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A Venture Capital Primer For Small Business

By LaRue Tone Hosmer Professor and Chairman Policy and Control Graduate School of Business Administration at The University of Michigan Ann Arbor, Michigan

Summary

Small businesses never seem to have enough money. Bankers and suppliers, naturally, are important in financing small business growth through loans and credit, but an equally important source of long term growth capital is the venture capital firm. Venture capital financing may have an extra bonus, for if a small firm has an adequate equity base, banks are more willing to extend credit.

This Aid discusses what venture capital firms look for when they analyze a company and its proposal for investment, the kinds of conditions venture firms may require in financing agreements, and the various types of venture capital investors. It stresses the importance of formal financial planning as the first step to getting venture capital financing.

What Venture Capital Firms Look For

One way of explaining the different ways in which banks and venture capital firms evaluate a small business seeking funds, put simply, is: Banks look at its immediate future, but are most heavily influenced by its past. Venture capitalists look to its longer run future.

To be sure, venture capital firms and individuals are interested in many of the same factors that influence bankers in their analysis of loan applications from smaller companies. All financial people want to know the results and ratios of past operations, the amount and intended use of the needed funds, and the earnings and financial condition of future projections. But venture capitalists look much more closely at the features of the product and the size of the market than do commercial banks.

Banks are creditors. They're interested in the product/market position of the company to the extent they look for assurance that this service or product can provide steady sales and generate sufficient cash flow to repay the loan. They look at projections to be certain that owner/managers have done their homework.

Venture capital firms are owners. They hold stock in the company, adding their invested capital to its equity base. Therefore, they examine existing or planned products or services and the potential markets for them with extreme care. They invest only in firms they believe can rapidly increase sales and generate substantial profits.

Why? Because venture capital firms invest for long-term capital, not for interest income. A common estimate is that they look for three to five times their investment in five or seven years.

Of course venture capitalists don't realize capital gains on all their investments. Certainly they don't make capital gains of 300% to 500% except on a very limited portion of their total investments. But their intent is to find venture projects with this appreciation potential to make up for investments that aren't successful.

Venture capital is a risky business, because it's difficult to judge the worth of early stage companies. So most venture capital firms set rigorous policies for venture proposal size, maturity of the seeking company, requirements and evaluation procedures to reduce risks, since their investments are unprotected in the event of failure.

Elements of a Venture Proposal

Provisions of the Investment Proposal

What happens when, after the exhaustive investigation and analysis, the venture capital firm decides to invest in a company? Most venture firms prepare an equity financing proposal that details the amount of money to be provided, the percentage of common stock to be surrendered in exchange for these funds, the interim financing method to be used, and the protective covenants to be included.

This proposal will be discussed with the management of the company to be financed. The final financing agreement will be negotiated and generally represents a compromise between the management of the company and the partners or senior executives of the venture capital firm. The important elements of this compromise are: ownership, control, annual charges, and final objectives.

Types of Venture Capital Firms

There is quite a variety of types of venture capital firms. They include:

In addition to these venture capital firms there are individual private investors and finders. Finders, which can be firms or individuals, often know the capital industry and may be able to help the small company seeking capital to locate it, though they are generally not sources of capital themselves. Care should be exercised so that a small business owner deals with reputable, professional finders whose fees are in line with industry practice. Further, it should be noted that venture capitalists generally prefer working directly with principals in making investments, though finders may provide useful introductions.

The Importance of Formal Financial Planning

In case there is any doubt about the implications of the previous sections, it should be noted: It is extremely difficult for any small firm--especially the starting or struggling company--to get venture capital.

There is one thing, however, that owner-managers of small businesses can do to improve the chances of their venture proposals at least escaping the 90% which are almost immediately rejected. In a word--plan.

Having financial plans demonstrates to venture capital firms that you are a competent manager, that you may have that special managerial edge over other small business owners looking for equity money. You may gain a decided advantage through well- prepared plans and projections that include: cash budgets, pro forma statements, and capital investment analysis and capital source studies.

Cash budgets should be projected for one year and prepared monthly. They should combine expected sales revenues, cash receipts, material, labor and overhead expenses, and cash disbursements on a monthly basis. This permits anticipation of fluctuations in the level of cash and planning for short term borrowing and investment.

Pro forma statements should be prepared for planning up to 3 years ahead. They should include both income statements and balance sheets.

Again, these should be prepared quarterly to combine expected sales revenues; production, marketing, and administrative expenses; profits; product, market, or process investments; and supplier, bank, or investment company borrowings. Pro forma statements permit you to anticipate the financial results of your operations and to plan intermediate term borrowings and investments.

Capital investment analyses and capital source studies should be prepared for planning up to 5 years ahead. The investment analyses should compare rates of return for product, market, or process investment, while the source alternatives should compare the cost and availability of debt and equity and the expected level of retained earnings, which together will support the selected investments. These analyses and source studies should be prepared quarterly so you may anticipate the financial consequences of changes in your company's strategy. They will allow you to plan long term borrowings, equity placements, and major investments.

There's a bonus in making such projections. They force you to consider the results of your actions. Your estimates must be explicit; you have to examine and evaluate your managerial records; disagreements have to be resolved--at least discussed and understood. Financial planning may be burdensome but it's one of the keys to business success.

Now, making these financial plans will not guarantee that you'll be able to get venture capital. Not making them, will virtually assure that you won't receive favorable consideration from venture capitalists.

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