Venture capital is an important source of funding for start-up and other companies that have a limited operating history and don’t have access to capital markets.  A venture capital firm (VC) typically looks for new and small businesses with a perceived long-term growth potential that will result in a large payout for investors. 

Who is a Venture Capitalist?  

A venture capitalist is not necessarily just one wealthy financier.  Most VCs are limited partnerships that have a fund of pooled investment capital with which to invest in a number of companies.  They vary in size from firms that manage just a few million dollars worth of investments to much larger VCs that may have billions of dollars invested in companies all over the world.  VCs may be a small group of investors or an affiliate or subsidiary of a large commercial bank, investment bank, or insurance company that makes investments on behalf clients of the parent company or outside investors.  In any case, the VC aims to use its business knowledge, experience and expertise to fund and nurture companies that will yield a substantial return on the VC’s investment, generally within three to seven years.  

Returns for Investors: 

Not all VC investments pay off.  The failure rate can be quite high, and in fact, anywhere from 20 percent to 90 percent of portfolio companies may fail to return on the VC’s investment.  On the other hand, if a VC does well, a fund can offer returns of 300 to 1,000 percent.    

Partnership: 

In additional to a portion of the equity, a VC expects to have a say in how its portfolio company operates.  Ideally, the VC fosters growth at the company through its involvement in managerial, strategic, and planning decisions.  To do this, the VC relies on the expertise of its general partners who may be former CEOs, bankers, or experts in a particular industry.  In most cases, one or more general partners of the VC take Board of Director positions at a portfolio company.  They may also help recruit key executives to the portfolio company. 

Size of Funding:

It’s important to do your homework before approaching a VC for funding, to make sure you’re targeting the right potential partner for your business needs.  Not all VCs invest in ‘start-ups.’  While some may invest small amounts of “seed” capital for very early ventures, many focus on early or expansion funding, while still others may invest at the end of the business cycle, specializing in buyouts, turnarounds, or recapitalizations.  

Investment Preferences: 

VCs may be generalists that invest in a variety of industries and locations.  More typically, they specialize in a particular industry.  Make sure your company falls within the VC’s target industry before you make your pitch – a VC that’s focused on biotechnology start-ups will not consider your request for later-stage funding for expansion of your semiconductor firm.  You can often gain insight into a VC’s investment preferences by reviewing its website. 

In addition to industry preferences, VCs also typically have a geographic preference.  Being in the same general location as a portfolio company allows the VC to better assist with business operations such as marketing, personnel, and financing.     

Keep in mind that venture capital is not an option for all new businesses.  In fact, VCs are very selective in choosing new companies to invest in, so your company may not qualify.  They’re most interested in businesses with high growth potential that will allow them to successfully exit with a higher than average return in a time frame of roughly three to 10 years, depending on the type of investment.  Given the rigorous expectations, most venture funding goes to companies in rapidly expanding industries such as technology, biotechnology, and life sciences.

Commercially viable.  Does the company have a product or service that can be reproduced efficiently to generate revenue? 

Identifiable market.  Is there a clearly defined market for the company’s product or service?  Does the company’s product or service meet an identifiable need in that industry?  Does the company have a reasonable plan to meet the identified need in an efficient, revenue-generating manner?

Strong management.  Does the company’s leadership inspire confidence?  Do they have the vision, expertise, and the ability to propel a business to a significant level of growth?  Does the team consider best practices of those that have gone before them? 

Sustainable competitive advantage.  Has the company hit upon an idea that’s truly unique to the industry, one that has significant barriers to entry that will inhibit others from encroaching upon its market?  Has the company considered economic and technological change that may affect the business model?  Who are the company’s potential competitors, and what are those companies’ strengths and weaknesses? 

Like a banker, a VC will also consider factors such as results of past operations, amount of funds needed and their intended use, future earnings projections and conditions.  But unlike a banker, a VC is a part owner rather than a creditor, so it’s looking for potential long-term capital, rather than interest income.  A common rule of thumb is that a VC looks for a return of three to five times its investment in a five- to seven-year time period. 

