WINTER
2003
Venture
Capital Crunch
Thinking
about seeking financing? Better think long and hard, says
an expert
By
DANTE FICHERA
Seeking
venture capital is not for the weak-hearted—especially
these days. The venture capital market has been declining
since the great dotcom bubble burst in 2000, and the downward
spiral was only accelerated with the tragedy of 9/11 and
the ensuing economic downturn.
If
you’re thinking about raising capital for a new start-up,
be aware that available sources have virtually dried up.
Today’s venture capitalists are trying to preserve
their money to support their existing portfolio of companies
and are rarely financing new or unproven ventures.
According
to a PricewaterhouseCoopers MoneyTree survey, total venture
capital investments fell to $4.5 billion during the third
quarter of 2002—a 26 percent decrease from the previous
quarter and the lowest level since the first quarter of
1998.
The
same survey found that about 2,310 American companies received
venture capital financing during the first three quarters
of 2002 and only 119 of those were start-ups. That’s
compared to 6,432 companies nationally during the first
three quarters of 2000; 527 of those were new firms.
It’s
a grim dose of reality, added to the longstanding fact that
many of the larger venture capital funds will receive thousands
of business plans before they finance a deal—and that
they will only invest in about 10-20 companies over the
life of the fund.
Yet
this reality coincides with a time of rapidly growing demand
for start-up capital from Hispanic-run enterprises.
Hispanic-owned
businesses grew by 82 percent from 1992 to 1997, many of
them financed by personal savings or bank debt. Only 5 percent
of Hispanic start-ups rely on equity capital, according
to a study by Artium Capital Partners LLC of New York. In
fact, about 58.6 percent of Hispanic owners used less than
$5,000 in start-up capital.
However, the demand for equity capital is increasing dramatically
as Hispanic entrepreneurs shift from building retail- and
service-sector businesses towards technology, telecommunications,
manufacturing and biotech. And government initiatives through
the Small Business Administration have not gone far to fill
the gap, with only 4.25 percent of financing by Small Business
Investment Corporations going to Hispanic-owned companies.
Given
this economic picture, you need to take a long hard look
at your venture and honestly determine whether it’s
a good candidate for financing. Even if it is, you’ll
need to be mentally ready to be perpetually rejected, spend
countless hours in meetings, undergo endless questioning
and put together an abundance of documentation.
My
intention here is not to shatter your dreams and talk you
out of starting or growing a business, but rather to have
you understand that raising capital, in this environment,
is very difficult. If you think you have an attractive business
model and you’re willing to make sacrifices to launch
and grow your company, then I encourage you to move forward—but
with the understanding that venture capital financing might
not be available.
Getting
Ready to Prospect
Venturing
for capital is a long process that, if successful, can take
anywhere from three months to a year—or longer. Raising
capital in any environment is difficult, but in this current
climate it may be the most difficult and mind-numbing experience
of your life.
That’s
why your first thoughts about raising capital absolutely
must be: Do I really need venture capital in order to grow
or launch my enterprise, and if so, is my business a great
investment opportunity that will provide the returns necessary
to get investors excited?
If the answer to both questions is “yes,” the
following are the milestones that you are likely to encounter
as you travel along the venture capital highway.
Focus
on the basics. Remember that investors will not finance
your business because they like you. They’ll invest
because they want to get high returns on their investment
with the least amount of risk possible. Having worked with
hundreds of start-ups, I’ve concluded that if most
of these entrepreneurs had spent their time obtaining customers,
developing their product, creating partnerships, and analyzing
their market rather than prospecting capital, they would
have been much more successful at launching or growing their
business. In
other words, because raising capital is a full time job,
it’s imperative to make sure your company is extremely
attractive from an investor’s standpoint before you
take precious time away from your main responsibility: corporate
growth. In fact, you’ll want to make sure your company’s
business model is fundamentally strong and that within a
few months to a year it will break even or achieve profitability.
Make
sure the cash flows. Cash flow is more important than
ever, since investors realize that the company might not
obtain a follow-up round of financing as it could have in
previous times.
Remember
that growth is key. Investors are seeking companies
that have the potential to generate hundreds of millions
of dollars in sales and operate in multi-billion dollar
industries. Growth industries are preferred, as they offer
the best opportunities for capturing market share and provide
better chances for the investor to cash out later. (Usually,
slow-growth markets include many large competitors and other
barriers to success.)
Be
revolutionary. Your company must have significant competitive
advantages such as a “disruptive technology” that
will revolutionize an industry. Shorter sales cycles are
also increasingly important, because those start-up companies
that require a long period of time to generate revenue often
fail before getting their first customer.
