| The First Step: Understanding the Process
Profile of a Typical Venture Capital Fund
Professionally managed venture capital funds provide
seed, startup and expansion financing as well as
management/leveraged buyout financing.
Venture capital firms are typically established as
partnerships that invest the money of their limited
partners. Since investors in venture capital funds have
specific return-on-investment requirements, a venture
capitalist must evaluate potential investments with a
similar return-on-investment consideration.
Many funds invest between $.5-$3.0 million in any one
venture over a period of three to five years and look for
companies with a market potential of $50 - $100 million.
Venture capitalists will be looking for a 30-40% or more,
annual return on investment and for a total return of 5 to
20 times their investment.
Venture capitalists are not passive investors. Usually they
become involved as advisors to management and/or
members of the company's board of directors. By actively
participating, venture capitalists seek to maximize their
return.
An entrepreneur should exact the same diligence in
evaluating the benefits that a particular venture firm can
provide the company.
- Do the venture capitalists have experience with similar
types of investments?
- Do they take a highly active or passive management
role?
- Are there competing companies in their portfolio.
- Can they help provide contacts for distribution channels
and executive search?
The Valuation Process
It is critical for an entrepreneur seeking venture capital to
assess the value of the company from the perspective of
the venture capitalist and to appreciate the dynamics of
the entrepreneur/venture capitalist relationship. This
relationship revolves around a tradeoff. Funds for growth
are exchanged for a share of ownership. The entrepreneur
gives up a large share of ownership, possibly a majority
stake, while the venture capitalist seeks a substantial
return on investment.
Entrepreneurs seek to raise as much money as they can
while giving up as little ownership as possible. Venture
capitalists strive to maximize their return on investment
by putting in as little money as possible. Through the
negotiation process, the two parties come to an
agreement. While each has their individual goals, both
parties should agree on one mutual goal -- to grow a
successful enterprise.
The first step in the negotiation process is to determine
the current value of the company. Factors include stage of
development, product revenues, expense history,
management teams, and company goals.
The best way to build value in a company is to achieve
goals and milestones within the time frames designated in
the business plan. Many entrepreneurs "bootstrap"
themselves during the early stages with money coming
from family, friends, private investors or money-raising
strategies such as consulting or custom development.
Pricing and Control: The Investors' Perspective
Pricing venture capital deals involves the estimated future
value of the entity being financed and is highly subjective.
Theoretical approaches can be used to estimate the
company's future value and the corresponding percentage
ownership that the investor requires -- in other words,
estimated future value based on the venture's expected
profitability and estimated earnings multiples. The
estimated percentage ownership the investor must receive
can then be calculated to derive the desired return on
investment.
Remember that venture capital investors expect an annual
rate of return of 30% to 40% or more. If the estimated
future market value is high, a smaller percentage of
ownership will provide the required return.
Go to Step 2
Return |