A lot may also depend on the relationship between you and the VC.  Often, the firm will have you meet with every one of its individual partners to determine whether there’s a consensus on how the company will be co-managed.  Don’t underestimate the value of mutual respect, teamwork, and understanding.

Seed Capital.  If you’re just starting out and have no product or organized company yet, you would be seeking seed capital.  Few VCs fund at this stage and the amount invested would probably be small.  Investment capital may be used to create a sample product, fund market research, or cover administrative set-up costs. 

Startup Capital.  At this stage, your company would have a sample product available with at least one principal working full-time.  Funding at this stage is also rare.  It tends to cover recruitment of other key management, additional market research, and finalizing of the product or service for introduction to the marketplace.   

Early Stage Capital.  Two to three years into your venture, you’ve gotten your company off the ground, a management team is in place, and sales are increasing.   At this stage, VC funding could help you increase sales to the break-even point, improve your productivity, or increase your company’s efficiency. 

Expansion Capital.  Your company is well established, and now you are looking to a VC to help take your business to the next level of growth.  Funding at this stage may help you enter new markets or increase your marketing efforts.  You should seek out VCs that specialize in later stage investing.  

Late Stage Capital.  At this stage, your company has achieved impressive sales and revenue and you have a second level of management in place.  You may be looking for funds to increase capacity, ramp up marketing, or increase working capital.  

Bridge Financing: You may also be looking for a partner to help you find a merger or acquisition opportunity, or attract public financing through a stock offering.  There are VCs that focus on this end of the business spectrum, specializing in initial public offerings (IPOs), buyouts, or recapitalizations.  If you are planning an IPO, a VC may also assist with mezzanine or bridge financing – short-term financing that allows you to pay for the costs associated with going public. 

A key factor for the VC will be risk versus return.  The earlier a VC invests, the greater are the inherent risks and the longer is the time period until the VC’s exit.  It follows that the VC will expect a higher return for investing at this early stage, typically a 10 times multiple return in four to seven years.  A later stage VC may be seeking a two to four times multiple return within two years.

You might also consider a strategic investor partner in place of a VC investment.  This could be a vendor, customer, or other business partner with whom you’re currently working, who might be interested in investing in your company.  A strategic investor often has deeper pockets than an angel investor, but typically has a specific reason for investing in your company – make sure you know the reason behind the investment.  The investor may only want to leverage your technology for its own purposes, which could have a negative impact on your business.  Or, the investor may want a licensing distribution agreement if your company succeeds, which could benefit you.  Make sure your interests are aligned.

Before you approach a VC for funding, examine your goals.  How much capital do you need?  Do you want passive or active investors?  Are you looking to ramp up your marketing efforts?  Grow your management team?  Does your Board of Directors need more seasoned expertise?  Answering these questions for yourself will help you decide whom to approach for investment capital, whether that be a VC, angel investor, strategic investor, or other. 

If you choose the VC path, make your best effort to get an entrée into your target VCs through a trusted referral.  And always do your homework, both on the VCs you’re targeting and on your own business needs.  ‘Do the math,’ come to the table prepared, and keep your presentation brief and to the point.  Know your ultimate business objectives, and be honest about those goals with your prospective investors.

The importance of a well-thought out, comprehensive business plan can’t be overstated.  VCs, in particular, review an average of 200 business plans each month.  Of the total number of plans submitted, just 0.3 percent ultimately receive VC funding.  So to even be considered, your plan needs to be thorough and engaging. 

The main elements you should have in your business plan include:

• Executive Summary
• Company Description
• Product or Service
• Market Analysis and Competition
• Marketing Plan
• Management and Organization
• Financial Projections
• Fundraising and Use of Funds

Keep in mind that potential investors will judge you not just on your ideas, but also on the way they’re presented.  The more time you spend researching your ideas and mapping out your operations, the better off you’ll be.  It typically takes several weeks to complete a good, solid plan.  You won’t regret the effort because it will also help you to determine how to allocate your resources properly, address problems, and make informed business decisions as you move forward.  So take your time and write a thoughtful, comprehensive business plan that will serve you and your investors well as your business progresses.

