Mark Suster, a venture capitalist/entrepreneur maintains one of the most popular blogs on VC investing. His most recent post provides an effective strategy for entrepreneurs in developing his/her own fund raising strategy http://www.bothsidesofthetable.com/2012/01/16/how-to-develop-your-fund-raising-strategy/.
In Wisconsin and much of the Midwest, we don’t have access to the venture capital that one can find in Boston, the Bay Area, San Diego, and Austin, Texas. However, it’s valuable to realize that the investing philosophy of Venture Capitalists doesn’t differ from the more traditional investors the we find here in the Midwest – lenders and angel investors. Regardless of the type of investor, they are looking for great opportunities with market potential, solid teams, etc. but only differ based on the degree of the risk and reward.
Critical to entrepreneurs is that they understand the fit of their business to the risk/reward profile of different categories of investors. In general, less than 1% of new ventures ever receive financing from traditional institutional funds like venture capital. There are many reasons for this. A larger venture capital fund typically targets a fund internal rate of return of 25% per year or more for their limited partners. That fund, with a limited life of 10 years or so, will typically invest in ten or more companies. Historically, venture capital funds will see a few great investments that will generate a 5X-10X or higher return on the original investment but also see several investments where they might lose all their money. The remainder will return part or all of their principal without a much incremental profits above the capital investment.
Why is this important to understand? A few reasons. First, most VC firms will have a minimal investment they will make in a new venture. It just isn’t worth their time to try to manage a small investment with the limited personnel most of the firms have. Second, and this is related to first point, the firms must make multi-million dollar investments in single firms. If they need an investment that will generate a return of 5X or 10X their invested capital, they need a high potential venture to do this. An example illustrates this.
Assume that XYVC investment firm makes a $5 Million investment in Firm Z. In five years, XYVC will desire a liquidity event that will generate a 10X increase or $50 million value. Assuming that the investment firm doesn’t own all or a majority of the firm, Firm Z will have to have some extreme growth potential. If XYVC owns 10% of the firm at exit, the company will have to have an total equity value of $500Million or more. At that equity value, assuming a P/E ratio of 10, the firm will need to be at the $50 million level of net profits in only its fifth year of existence. Not many new ventures can meet these needs.
It’s critical for new ventures when raising money to understand the investment criteria used by high risk/high reward investors. Doing so will save them a lot of time and effort.