Right for Your Business?
If you are willing to report to a board of directors, bring partners into your company, share in governance and decision-making, then you might wish to consider venture capital. When considering such funding, know that you will lose some control and ownership over your company in exchange for financing, connections, speed to market, and business experience from the venture capitalist.
Can you Deal with Not Being the CEO of Your Company?
Usually the CEO founder of the company does not have all the skills to take the company to the next level, whether it is a merger of acquisition or an initial public offering. Many founding CEOs are very skilled in some areas—perhaps technical or entrepreneurial—but lack in financial, sales, marketing, or other areas of experience.
Venture capitalists usually have a network of people from many industries that can take the helm of a company. These people have risen through the ranks in other companies and have extensive experience in different areas of business management. Venture capitalists as well as entrepreneurs must clarify all contributions to the deal and skills brought to the table. It may be to everyone’s best interests for you—as the entrepreneur—to step down from the CEO position.
Venture capitalists consider it a success if they get a 40 to 60% return on their investment, which is not out of line considering the amount of risk they are taking. However, on average, they get returns ranging from 10 to 20%. They expect to net these returns after they “cash-out” of the company, if possible within a three- to five-year period. However, the cash-out period can be as long as ten years or more. Consider this when assessing your business potential return on an investment. On another note, it is normal for venture capitalists in the earlier stages of financing to expect a tenfold return.
Approaching Venture Capitalists
You can use two methods when approaching venture capitalists. You can randomly present your executive summary to venture capitalists or you can research your target to see if it matches your industry, region, development, and capital requirements.
Venture capitalists and other professionals favor the targeted approach because it reduces the number of extraneous opportunities to a few manageable ones.
You can speak with lawyers, accountants, or specialized financial intermediaries who have relationships with venture capital companies. Usually intermediaries charge a standard fee plus commission, so make sure you are working with a reputable one. You can also get access to these financiers in venture capital seminars
You can also visit the American Entrepreneurs for Economic Growth (AEEG) (http://www.aeeg.org) is an organization serving entrepreneurs interests regarding public policy. The AEEG is affiliated with the National Venture Capital Association (NVCA) (http://www.nvca.org) that represents the Venture Capital industry. This alliance allows AEEG to provide networking opportunities.
Things to Remember When Considering Venture Capital
- Determine whether you actually need venture capital. Can you run your business with other forms of financing such as loans, friends, or relatives?
- Prepare a business plan—a must for venture capital funding.
- Research your target venture capitalist. Find out what his or her investment criteria are.
- Network your way into an introduction with a venture capitalist. Lawyers, accountants, and other professionals that help venture capitalists are a good source.
- Use the Web to your advantage; some venture capital managers have Web sites where they write down their ideas. Read them to get a better idea of how these managers evaluate business opportunities. It will give you a better idea where to focus your efforts.
- Make sure that your plan endures due diligence. Ensure that you can support and explain any part of your plan and business projections.
- You will have to meet people and expand your rolodex if you want to have an opportunity to meet a venture capitalist
Other Points to Keep in Mind:
Equity financing is expensive. You need to compensate your investors for the risks they take in your company. If your business is successful, your company will end up paying more for the equity invested than it would have with a loan.
Develop your business strategy. Your executive summary must clearly state what your business does and how you expect to make money. Investors will question your revenue projections and how you plan to achieve them, particularly in relationship to the current market environment, costs, distribution, and supply.
Strengthen your management team. Venture capitalists invest in a company’s management as well as the product or service. Think on any weaknesses that your team may have and look for people to join or mentor your company.
Your company should generate cash flow. You will have an easier time finding financing if you start your company without outside capital. Although this sounds counterintuitive, venture capitalists constantly receive business plans and projects to invest in, many from entrepreneurs who have not yet launched a business. You will have a better chance to find capital if you start your business with money from loans, personal investment, family and friends, or sweat equity and then look for outside investors.
Work on your business plan and financial projections. Your business model should be clear to you and your investor. The model should communicate the value of your company to all the stakeholders. You can use an Annual Statement Studies® from the Risk Management Association (http://www.rmahq.org) to verify that the financial ratios in your projections match the ones from a company in your industry and your size. Provide explanations if you project more aggressive numbers. For more figures to help your research, you can check the U.S. Census (http://www.census.gov) or the SBA Web site (http://www.sba.gov) for further statistical data.
Consider your market. Venture capitalists are looking for large markets with high compound rates of return and low penetration. If your business has an obscure market, the venture capitalist might not be able to predict the success of your business idea and will not feel comfortable investing.
Look at corporations for possible funding. Corporations may look for companies such as yours for possible funding
Although a business plan helps you solidify your business idea and anticipate problems that you may encounter, it is also a marketing tool to obtain finance or strategic partners. Venture capitalists invest in management as well as in ideas. Your job is to prove that you can make the idea work. Why would you expect somebody else to take the risk and invest in your company if you are not willing to do the same? You will be in a better position to seek financing if you have already started your business.
For more financing information proceed to the next section. Angel Investors