A Venture Capital Primer for Would-be Entrepreneurs
P> The following are five questions an entrepreneur should be able to articulate before he approaches the venture capital market. Any venture capitalist worth 1 percent of his portfolio will want to know the answers to these five questions right off the bat:
1. How much can I make?
Given the inherently higher risks of venture capital, the standard for minimum annual return is 20 to 25 percent over the life of the investment.
Because about half the companies receiving venture capital end up dropping through the ice and going out of business, a venture capital firm must get phenomenal returns on companies that do succeed. It's the "big hits" that support the mundane losers in the portfolio. A big hit is an investment that will average a return of 100 percent or more over the life of the investment, usually five to 10 years.
Many venture capitalists use the shape of a hockey stick to describe the life of an investment. In the first years they lose money, the graph dips. Then, if the synergy between capital and entrepreneur is right, it will rise steeply -- making up for initial losses and recouping the 20 to 25 percent. Many big hits take big dips before they reach the golden handle of the stick. The tricky part is the early years. Thus the entrepreneur should be able to persuade venture capitalists that the company has the management skill to use resources wisely and weather the early years when deficit spending is required to keep the new venture afloat.
2. How much can I lose?
A venture capitalist and entrepreneur can, and do, lose everything they put in. Too much faith can be costly. Often the only way not to lose everything is to cut losses early. Some venture capitalists kick themselves later for not pulling the plug soon enough, thereby cutting losses. Keeping the faith may cost a venture capitalist everything.
Entrepreneurs, on the other hand, usually have more faith in their ideas and therefore often take it hard when their partner, the venture capitalist, starts behaving like a "vulture" capitalist in the argot of the industry.
The wise entrepreneur steels himself from this disappointment while not losing any enthusiasm for the company. That way, if the business does fail, the entrepreneur won't take such an emotional hit. After all, business is business, and that means winners and losers.
3. How do I get my money out?
There's usually just two ways out: going public or selling the venture capitalist's shares back to the entrepreneur's management team.
Venture capitalists prefer love affairs to marriage. The bond between an entrepreneur and a venture capitalist is not supposed to be a long-term commitment. Most venture capitalists would ideally like to get their profit and their money out in three years, but five to 10 years is the norm.
Exit strategies are what a prepared entrepreneur must be able to discuss thoroughly with a venture capitalist.
When an entrepreneur has a working knowledge of this, it shows the venture capitalist that the entrepreneur has the imagination and judgment to see things from both sides of the street.
4. Who says this deal is any good?
Venture capitalists feel more comfortable when their judgment is validated. You'll gain their confidence if you can name reputable business people who think your idea or company has potential. It's a little like politics: Endorsements don't change who a candidate is or what he stands for, but they can get other people to believe in him.
5. Who else is in the deal?
Management is vital. Once talent is signed on, a venture capitalist becomes curious about what has attracted these people to this management team.
That emphasis on people illustrates one of the axioms of the business: Most venture capitalists would choose a second-rate idea with first-rate management over a first-rate idea with second-rate management. In the end, it's competent business people who succeed at growing businesses. Great ideas are good but they're not the whole picture, and probably not the most important part, either.