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OBTAINING VENTURE AND GROWTH CAPITAL

'Money is like a sixth sense without which you cannot make a complete use of the other five."

- W. Somerset Maugham, Of Human Bondage

The Capital Markets Food Chain

Consider the capital markets for equity as a "food chain," whose par­ticipants have increasing appetites in terms of the deal size they want to acquire (Exhibit 5.1). This framework can be quite useful to small business owners to identify and appreciate the various sources of equity capital at various stages of your business's development, the amount of capital they typically provide, and the portion of the company and the share price you might expect, should your company eventually have an initial public offering (IPO) or trade sale.

In the bottom row of Exhibit 5.1, you can see the ultimate progres­sion from R&D stage to IPO, wherein the capital markets are typically willing to pay $12 - $ 18 per share for new issues of small companies. Obviously, these prices are lower when the so-called IPO window is tight or closed, ask was in 2 000 through 2 002. Prices for the few offer­ings (one to three per week versus fifty-plus per week in June 1996) are single digits, $5-$9 per share. In hot IPO periods, 1999 for instance, offering prices reached as high as $20 per share and more.

Exhibit 5.1 The Capital Markets Food Chain for Entrepreneurial Ventures

Stage of Venture

R&D

Seed

Launch

High Growth

Company Enterprise Value at Stage

Sources

<$IM

Founders; high-net-worth individuals; FFF*; SBIR

$IM-$5M

FFF; angel funds; seed funds; SBIR

>$IM-$50M +

Venture capital series A, B, C . . . ; strategic partners; very-high-net-worth individuals; private equity

>$I00M +

IPOs; strategic acquirers; private equity

<$50K-$200K

Amount of Capital Invested

Percent Company Owned 10-25% at IPO

$I0K-$500K 5-15%

$500K-$20M $I0M-$50M +

40-60% by prior investors 15-25% by public

Share Price and Number* $0.0l-$0.50; I-5M

$0.50-$l.00; I-3M

$I.OO-$8.00±;5-IOM

$!2-$l8+;3-5M

One of the toughest decisions for you and any partners is whether to give up equity, and implicitly control, in order to have a run at creating very significant value. In the row "% company owned at IPO," you can see that by the time a company goes public, you may have sold 70-80 percent, or more, of your equity.

In the remainder of this chapter, we will discuss these various equity sources and how to identify and deal with them. Exhibit 5.2 summa­rizes the recent venture capital food chain. In the first three rounds (series A, B, C), you can see that on average, the amount of capital invested was quite substantial: $5 million, $7.5 million, and $12 million. Note that the total number of shares will not equal 100 percent if you add the maximum equity all investors might acquire. If that did happen, previous rounds would be diluted. Also, the total number of shares out­standing and your total number of shares owned will increase as you sell more shares. That happens mostly because you will issue new stock. You may also enact a stock split. The key is if you perform well, the share price (valuation of the company) will increase and your value at IPO can be substantial.

Cover Your Equity

One of the toughest trade-offs for any young company is to balance the need for growth capital with the preservation of equity Holding on to as much as you can for as long as possible is generally good advice for small business owners. The earlier the capital enters, regardless of the source, the more costly it is. Creative bootstrapping strategies can be great preservers of equity, as long as such parsimony does not slow down the venture's progress - a problem with many small businesses.

Exhibit 5.2 The Venture Capital Food Chain for Entrepreneurial Ventures

Venture Capital Series A, B, C, . . . (average size of round):

f "A" @ $5M - Start-up
Round (Q4 2000)* 1 "B" @ $7.5M - Product development

%, "C"+ @ $ 12M - Shipping product

There are three central issues to consider when beginning to think about obtaining risk capital: (1) Does the venture need outside equity capital? (2) Do the founders want outside equity capital? (3) Who should invest? Although these considerations should be the focus of your management team, it is also important to remember that a smaller percentage of a larger pie is preferred to a larger percentage of a smaller pie. Or as one entrepreneur stated, "I would rather have a piece of a watermelon than a whole raisin."1

After reviewing the venture opportunity screening exercises and the free-cash-flow equations (including OOC, TTC, and breakeven), it will be easier to assess the need for additional capital. Deciding whether the capital infusion will be debt or equity is situation specific, and it may be helpful to be aware of the trade-offs involved. In the majority of the high-technology early-stage companies, some equity investment is nor­mally needed to fund research and development, prototype develop­ment and product marketing, launch, and early losses.

Once your need for additional capital has been identified and quanti­fied, you and your management team must consider the desirability of an equity investment. Bootstrapping continues to be an attractive source of financing. For instance, Inc. magazine suggested that entre­preneurs in certain industries "tap vendors"2 by getting them to extend credit.

Other entrepreneurs interviewed by Inc. recommended quick pay­ments from customers.3 For instance, one entrepreneur, Rebecca McKenna, built a software firm from scratch that did $8 million in sales in 2001 with customers in the health-care industry. The robust eco­nomic benefits to her customers justified a 2 5 percent advance payment with each signed contract. This up-front cash has been a major source for her bootstrap financing. These options, and others, exist if your management team members feel that a loss of equity would adversely impact the company and their ability to manage it effectively. An equity investment requires that the management team firmly believe that investors can and will add value to the venture. With this conviction, your team can begin to identify those investors who bring expertise to the venture. Cash flow versus required rate of return is an important aspect of the "equity versus other" financing decision.

Deciding who should invest is a process, more than a decision. Your management team has a number of sources to consider. There are both informal and formal investors, private and public markets. The single most important criterion for selecting investors is what they can con­tribute to the value of your venture - beyond just funding. Angels or wealthy individuals are often sought because the amount needed may be less than the minimum investment required by formal investors (i.e., venture capitalists and private placements). Whether a venture capital­ist would be interested in investing can be determined by the amount needed and the required rate of return expected.

Yet, small business owners should be cautioned that only a small per­cent of the companies seeking private equity actually wind up getting it at the end of the process. Additionally, the fees due the investment bankers and attorneys involved in writing up the prospectus and other legal documents must be paid whether or not your company raises capital.

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