Venture Capital High Risk, High Profits
Venture capital is high risk capital.
Another important distinction: people with available venture capital are investors first, not lenders. They want more than repayment with interest and they want equity; "a piece of the action."
The driving force behind this type of investor is not so much interest in your tangible assets as security, but rather an openness to innovative ideas and formulas, dazzling management techniques, intellectual property, imaginative products that could sell big and produce big profits fast.
Where banks and institutional lenders want hard security to backup loans, the venture capitalist uses your debt and his acquired loan equity in your business as his investment vehicle. That's why this form of available business money is appropriately called "risk capital." In this sometimes chancy arrangement, your ultimate business success is the investor's only real guarantee of a return on investment.
Two Different Worlds
As further evidence of public miss perceptions about business, most people tend to think of venture capital as the traditional, formal sources of such money. These are usually solid financial partnerships backed by high dollar funding from big institutions -- insurance companies, business and labor union pension funds, foundations or even the state and federal government, in cases such as Small Business Investment Companies (SBICS)or Minority Enterprise Small Business Investment Companies (MESBICs).
There are fewer than 1,000 of these venture capital firms nationwide, and many are subsidiaries of banks or major corporations. These operations are run very carefully, for the most part, by professional money managers with strict fiduciary responsibilities to their funding sources, groups that demand capital preservation, prudent investment and big returns.
Of the $30 billion of private venture capital invested in American business each year, only about 10 percent, or $3 billion, comes from these traditional, established venture capital sources. There are approximately 18 million businesses in the US, but only about 2,000 of them succeed each year in obtaining venture capital from such institutional investors. That means fewer than 1,400 businesses get help each year, and of those, only about 250 are new start-up businesses.
And yet this is the "venture capital" segment that gets all the media attention when the business news is reported.
What these cautious institutional investors are looking for are "sure things," not risk. By their cautious policies they have long since taken the "adventure" out of venture capital, searching instead for investments averaging 100 percent return or more every year over the life of their investment. They know that half of the applicants will fail, and the other half will be lucky if they produce 20 or 25 percent returns. That is why less than one percent of all applicants to these "traditional" venture capital sources ever get any of this institutional money.
Financial Angels
The true unsung heroes and heroines of venture capital -- the "financial angels" as they are called -- are the individual private investors who put up the other 90 percent of that $30 billion of capital available to businesses annually.
Without them, American small business would have little chance of collective or individual success. They are usually professional people with extra cash, on the lookout for good moneymaking investments -- doctors, lawyers, dentists, accountants, managers, retired people of wealth, relatives and friends.
More than half of the $27 billion annually invested by these truly adventuresome people goes directly to new start-up businesses, almost all of it to small businesses. While only about 31 percent of traditional venture capital goes into financings under $1 million, and only 13 percent under $500,000-- the informal private venture capital community invests 90 percent in financings under $1 million and 82 percent under $500,000.
The term "angel" comes from Broadway, where it was first used in the early part of this century to describe high risk investors willing to put up money in order to launch new Broadway plays and musicals. Now an angel is any investor willing to take a chance on an entrepreneurial business venture. Together this host of more than a million angels is the largest single source of risk capital in the nation. Sometimes these angels are truly blessed; in 1903 five of them invested $40,000 each in a company started by a fellow named Henry Ford, and over the next 16 years it earned them $145 million.
In and Out Profits
Either institutional or private, venture capital investors tend to look for similar things in any business.
First and foremost, they want to make a lot of money in a very short time – ten years or less, usually.
They want a company that has absolute, exclusive control over a unique proprietary product or service protected by patents, copyrights, trade secrets or private formulas no one else has or is likely to get anytime soon.
They want to see proof of a potential growth market of $50 to $100 million in gross revenues within five to ten years, and only then will they agree to pick up the tab. They want -- at a minimum -- an annual average return on their investment of at least 20 or 25 percent, and some demand as much as 30 or 40 percent return.
They want a good management team, financial controls and structure -- people with ideas and ability and a proven record of personal success. To the venture capital lender, exceptional, seasoned management is often the most important single factor. They look for honest high-achievers with competence, experience, good character, and lots of energy, realism and commitment.
They want products that are innovative, but not necessarily revolutionary. The next generation of an established product under the aegis of good management is more attractive than something no one has ever heard of before, being brought to market by a start-up company with an inexperienced management team.
Shared Ownership
Few venture capital investors require hard security as collateral in exchange for making money available to a business. What they do want is a profit and an unfettered right to receive that profit. As a practical matter, this usually means the money comes with a demand for part ownership, or equity, in the proposed enterprise, often in the form of a partnership.
The possibility of such an outside intrusion into the management of your existing business might -- and should -- give you serious concern. You must decide whether or not you are willing to surrender absolute control of your business in exchange for needed capital.
It is entirely possible that an experienced venture capitalist could well turn out to be the best partner you could have. The advice and experience injected could be far more valuable than even the total dollars invested. It could mean new business contacts and customers or other financing sources allowing expansion and growth. On the other hand, it could mean irritating interference and the possibility of losing the company you worked so hard to create.
However, if you are sophisticated enough to seek venture capital investment and are aided by experienced financial management or advisors, you should have little trouble dealing with a partnership arrangement should it be required. The key is to make sure everything is clearly spelled out in writing before the agreement is formalized.
In what the law calls a "general partnership" there is an association of two or more persons (or other legal entities) formed to conduct a business for mutual profit. More than 90 percent of all partnerships in the United States are general partnerships in which each partner is a co-owner, jointly running the business, each acting as agents for, and having a fiduciary relationship with one another. As a result, each partner is personally liable for the business acts of the others, including partnership debts and liabilities.
General partners, by common agreement, may have the same or differing capital investments, and may share profits and losses in the same or varying proportions, usually corresponding to each one's investment. A partnership is recognized in law for most purposes including contracts, credit, bankruptcy, debt, and acquiring and transferring property. A partnership, as such, does not pay tax -- its partners do as individuals owing income tax on their partnership income.
What is known as a "limited partnership" has at least one
general partner who usually is the managing partner, and one or more
"limited partners," usually investors in the business, a likely role
for a venture capitalist. The limited partner, whose status by law forbids any
role in day-to-day management, has no personal liability beyond the amount of
their capital investment, but does have a right to receive agreed amounts of
income when distributed. This arrangement is created by a partnership
agreement, a basic governing document to which all partners are parties. Limited Liability Corporations (LLC’s),
currently available in most states offer benefits similar to “S” corporations
and partnerships.
While this may sound complicated, venture capital comes with a price tag and often that reads "shared control" of the business.
One last word about shared control by venture capital investors: the central purpose of such an investor is to invest at low cost in the stock of a young company with a bright future, stay with the company for as short a time as possible, then sell out at a "killing" -- meaning a big, fast profit followed by an equally fast exit. Most investors will want a prior agreement as to how this exit will occur, and there are two main possibilities: a) going public by the sale of shares on the open market; or b) a private sale of the investor's shares to management or to others. In order to retain control, most business owners will want the right to buy out the investor when the time comes, but this exit strategy should definitely be in writing, along with the partnership agreement and the original capital transfer from the investor to the company.
Governments as Venture Capital Sources
There are numerous government sponsored venture capital firms. On the federal level they are bankrolled by the taxpayers through the US Small Business Administration and are known as SBICS. Those directed toward helping with lending to minority groups are called MESBICS. The only major difference with these venture capital sources is that they are forbidden by law from taking over management or control of a company.
There are also a host of state government-sponsored small business capital programs, usually providing government guarantees as backing for conventional bank or other business loans. Your local economic development agency should be able to direct you to these programs.