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 know that even excellent products can be ruined by poor management.
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.
After the exhaustive investigation and analysis, if the venture capital firm decides to invest in a company, they will prepare an equity financing proposal. This details the amount of money to be provided, the percentage of common stock to be surrendered in exchange for these funds, the interim financing method to be used, and the protective covenants to be included.
The final financing agreement will be negotiated and generally represents a compromise between the management of the company and the partners or senior executives of the venture capital firm. The important elements of this compromise are ownership and control.
Venture capital financing is not inexpensive for the owners of a small business. The venture firm receives a portion of the business’s equity in exchange for their investment.
This percentage of equity varies, of course, and depends upon the amount of money provided, the success and worth of the business, and the anticipated investment return. It can range from perhaps 10% in the case of an established, profitable company to as much as 80% or 90% for beginning or financially troubled firms. Most venture firms, at least initially, don’t want a position of more than 30% to 40% because they want the owner to have the incentive to keep building the business.
Most venture firms determine the ratio of funds provided to equity requested by a comparison of the present financial worth of the contributions made by each of the parties to the agreement. The present value of the contribution by the owner of a starting or financially troubled company is obviously rated low. Often it is estimated as just the existing value of his or her idea and the competitive costs of the owner’s time. The contribution by the owners of a thriving business is valued much higher. Generally, it is capitalized at a multiple of the current earnings and/or net worth.
Financial valuation is not an exact science. The compromise on owner contribution’s worth in the equity financing agreement is likely to be lower than the owner thinks it should be and higher than the partners of the capital firm think it might be. Ideally, the two parties to the agreement are able to do together what neither could do separately:
1. grow the company faster with the additional funds to more than overcome the owner’s loss of equity, and
2. grow the investment at a sufficient rate to compensate the venture capitalists for assuming the risk.
An equity financing agreement with an outcome in five to seven years which pleases both parties is ideal. Since the parties can’t see this outcome in the present, neither will be perfectly satisfied with the compromise reached. The business owner should carefully consider the impact of the ratio of funds invested to the ownership given up, not only for the present, but for the years to come.
The partners of a venture firm generally have little interest in assuming control of the business. They have neither the technical expertise nor the managerial personnel to run a number of small companies in diverse industries. They much prefer to leave operating control to the existing management.
The venture capital firm does, however, want to participate in any strategic decisions that might change the basic product/market character of the company and in any major investment decisions that might divert or deplete the financial resources of the company.
Venture capital firms also want to be able to assume control and attempt to rescue their investments, if severe financial, operating, or marketing problems develop. Thus, they will usually include protective covenants in their equity financing agreements to permit them to take control and appoint new officers if financial performance is very poor.
John B. Vinturella, Ph.D has over 40 years’ experience as a management and strategic consultant, entrepreneur, and college professor. He is a principal in the business opportunity site jbv.com and its associated blog. John recently released his latest book, “8 Steps to Starting a Business,” available on Amazon.