and Business Resources
magazine - March
By David R. Evanson
Do you stand a chance of getting venture capital? Take this test and
The devil of getting venture capital lies in the semantics of the situation.
While almost every emerging enterprise requires a dollop of venture capital
to get to the next stage, venture capitalists are not the source of this
funding about 99.44 percent of the time.
The fact is, the vast majority of venture capital comes from sources
other than venture capitalists. Where most entrepreneurs err is in pursuing
the latter rather than the former. The distinction wouldn't be so important
if the six months to a year most entrepreneurs take learning this didn't
kill as many companies as it did.
There just isn't enough venture capital to go around. The $7.4 billion
or so the nation's venture capital partnerships started with last year
is just a fraction of the $50 billion to $60 billion America's emerging
high-growth companies need each year, says Jeffrey Sohl, director of the
Center for Venture Research at the University of New Hampshire in Durham.
When you look at numbers like this, it becomes obvious that professional
venture capitalists offer limited financing opportunities for a small
population of companies. The question, then, is whether yours is among
that small minority of enterprises a venture capitalist will finance.
To find out, run through the following seven-point diagnostic test from
John H. Martinson, managing partner of Edison Venture Fund, a Lawrenceville,
New Jersey, venture capital firm with more than $200 million under management.
And to add more weight to the numbers we've been talking about, consider
a typical year for Edison, according to Martinson: "We see 2,000 business
plans, of which we might visit 300, seriously consider and conduct due
diligence on 50, and invest in eight to 12." Here's the litmus test:
1. Are you a technology company? "In general, 80 percent of a
venture capitalist's portfolio is in technology," says Martinson. Why
the relentless focus on technology? Martinson says the key may lie in
the answer to the next question.
2. Are you capable of being a market leader? "We rarely finance
a company that is going up against a market leader with a similar product,"
says Martinson. The reason? "It's too difficult and too expensive to succeed."
But here's where technology plays a role. Breakthroughs can shatter the
established paradigm of existing markets or create vast new ones. With
low-tech consumer products, such as plastic housewares, or ubiquitous
services, such as restaurants, it's difficult to change the rules of the
3. Can the company be built inexpensively? In Martinson's nomenclature,
that means about $10 million or less. "Venture capitalists like to build
companies on the cheap," says Martinson, "to limit the downside risk and
because they don't want to have to rely on other sources of capital to
pitch in to help the company reach its goal."
4. Is there a clear distribution channel? Many times, entrepreneurs
come up with great products, but there's no clear or easy way to sell
them, says Martinson. And consistent with venture capitalists' focus on
overall cost containment, they also want to know that the distribution
channel can be accessed fairly inexpensively.
For instance, the existence of mass-market retailers appears to offer
inexpensive and wide distribution for many consumer products, and even
some technology products. However, there are often hidden costs that make
these channels prohibitive, such as inventory requirements, the stores'
right to return unsold product, "slotting" fees or mandatory cooperative
advertising costs. Martinson says companies that have joint venture marketing
opportunities--that is, the opportunity to move product through someone
else's distribution channel--or otherwise have direct and proven access
to the market are typically more attractive to venture capitalists than
those that must invent their own distribution systems or pay high fees
to use someone else's.
5. Does this product require significant support? Complex products
or services usually require customer support organizations that are expensive
and sometimes difficult to establish and maintain. For instance, a relatively
low-tech home alarm system sold through mass-market distribution channels
might seem appealing to an investor given Americans' rising concerns over
security, says Martinson. But can customers install it themselves, or
does a third party have to get involved? "If a third party is required,
it's much less appealing because of the costs involved and their impact
on the margins," he says.
But the need for customer support doesn't have to kill a deal. Sometimes
a third party wants to get involved because it spells opportunity for
them. For instance, SAP America Inc., a worldwide applications software
company based in Germany, relies heavily on Big Six accounting firms to
install and support its products. For SAP, funds that might otherwise
go to a massive customer support organization go instead to the bottom
6. Can the product or service generate gross margins of more than 50
percent? "For business owners who are trying to carve out a salary
and a living," says Martinson, "gross margins of 30 percent are fine."
But for professional investors who need to make a return, 30 percent margins
are too thin. Why? "First," says Martinson, "that margin leaves little
room for error." Second, and more important, he says, "my return depends
on an acquisition of the company or an initial public offering. With thin
margins, the prospect for either becomes dimmer because the next owner
of the company doesn't want to face all the attendant risks associated
with trying to overcome those thin margins."
7. Can the company grow to $25 million in five years, with the prospect
of growing to $50 million to $100 million? At $25 million in sales, a
company is just beginning to generate the kinds of profits that make it
worth enough so venture capitalists can get the kind of return they are
looking for. Say, for instance, that a $25 million enterprise was bringing
$5 million to the bottom line. Valuing the company as a multiple of its
earnings--a standard benchmark--and using a multiple of 10 just to keep
the math easy suggests a value of $50 million. If the venture capitalist
invested $10 million, then the return on this hypothetical company would
be five times the investment in five years--a middle-of-the-road target
return for most venture capitalists.
On this final point, Martinson is firm. "If there's no possibility you're
going to hit the $25 million benchmark within five years," he says, "it's
simply a waste of time to pursue institutional venture capital." But once
this hurdle is passed, Martinson offers encouragement: "If the business
can really be cranked up fast, I would encourage entrepreneurs to give
venture capitalists a try, because you just never know until you do."
Edison Venture Fund, 997 Lenox Dr., Lawrenceville, NJ 08648,
(609) 896-1900, ext. 18.
David R. Evanson, a writer and consultant, is a principal of Financial
Communications Associates in
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