The Business of Money
Everything You Need to Know about Venture Capital (but Were Afraid to Ask)
As well-known as the term ‘venture capital’ is in the public vernacular, few understand the nature of this high-risk, high-impact form of capital.
To shed some light on this complex capital source, it’s helpful to understand venture capital, first in context of other forms of growth capital, then in terms of requirements of venture-capital funders. What follows is a primer on this important subject.
The Spectrum of Capital
There is a wide spectrum of funds available to small, fast-growing businesses to support their capital needs — from loans and lines of credit to equity (provided by individuals and/or professionally managed funds). Capital sources vary according to their source (government, banks, friends and family, third-party investors) and to the risk associated with the capital. Company stage often defines your source, while risk level impacts pricing. Investors (individuals and funds investing in your company) who take the highest risk (equity investors) expect the highest return; those taking less risk (banks) can afford to charge less for the lower risk.
Venture-capital investors provide capital to fast-growing companies in return for a minority ownership position; these investors take outsized risks (company failure and loss of investment) in return for hopes of outsized returns if the company succeeds. Professional investors manage venture capital by assessing risk, negotiating investment partnerships with entrepreneurs and business owners (exchanging capital for ownership positions and, typically, a seat on the board of directors), and working with company management to optimize success — profitable growth and, ultimately, selling the company — in order to realize returns commensurate with risk taken.
Profile of a Venture-capital Company
Venture investors look for businesses that have potential to grow to a relatively large size, revenue-wise, within a four- to seven-year period. Business characteristics that VCs look for include:
- Strong gross margins: A business with relatively low gross margins (less than 35%) is a business competing on price or service, both of which are not strong differentiators. Businesses with stronger gross margins suggest an ability to compete on other criteria (product or service quality and/or uniqueness). Higher-gross-margin businesses indicate something special about the business and, more practically, provide the company with more internally generated cash when selling product, thereby enabling the company to self-fund rapid growth to a much greater degree than lower-margin businesses.
- Scalable business model: Scalability can be viewed through two lenses: product/service model and financial scalability. A scalable product model might be described best as ‘make once, sell many times.’ A software product, or a branded consumer product, offers scalability in this sense. Custom precision machining — where each design is developed uniquely for a given customer — is a model that does not scale as well. Financial scalability relates in part to gross margin (does the business provide meaningful self-funding?) and in part to the ability to find capital sources at different levels of growth. Software, as noted, is a high-gross-margin business (99%) and often is easier to secure subsequent rounds of financing.
- Barriers to entry/competitive position: Venture-capital investors seek businesses that are difficult for competitors to enter.
Barriers to entry can be technology-based (intellectual property and/or patents) and/or market based; an established brand with good on-shelf presence is a barrier to competitors — admittedly, less defensible than a technology patent. Generally, a venture investor will seek to invest in companies whose products (if performance-oriented, like technology) have multi-fold performance or cost advantages over competitive products.
One way to characterize this would be to say that the product would need to perform 10 times better than, or be available at one-tenth the cost of, its nearest competitor.
- Experienced management: It is often said that the jockey matters more than the horse — i.e., good management trumps good product, though both are preferable. Experience in early-stage ventures is defined in a few ways:
Domain experience: If you spent years in the food industry and are starting a food business, then your domain experience serves you in your current venture. If you are a biotech person starting a software business, then your domain is relatively useless to your new venture.
Early-stage experience: A senior manager at Microsoft starting a new software company may have tremendous domain experience but lack early-stage experience. Big company resources and experience are substantially different from capital-constrained small-company experience. Small-company professionals tend to do everything in the business (make copies and clean trash as well as develop and market the product). By contrast, a big-company executive might be accustomed to having staff, services, and capital resources that would obviate the need for that individual to do lower-level work that startup executives and small business owners do.
Venture experience: A venture capital-backed startup requires an understanding of the investor’s expectations and role. While venture investors don’t expect or want to run the business themselves, there is a level of involvement and partnership that this investor class expects from founders and senior management in companies in which they invest.
Ability (and willingness) to realize value: If you seek capital from professional money managers, you need to understand that you are signing up to realize and optimize value for investors (and you!) over a certain number of years. Value is maximized for all shareholders by sale or merger with a larger player (often competitor) or through a public offering. If you intend to keep your venture as a family or lifestyle business, then venture capital is not right for you.
Venture capitalists evaluate risk in two primary areas — business and stage. Business risk looks at management, market/competition, product, finance, and legal. Failure in a startup is almost always a result of problems in one or more of these areas.
So, venture capital investors research management (reference checks, strength/weakness analysis, completeness of team), market (size, growth of market, trends), product (comparative advantage vs. existing products and services), finance (strong gross margins, capital requirements, availability and likelihood of subsequent financing), and legal (patent protection, liability risk).
The ‘grades’ for each risk area result in a summary business risk level that the investor considers in assessing what return would fairly compensate the investor for the perceived risk.
The second area of risk relates to stage of development. Early-stage ventures carry a much higher probability of failure — borne out by national statistics on small-business failure — than later-stage ventures, meaning companies with established revenue, customers, and profits. Stage risk carries a risk premium that is coupled with business risk to arrive at a picture that the investor uses to figure out what level of ownership is required for a given capital investment.
Entrepreneurs often mistake a venture investor’s need for ownership as a reflection of greed, rather than a dispassionate assessment of the true risk. Early-venture investors typically lose all their capital on a third of their portfolio, break even on a third, and make all the fund’s money on the final third. So, either investors do a poor job picking winners, or their portfolio company heads fail to deliver on the promise they hoped to realize.
Venture capital is high-impact capital that can make a meaningful economic development impact in terms of job creation as well as value creation for all stakeholders. That said, the combination of investor expectations for growth and value realization coupled with the relative scarcity of capital (compared to demand) makes it a capital source not for everyone.
That said, if you’ve got the right stuff — management, product, market, etc. — and are game for the ride, venture capital can be an unmatched capital source in its appetite for risk and support for your company’s growth.
Michael Gurau is the managing general partner of Clear Venture Partners, a venture capital fund targeting New England;[email protected]