The executive summary – really just a compact version of your business plan – should concisely address the following:

1. what your company does;
2. why your product or service is unique and what opportunity you’re presenting;
3. how your management team is well qualified to execute your business plan;
4. how much capital you need and how it will be used.

Keep your summary brief – ideally, two pages or less. Think of it as everything you’d say to a prospective investor in a five-minute interview. There are some who advise that you write your executive summary last, to capture the crucial points you’ve written into your plan. Others advise that you write the executive summary first and use it as a road map to keep your business plan on track. Both approaches have merit. In either case, make sure your executive summary is professional, comprehensive, and concise.

Example:

iWidget, Inc. designs, manufactures and markets software solutions for the online gaming and desktop publishing industry. The company’s flagship product, iWidget Pro, is the leading software package for entrepreneurs seeking to start up a web business in the fast growing online gaming industry. iWidgetPro allows a user without any HTML skills to quickly set up an online gaming web site bundled with quick loading graphics and gaming technology. The company’s two accompanying software packages, iWidgetNext and iWidgetWorld, provide advanced design elements and technologies that allow users to customize their web sites. While the market is flooded with desktop publishing software, there is no other desktop publishing software company focused exclusively on the online gaming industry.

1. The Market

iWidget’s target market is the rapidly expanding online gaming industry and entrepreneurs seeking to set up gaming websites. Since its inception, the online gaming industry has experienced tremendous growth. Estimated at just over $1 billion in 2003, In-Stat/MDR expects the online gaming market to grow to nearly $4 billion by the end of 2008.

2. iWidget’s Competitive Advantage

As the only desktop publishing software maker focused exclusively on the online gaming industry with proprietary software that allows individuals to easily set up their own web businesses, iWidget is uniquely positioned to grow along with the industry and adapt to new industry developments quickly. Unlike other software makers’ products, iWidget’s products offer advanced and continuously updated technologies exclusive to online gaming. Software products offered by other software makers do not include these specialized technologies and do not offer the same ease of use or gaming graphics capabilities.

The expertise needed to design gaming industry-specific software is a significant barrier to market entry; iWidget’s management team includes desktop publishing industry pioneers with extensive knowledge and understanding of the online gaming industry and market.

3. Management Team

This is the second software venture for iWidget founders and co-owners J. Smith and R. Jones. Former classmates at M.I.T., the two teamed up to co-found iStudy, an online study system for college students that was acquired by BIG Textbooks Co. in 2002 for $8 million. Smith and Jones were among the pioneers of the desktop publishing software industry, and used their extensive knowledge and expertise to develop gaming-specific software that would allow individuals to set up lucrative online gaming web businesses. As the online gaming industry grows and develops, Smith and Jones are at the forefront of adaptive software that continues to evolve into a greater array of business options for online gaming industry entrepreneurs.

4. Investment

The capital sought in this proposal is iWidget’s third round of financing. Proceeds of the first round of $2.6 million in funding and second round of $3.5 million in funding have been used to expand the company’s highly knowledgeable team, develop new software products, and execute the company’s first software licensing agreement.

iWidget intends to raise an additional $3.5 million to develop additional software products, build out its marketing function, and successfully bring new products to the market.

5. Conclusion

First mover advantages have allowed iWidget to gain a dominant position in development and delivery of online gaming software. This early mover status, coupled with several years of desktop publishing management experience and technological expertise, will allow iWidget to continue to lead the field with cutting edge products in the fast growing online gaming industry.