Be
realistic. The days when “pie-in-the-sky”
business models attracted money are over, and venture capitalists
are back to business fundamentals. During the dotcom exuberance,
many venture capitalists were investing with plans of getting
out at a higher price in the near future—and not really
looking at whether the company could stand on its own if
the venture financing lifeline was pulled.
Investors aren’t investing in concepts anymore, unless
there’s also a functional prototype (or one close to
completion). The days of financing a promising business
plan are gone. There needs to be some meat on the company
bone!
Winding
Up to Pitch
Many
entrepreneurs don’t adequately understand their markets
and customers. Time and again, I have seen entrepreneurs
create a business model with weak assumptions and no support
for the pricing model they’ve outlined. Astoundingly,
many entrepreneurs don’t even know how a competitor
is pricing their product.
Before
you prospect for capital, spend time researching your market
and understanding your customer, technology, competitors
and the investment opportunity you’re proposing. Investors
want to know what problem or need in the marketplace you’re
solving/addressing, and how you’re going to make money
doing it.
All
of this should be clearly presented and factored into your
business plan and financial projections. If you don’t
do your homework, you’ll get torn apart when investors
start asking questions.
In
particular, make sure to prepare an executive summary that’s
short and powerful. Venture capitalists often have the attention
spans of 2-year-olds, so make sure you get your message
across as succinctly as possible.
In
addition to your business plan, executive summary and financial
projections, prepare a PowerPoint presentation and an “elevator
pitch.” Be ready to articulate your investment opportunity
within one minute and put together a formal presentation
lasting between 8 and 15 minutes.
Finding
the Money
So
you’ve completed your research and your venture has
all the makings of a great company? And you’re ready
to convince a venture capitalist to invest?
First,
realize that investment capital does not come without a
price: dilution. In other words, you’ll inevitably
lose some control over your company. Whether to accept that
trade-off is a decision you’ll have to make after weighing
the risks and rewards of what’s being offered.
In the current climate, investors are getting less return
for their money than in the past, and that means that entrepreneurs
have to give up more. Venture capitalists typically look
for a returns of 10 times their investment, but that number
may be greater or smaller depending on how soon they plan
to cash out. The shorter the
timeline, the lower the multiple; the longer the timeline,
the higher the multiple.
If
you’re a new start-up seeking your first source of
financing, you may want to talk to friends, family and others
who will be involved in starting the company. Many companies
receive their first investment from family members. Home
equity loans are another way entrepreneurs choose to finance
the launch of their enterprise.
Subsequent stages of venture capital include seed, early,
expansion, and later-stage financings. Seed-stage financing
represents the first investment in a business and is typically
obtained from outside investors called “angels.”
“Angels” are accredited investors that invest
in privately held companies. These individuals are taking
a higher level of risk than most venture capitalists, so
they expect greater ownership interest in the company. A
good way to find these people is through attorneys, accountants,
bankers and other service providers. In addition, many large
cities have formal organizations of angels. These are clubs
or bands of high-net-worth individuals that get together
to scout private equity investments.
Early-stage
companies typically seek their first round of institutional
investments from venture capitalists who manage pools of
cash for other individuals, institutions, and trusts. The
pools of cash that they manage are called venture funds
and are structured as limited liability partnerships.
The
mission of the venture capitalist is to provide investors
with above-average returns on their investments within a
five-to-seven-year time period. So as soon as the venture
capitalist makes an investment, he’s determined to
cash out (for example, through Initial Public Offerings
or mergers and acquisitions) quickly, and at the highest
price possible.
As
with angels, you’ll want to leverage your connections
to find venture capitalists interested in your business.
Out of the thousands of venture capitalists I’ve spoken
with over the years, none have invested in a business plan
that came in “cold over the wire.”
Make sure you get an introduction from a source that a venture
capitalist will consider reliable. Once again, your attorney,
accountant, banker, or other service provider can be a great
resource for providing an introduction.
Another
strategy is to research some of the venture capitalists
that invest in your industry and that are located in your
geographic area. Contrary to what you may hear, most venture
capitalists prefer to be able to get in their car and drive
over to your business or take an hour airplane flight to
visit the company. Research the fund and see if you know
anyone who can introduce you.
Finally,
in pursuing any of these investors, make sure that your
business goals are in line with theirs, because they’re
now your partners and can bring more to the table than just
cash. Many venture capitalists have access to top quality
management, potential customers and partners, and other
providers that can help you grow your business.
Forming
a good advisory board may be critical, too, since many of
these individuals may be able to give you technical advice,
seed financing, access to customers and partners, and domain
experience—as well as introduce you to venture capitalists.
But even with all this support, don’t expect to ever
come across anything like the crazy amount of venture activity
that you saw in 1999 and 2000.
That
may never happen again.
