Wednesday, 20 June 2012

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 percent to 500 percent 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.

Size of the Venture Proposal.

Most venture capital firms are interested in investment projects requiring an investment of 250,000 Pounds  to 2,500,000 Pounds. Projects requiring under 250,000 are of limited interest because of the high cost of investigation and administration; however, some venture firms will consider smaller proposals, if the investment is intriguing enough.

The typical venture capital firm receives over 1,000 pro­posals a year. Probably 90 percent of these will be rejected quickly because they don't fit the established geographical, technical, or market area policies of the firm -‑ or because they have been poorly prepared.

The remaining 10 percent are investigated with care. These investigations are expensive. Firms may hire consultants to evaluate the product, particularly when it's the result of innovation or is technologically complex. The market size and competitive position of the company are analyzed by contacts with present and potential customers, suppliers, and others. Production costs are reviewed. The financial condition of the company is confirmed by an auditor. The legal form and registra­tion of the business are checked. Most importantly, the character and competence of the management are evaluated by the venture capital firm, normally via a thorough background check.

These preliminary investigations may cost a venture firm between 2,000 and 5,000 pounds per company in­vestigated. They result in perhaps 10 to 15 proposals of interest. Then, second investigations, more thorough and more expensive than the first, reduce the number of proposals under consideration to only three or four. Eventually the firm invests in one or two of these.

Maturity of the Firm Making the Proposal.

Most ven­ture capital firms' investment interest is limited to pro­jects proposed by companies with some operating history, even though they may not yet have shown a profit. Companies that can expand into a new product line or a new market with additional funds are particularly interesting. The venture capital firm can pro­vide funds to enable such companies to grow in a spurt rather than gradually as they would on retained earn­ings.

Companies that are just starting or that have serious financial difficulties may interest some venture capitalists, if the potential for significant gain over the long run can be identified and assessed. If the venture firm has already extended its portfolio to a large risk concentration, they may be reluctant to invest in these areas because of increased risk of loss.


Management of the Proposing Firm.

Most venture capital firms concentrate primarily on the competence and character of the proposing firm's management. They feel that even mediocre products can be suc­cessfully manufactured, promoted, and distributed by an experienced, energetic management group.

They look for a group that is able to work together easi­ly and productively, especially under conditions of stress from temporary reversals and competitive pro­blems. They know that even excellent products can be ruined by poor management. Many venture capital firms really invest in management capability, not in pro­duct or market potential.

Obviously, analysis of managerial skill is difficult. A partner or senior executive of a venture capital firm normally spends at least a week at the offices of a com­pany being considered, talking with and observing the management, to estimate their competence and character.

Venture capital firms usually require that the company under consideration have a complete management group. Each of the important functional area - pro­duct design, marketing, production, finance, and control - must be under the direction of a trained, experienced member of the group. Responsibilities must be clearly assigned. And, in addition to a thorough understanding of the industry, each member of the management team must be firmly committed to the company and its future.

The "Something Special" in the Plan.

Next in impor­tance to the excellence of the proposing firm's manage­ment group, most venture capital firms seek a distinc­tive element in the strategy or product/market/process combination of the firm. This distinctive element may be a new feature of the product or process or a par­ticular skill or technical competence of the manage­ment. But it must exist. It must provide a competitive advantage.

...to be continued

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