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Venture Capital

You have taken a big step. With a couple of friends, you have formed a corporation to open a number of fast-food outlets, offering innovative combinations of national dishes such as sushi with sauerkraut, curry Bolognese, and chow mein with Yorkshire pudding. Breaking into the fast-food business costs money, but, after pooling your savings and borrowing to the hilt from the bank, you have raised $100,000 and purchased 1 million shares in the new company. At this zero-stage investment, your company`s assets are $100,000 plus the idea for your new product.

That $100,000 is enough to get the business off the ground, but if the idea takes off, you will need more capital to pay for new restaurants. You therefore decide to look for an investor who is prepared to back an untried company in return for part of the profits. Equity capital in young businesses is known as venture capital and it is provided by specialist venture capital firms, wealthy individuals, and investment institutions such as pension funds.

Most entrepreneurs are able to spin a plausible yarn about their company. But it is as hard to convince a venture capitalist to invest in your business as it is to get a first novel published. Your first step is to prepare a business plan. This describes your product, the potential market, the production method, and the resources ¤time, money, employees, plant, and equipment ¤needed for success. It helps if you can point to the fact that you are prepared to put your money where your mouth is. By staking all your savings in the company, you signal your faith in the business.

The venture capital company knows that the success of a new business depends on the effort its managers put in. Therefore, it will try to structure any deal so that you have a strong incentive to work hard. For example, if you agree to accept a modest salary (and look forward instead to increasing the value of your investment in the company`s stock), the venture capital company knows you will be committed to working hard. However, if you insist on a watertight employment contract and a fat salary, you won`t find it easy to raise venture capital.

You are unlikely to persuade a venture capitalist to give you as much money as you need all at once. Rather, the firm will probably give you enough to reach the next major checkpoint. Suppose you can convince the venture capital company to buy 1 million new shares for $.50 each. This will give it one-half ownership of the firm: it owns 1 million shares and you and your friends also own 1 million shares. Because the venture capitalist is paying $500,000 for a claim to half your firm, it is placing a $1 million value on the business. After this first-stage financing, your company`s balance sheet looks like this:

Suppose that 2 years later your business has grown to the point at which it needs a further injection of equity. This second-stage financing might involve the issue of a further 1 million shares at $1 each. Some of these shares might be bought by the original backers and some by other venture capital firms. The balance sheet after the new financing would then be as follows:

Notice that the value of the initial 1 million shares owned by you and your friends has now been marked up to $1 million. Does this begin to sound like a money machine? It was so only because you have made a success of the business and new investors are prepared to pay $1 to buy a share in the business. When you started out, it wasn`t clear that sushi and sauerkraut would catch on. If it hadn`t caught on, the venture capital firm could have refused to put up more funds.

You are not yet in a position to cash in on your investment, but your gain is real. The second-stage investors have paid $1 million for a one-third share in the company. (There are now 3 million shares outstanding, and the second-stage investors hold 1 million shares.) Therefore, at least these impartial observers ¤who are willing to back up their opinions with a large investment ¤must have decided that the company was worth at least $3 million. Your one-third share is therefore also worth $1 million.

For every 10 first-stage venture capital investments, only two or three may survive as successful, self-sufficient businesses, and only one may pay off big. From these statistics come two rules of success in venture capital investment. First, don`t shy away from uncertainty; accept a low probability of success. But don`t buy into a business unless you can see the chance of a big, public company in a profitable market. There`s no sense taking a big risk unless the reward is big if you win. Second, cut your losses; identify losers early, and, if you can`t fix the problem ¤by replacing management, for example ¤ don`t throw good money after bad.

The same advice holds for any backer of a risky startup business ¤after all, only a fraction of new businesses are funded by card-carrying venture capitalists. Some startups are funded directly by managers or by their friends and families. Some grow using bank loans and reinvested earnings. But if your startup combines high risk, sophisticated technology, and substantial investment, you will probably try to find venture capital financing.

VENTURE CAPITAL Money invested to finance a new firm.