We look at the benefits venture capital investment can bring beyond an initial cash injection – and how to avoid the pitfalls of giving up equity.
No entrepreneur takes the decision to sacrifice equity lightly. Venture capital investment – arguably a more likely source of investment for entrepreneurs given the banking sector’s liquidity collapse – comes with both the promise of added value and the risk of sacrificing control. Here, we consider what venture capitalists (VCs) look for in a potential investment, what an entrepreneur should look for in an investor and the non-monetary value a VC can bring.
What do investors look for?
Venture capital investors are looking for a good return on their investment by increasing the capital value of the business at exit - typically they'll be looking to double their money over a three-year period.
They want businesses in dynamic, growing, scalable, cash-generative sectors, but that aren't necessarily the finished article. You don't need to have the perfect corporate structure with all the jigsaw pieces in place. The business needs a good ‘storyboard' for future growth - a strong proposition that the investor can assist in achieving. It might be rolling out more stores, embarking on customer acquisition or the looking for a more professional management team.
Investment targets usually have an existing business model which has driven growth over the last couple of years. They'll be operating in a sector that's still growing and be hungry to take the company to the next stage.
Why venture capital?
The money is, of course, important, but venture capital investment is about more than just cash; it’s about a mix of investment, bringing in business know-how and providing opportunities to fuel a company's growth. Being an entrepreneur can be a lonely pursuit and owners often get too close to their business and too embroiled in running it. A venture capital investor can provide a fresh perspective on the people, business platform and market position, and add value in all these areas to accelerate growth and profitability.
The ideal investor is not just the one who provides the cheapest capital, but the one who can also help management build its business so that everyone profits in the end. Assessing the potential to make operating improvements and helping management execute are now pre-requisites for successful private equity investing.
What are the risks?
Venture capital changes a business fundamentally. Once you've committed to the VC route you're on a journey with no turning back: there has to be an exit at some point. It's a tough decision for business owners; you won't necessarily be able to pass the business on to the next generation. So, if you want to keep a business in the family, VC is not the way to go. Priorities and rules of play are shifted forever. As an owner, you can't afford to have the same sort of emotional attachment to the business because the driving force is now about making a return on investment.
Relinquishing control is also tough for entrepreneurs. A recurring complaint is that the investor showed either too much or not enough interest in the business. There's a big danger of personality clashes and one person's welcome advice can quickly become another's unwelcome interference.
VC firms won't just invest in your business and leave you to it. They'll have rights over dividend payments, salaries and new share issues, to make sure their interests are protected. In extreme cases, entrepreneurs, particularly where there is substantial underperformance, can be removed totally from the business.
What to look for before striking a deal
Deciding what you want the investment for is key. What do you want to achieve? What do you want the trajectory of your business to be? Potential investors often complain that entrepreneurs have a short-term mind set - they look for a quick fix for their business. They also tend to have incredible self-belief, so they don't necessarily think about the long-term consequences of the investment deal. Many very successful entrepreneurs simply stop listening when it comes down to the detail. They think ‘we'll sort it out later' and don't pay attention to the terms of the deal. Pay close attention to the long-term consequences and the fine detail of the investment deal. It is not simply about which private equity house takes the lowest percentage of the equity or pays the highest price. It is about all the terms of the deal from the warranties through to the exit horizon.
Choosing the right investor
The relationship has to be rewarding for both sides and finding the right partner isn't easy. Some investors are focused on particular sectors, whereas others have a strict size of investment they're prepared to make. You probably don't want to be the venture capitalist's biggest investment, but then you certainly don't want to be the smallest - you want to matter to them.
You'll find some investors have a good reputation for delivering, while others will make offers and then drop them just as the owner gets interested.
There will be differences in terms of exit strategy, investment structure and house style, i.e. how involved they want to be in managing the business. The best policy is to talk to entrepreneurs who've been through the process and have experience of working with the investors after the wedding bells have faded.
Incompatibility between the management team's operational aspirations for the business and the investor's financial strategy will soon lead to frustration. It's vital that the goals of both the investor and management are agreed in advance. This is usually achieved by both parties buying in to an agreed business plan over the life of the investment, including a shared vision as to when and how to seek an exit.
Finally, make sure you get the right advice. As a business owner, VC investment might be something you'll only ever deal with once in your life, and choosing a partner in haste will leave you a long period in which to repent.
© Crimson Business Ltd. 2009