Obtaining the financing necessary to develop a successful business is one of the major challenges facing any company. There are a number of different sources of capital, including the sale of equity and debt securities to private and public investors, commercial loans and government financing. However, for emerging companies involved in high risk and reward businesses, there is one unique source of funding that warrants careful consideration: venture capital. Researchers have argued that venture capitalists bring a wide array of additional resources to their portfolio companies in areas such as strategic and operational planning, personnel selection, supplier selection, marketing, human resource policy decisions and investment and financing decisions. The roles played by venture capitalists in relation to their portfolio companies have been described as strategic, financial, disciplinary, interpersonal, networking oriented and reputational. But, while the venture capital industry includes a large number of well-organized firms with substantial funds to invest, venture firms are very selective and this means that it can be difficult for companies to tap into this source of assistance.
The attractive returns obtained by investors in venture capital funds in the past have created exceptional expectations for future returns, a situation that has placed the managers of venture capital funds under substantial pressure to identify “winners” that can provide quick returns. However, this has proven to be a difficult task and venture capitalists have repeatedly chased after apparently promising opportunities and agreed to valuations well in excess of reasonableness only to find out soon after the closing that they overpaid. In fact, it has been estimated by reliable sources that anywhere from 40% to 75% of the start-up companies that received venture capital financing never return monies to their investors. The result has been a dramatic pushback from venture capitalists regarding the terms they are demanding of management as well as longer periods of pre-investment scrutiny as venture capitalists pour over information regarding prospective portfolio companies and the projected markets for their products and services. With respect to the terms of investment, venture capitalists have become particularly focused on “downside protection” that gives them at least some minimum return if the portfolio company fails and on gaining control over execution of exit strategies should the company begin to flounder and it becomes clear that an initial public offering for the company’s common shares is not in the offing. Another consequence of the difficult economic times has been that companies that were able to secure venture capital financing in better times encountered greater difficulty raising additional funding and often had to accept lower valuations than in previous rounds, which often had an adverse impact on the morale of management and employees and led to setbacks in the pace of product development and firm expansion.
Getting ready for your venture capital debut? You should download the chapter on “Venture Capital” prepared by the Sustainable Entrepreneurship Project. It opens with an extended discussion of the advantages and disadvantages of venture capital funding and an overview of the stages of development for companies that are supported by venture capital investors. It then continues with coverage of all of the key steps in launching and maintaining a business relationship with a venture capitalist including a discussion of how venture capital funds operate, how to local potential venture capital investors, the factors that venture capitalists general consider when making their investment decisions, the questions that founders and managers should ask when evaluating and selecting venture capital investors, the terms of securities typically issued to venture capitalists, the considerations that go into valuation and pricing for a venture capital financing and, finally, the covenants and agreements of companies and their managers that are generally included in venture capital deals. The chapter also covers the procedures used by venture capitalist to monitor the performance of their portfolio companies and exit strategies.
Other tools that might be useful are available from the Business Counselor Institute and can be accessed here. You’ll find an Executive Summary describe the purpose and content of offering documents and an annotated version of the summary of terms for a Series A Preferred Stock financing.