Winner's circle: your chances of hitting the venture capital jackpot could depend on who you know

Entrepreneur, April, 1998 by Tomima Edmark

A venture capitalist is a company or partnership that has a large fund available to invest in products or ventures. Unlike banks, venture capitalists are willing to get involved in projects where there is a significant risk; however, they demand a greater return, may require control over many aspects of the enterprise and many times dictate who will be hired.

Some say working with a venture capitalist is like selling your soul to the devil. If you've exhausted all avenues of financing, however, and thoroughly understand the agreement you make with a venture capitalist, the rewards can be great. Remember, a venture capitalist also wants to make money with your idea, so he or she wants you to succeed. And being in the business of building businesses, he or she has the advantage of seeing how many businesses work and can act as a consultant to help you succeed.

STARTING YOUR SEARCH

How do you find a venture capitalist? A good place to start is with Pratt's Guide to Venture Capital Sources (Venture Economics). It is updated once a year, and most libraries have it in their reference section. This guide lists venture capital firms by state and includes a list of foreign venture capital firms.

Almost all the information you need to make an informed decision is included in each write-up. For example, Pratt's tells you what type of financing the venture capital firm prefers (seed capital or leveraged buyouts, for example). This is important because as an inventor, you are no doubt looking for investors who have a bias toward early-stage financing (more about this later). Pratt's also spells out what each company's minimum and preferred level of investment is and their geographic preferences. Most venture capitalists want easy access to their investments; this is important to know when compiling a list of prospective firms.

Another valuable piece of information provided by Pratt's is a percentage breakdown of each venture capitalist's current portfolio; for example, it may break down as 35 percent communications, 38 percent technology, 14 percent medical and 13 percent telecommunications. Obviously, in this example, it wouldn't be a good idea to send this venture capitalist a business plan discussing a retail venture. Send your business plan to investors who specialize in your industry.

TYPES OF FINANCING

Venture capitalists typically offer one of three types of early-stage financing: seed financing, research and development financing, or start-up financing.

Seed financing is generally given to entrepreneurs to help them prove that their invention or concept works. It's usually a small amount of money that pays for product development and market research. If the idea works, the venture capitalist will then consider providing start-up capital to further develop the project.

Research and development financing can be beneficial to both the inventor and the venture capitalist. This kind of financing has tax advantages if it's set up as product development financing. Venture capitalists can receive tax write-offs for their investments or a share of the future profits if the product is successful.

If you are far enough along that you have developed your idea and done some initial marketing, you should look for start-up financing. This type of financing is usually for a larger amount than the previous two types because the early stages have proved successful, and the venture capitalist feels his risk has been reduced.

MAKING A PLAN

Without exception, you must have a business plan if you want to do business with a venture capitalist.

There are some strict do's and don'ts you should heed when writing a business plan. Do give a clear and simple explanation of your idea. Do have a well-thought-out sales and distribution plan. Do show that you are knowledgeable about your market. Do explain who your competitors are and how you will compete against them. Do include full resumes of your key managers. And do, if possible, write your own business plan. Pat Hamner, vice president of Capital Southwest Corp. in Dallas, says he wants to read business plans that "make sense and exude credibility. I like to see if all the sections of the business plan hang together, having been supported through well-documented statements and data," he says.

Venture capitalists notice certain red flags when reviewing a business plan. For example, don't make statements such as "there is no competition," "this is a paradigm shift for the industry," or "my idea represents a multibillion-dollar market." Al Fleener of Seed Company Partners LP in Dallas feels that the more grandiose the business plan, the harder it will be to sell. "Demonstrating that you have analyzed the market and will initially go after a segment of it is far more attractive to a venture capitalist than going after the entire market all at once," he says.

An employee list that only includes family members is another red flag. It's one thing to have friends on the list; it's hard to believe, however, that one family has all the skills necessary to make a venture successful.