Example:

iWidget intends to raise $3.5 million in this third round of financing.  This round of finance will address a number of needs, including development of additional software products,  expansion of the company’s marketing function, and  introduction of new products to the marketplace.

i. P&L

This is a snapshot of your business, laying out revenues, expenses, and profit for a particular period (monthly or quarterly, for example).  It shows whether or not your business is profitable during the given period.  If you’re laying out projected P&L, you should project numbers going out one year.  Be careful not too be too conservative in your estimates, or you’ll lose your investor audience.  On the other hand, an overly aggressive P&L suggests you have unrealistic expectations and won’t be able to meet them.  Use your best judgment on these projections. 

ii. Capitalization and Financial Projection

This is your plan for how much capital you want to raise.  A couple of things you should keep in mind as you plan:

1. Be realistic.  Don’t try to plan for an amount you think you can raise; plan for the amount of capital you think you’ll need.  You will appear more credible to your investors.
2. Plan your capital requirements in stages, and try to figure out how much you’ll need for each stage.  If you raise too much money too quickly, there’s a greater chance you’ll burn through it less efficiently.  If you raise less than you need, you’ll have to adjust your growth and expansion plans.  

Your business plan should list your revenue and income projections for the next three to five years.

Example:

A strong management team is extremely important to investors, often even more important than the business idea itself.  Take the time to explain exactly what your management team brings to the table.

Example:

iWidget’s management team includes desktop publishing and online gaming industry pioneers and innovators.  They are highly specialized and talented individuals who helped to launch the industry and continue to help shape its present and future course.  The company’s principals have had previous success as entrepreneurs.  The core team is well qualified to continue iWidget’s operations  and expand upon its current success.     

J. Smith, Chief Executive Officer

Mr. Smith received his BS in engineering at Massachusetts Institute of Technology in May, 1995 and co-founded his first business, iStudy, while a student at MIT.  The venture was acquired by BIG Textbooks Co. in 2002 for $8 million.  Smith worked as a senior software developer at BIG Software from 1996 to 2002 and helped to develop the company’s leading BIG-Pub desktop publishing software.    He co-founded iWidget, Inc. with R. Jones in 2002 and together, they successfully launched iWidget Pro in 2004. 

R. Jones, Chief Operating Officer

Mr. Jones received his BS in engineering at Massachusetts Institute of Technology in May, 1995 and co-founded iStudy with Mr. Smith while a student at MIT.  Mr. Jones helped to develop some of the online gaming industry’s first software while as an associate at Ace Online Game Co. of Las Vegas, Nevada.  He then joined J. Smith to to co-found iWidget, Inc. in 2002.  

Jane Doe, Chief Financial Officer

Ms. Doe received a BS in Statistics and Finance from Massachusetts Institute of Technology and holds an MBA from MIT’s Sloan School of Management.  Prior to joining iWidget, Ms. Do served as Chief Financial Officer of iTarget Software and Senior Vice President in charge of Finance at New Angle Software.

 1. Marketing Channels

Where are your products distributed?  How do potential customers learn about your product or service?  Through word of mouth?  Through internet advertising?  Direct marketing?  Print, TV or radio advertisements?  Be specific about your current and future plans for marketing channels.

Example:

iWidget markets its products through a number of online distributors, with plans to increase those channels in the near term.   The company uses viral marketing strategy and has received significant business through word-of-mouth referrals from satisfied customers. 

iWidget plans to roll out a more aggressive online advertising campaign next year.  Long-range plans include the use of television and radio advertising. 

2. Sales Target

Your business plan should include achievable sales targets for the next three to five years to give investors a realistic picture of how your venture will progress in the near and medium term.

Example:

iWidget Pro was introduced to the market in June 2004 and produced first year sales of $19.7 million.  Sales rose 32% in 2005 to $26 million, and are projected to grow to $38 million in 2006 and $52 million in 2007. 

iWidget Next and iWidget World followed in December 2004 and March 2005, respectively.  iWidget Next first year sales were $12.8 million and are projected to rise to$18 million in 2006.  iWidget World first year sales are projected at $13 million and are also expected to rise to $18 million in the second year.

iWidget Sales Projections: