An Introduction to Venture Capital

This article is a reprint of Wise Bread's contribution to OPEN Forum from American Express -- where small business owners can get advice from experts and share tips with each other.

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Venture capital — capital investments made by either private investors or investment firms — focus on giving new businesses the money they need to grow rapidly. Of course, venture capitalists expect a profit from their investments; they look carefully for companies with a potential for major growth so that they can realize a profit during an IPO or sale of the company. Most venture capital investments are made in exchange for shares in the company. Venture capital can be an option for certain small businesses, although not all companies are a good fit.

When does venture capital make sense?

Healy Jones has led investments at several venture capital firms and has since joined OfficeDrop to provide marketing expertise and help the startup raise money. Jones suggests that small businesses should only consider seeking out venture capital when you have a concrete plan for using it and when you have a very specific use of capital that will fundamentally change the trajectory of your business.

For example, your customers have been asking for a specific product and you have a clear path to developing it and getting that product sold. VCs may be interested in funding that product's creation and sales ramp up. Or if you have perfected a customer acquisition strategy for a product and now need money to rapidly grow your sales...Most venture funds are looking for that one in a million company that can grow to $50 or $100 million in three to five years. If a good small business needs a couple of million dollars to grow to $5 or $10 million in revenue then they should probably seek angel financing, not venture capital.

Depending on what you need the capital for, different venture capital firms may be a better fit. Jones points out that, for instance, there are some VCs that help companies specifically with money or geographic expansions or with funding for acquisitions.

Don't think of venture capital as the easiest way to raise money for your business, though. Jones notes:

Just getting venture capital is the hardest. In 2009, 2,868 companies in the US raised VC. Only 1,238 of them were seed or early stage — more than half were expansion stage or late stage investments. So if you've got a very young early stage business the purely statistically correct answer is that raising capital is very unlikely.

How do you actually find venture capital?

Healy says:

The first major hurdle is getting introduced to venture capitalists. VCs rely on social proof in making investments, which means they look for signals from people they trust when evaluating new investment opportunities. Investing in an early stage company is a bet on the team running the company. The VC will be more interested in a company who has been introduced by someone he or she trusts. You need to get warm introductions to venture capital firms, and the best warm intro's are from successful entrepreneurs/executives. Use LinkedIn; work backwards and see which of your contacts can help you. The second issue is that most entrepreneurs don't understand how to pitch a venture capitalist. And how would they, since it's not a process most people have been part of, and the act of running a successful business is not at all really the same skill set in pitching to VCs.

The first step to looking for venture capital is, according to Healy:

Figure out your value creation milestones. In other words, what do you have to do to be worth a lot more after you've spent the VC';s money. Saying you are going to have enough cash to last for 18 months is not the right answer. You need to prove something with the capital, either developing and testing a particular technology, selling a particular amount of a solution, growing to a particular size, etc. And you need to know how much money you need to get there. For OfficeDrop, among other things, we wanted to prove our customer acquisition strategy, grow to a certain amount of revenue/cash flow and test the viability a number of partnership/product sets.

You'll also need to be able to describe your business model before you start talking to venture capitalists. You'll need to be able to make an amazing first impression, convincing a venture capital firm that you can earn a solid return on their money for them.

The Key to Convincing Venture Capitalists

If you do decide to seek venture capital funding, Healy suggests focusing on building an excellent management team. That was the first thing he looked at any time he was considering funding a new company when working as a venture capitalist.

The best thing is if you were previously successful at your last entrepreneurial position — as in you sold a business for millions or went public. But that is really hard; how many people can say that? Solid proof points that you are going to be able to lead a team, such as getting great people to work with you for low cost, or getting customers to rapidly adopt or sign up for your not-yet refined product are also great proof points. Harder to put on paper is the gut feeling of whether or not the VC feels that working with the entrepreneur will be a positive experience; that they work well together and that they have good lines of communication. Good management teams also have a clearly articulated vision. This is a mixture of understanding the pain point and clearly explaining how your product or service will solve this problem profitably. Also, the ability to explain how the market changes over the coming years and how your solution will evolve to meet the needs of the customer and fight off the competition.

Of course, you have to have a solid plan for your business. Because venture capitalists typically stand to lose a substantial amount of money if a company they invest in goes under, though, they often choose to trust the people in charge of the business, rather than the business plan. If a business owner is savvy, the business has a better chance of being successful, no matter how good the business plan is.