Business Strategies
by jerome s. osteryoung, ph.d.
Becoming A Venture Capitalist
In a growing economy, making investment decisions can be difficult if
only because there are so many options. If you haven't considered venture capital
investments in the past, now might be the time to do so.
Small, privately held businesses and entrepreneurs are the driving
force in our economy. These firms often need private funds to expand. That's where venture
capitalists - or angels as they are sometimes called - come in.
Investing in entrepreneurial firms is exciting and often rewarding. The
more you know about the entrepreneur, his idea, the marketplace, and your own risk
tolerance, the more satisfying - and lucrative - the experience will be.
When investing in a private company, you should shoot for an average
compound annual rate of return of 50 percent. This sounds very high but, remember, the
average return for small, publicly traded stocks in the stock market has been around 20
percent. With publicly traded stocks, you have the liquidity of the stock market and
normally, the firm has been established for some time. In a young, private firm, there is
no immediate liquidity and a company's youth is often the time of its most rapid growth.
You do not have to take majority control of the company to get this
required return. If fact, you only need control if the entrepreneur does not deliver on
his promises. That's why you should insert clauses in the agreement specifying that if the
entrepreneur falls short of expectations, you gain control. The threat of loss of control
of the business is a powerful motivator for an entrepreneur. You just want to protect your
rate of return in a timely and low-risk fashion; whether it's with a minority or a
controlling interest is beside the point.
Another important point you should consider is the time and manner of
the harvest; that is the point at which you get out of the business and take your earnings
with you. The entrepreneur should specify in his business plan the method he will use for
getting your investment funds out of the business. Typically, an entrepreneur assumes that
in five to seven years he will hold an initial public offering or merger to get the
investor out. In evaluating deals, you need to verify that the harvest scenario is a
reasonable one.
Another key factor you should consider is the make-up and experience of
the entrepreneur's management team. An investor is betting on the jockey and not the
horse; a great idea will never be more than that if it is not brought to market
profitably. Some of the critical areas of experience are in marketing, channels of planned
distribution, and financial controls. No matter how good the idea, if the entrepreneur
does not have the relevant business experience, you should probably take a pass on the
deal.
Two other basic criteria also need to be considered when becoming a
venture capitalist. First, does the product or service you are going to invest in have a
market, and second, can this product or service produce a profit in its market? The best
way to evaluate the market and profitability of the product or service is to look at the
prior history.
For new ventures, however, this is not possible. In that case, you will
have to rely on your own knowledge and expertise, the accuracy of the business plan, and
the respective pro forma financial statements. It is amazing how many entrepreneurs in
their business plans expect to become millionaires in two or three years. If you think the
pro forma statements are unrealistic, steer clear of the deal.
Once you find a deal that looks promising, here are some important
elements that need to be built into the agreement between an investor and entrepreneur:
Performance goals and cost containment. If the entrepreneur does
not meet his expectations, there should be a mechanism for you to gain additional control.
You do not initially need control of the corporation as an investor; however, if the
entrepreneur does not perform, you must have the rights to control the business in order
to protect your investment.
Management salary and perks. Management salary and perks must be
limited while you are an investor.
Dividends. There must be a limit on dividends paid. If there is
no limit, the entrepreneur could siphon the cash out the business.
Check signing. For checks over a certain amount, the authority
of the management to sign checks without your approval should be limited.
Audit. The firm should provide you an annual audit of the
business.
Expenditures. Any expenditures on investments over a certain
limit must have your approval.
Employment. You should have approval power over the employment
of members of the entrepreneur's family.
Monthly reports. You should receive monthly reports on the
financial performance of the business.
Investing in a promising young company or startup is risky, but it
doesn't have to be a high-stakes game of chance. With a little bit of effort, you can
minimize the risk of your venture capital investments, thus protecting your stake and
producing higher returns.
Jerry Osteryoung is the executive
director of The Jim Moran Institute For Global Entrepreneurship at the College of
Business, Florida State University.
SIDEBAR
Matchmaking
If you've got some money in your pocket, there's always someone willing
to take it. When it comes to venture capital, finding the right marriage between those who
have the money and those who want it can be a little tricky. So, here's our matchmaking
guide:
In many Florida cities, there are venture capital clubs that hold
monthly meetings. Usually at these meetings, entrepreneurs present their business plans
and venture capitalists get a chance to network. To find one in your area, contact
Enterprise Florida at (407) 316-4646.
The mother of venture capital meetings is the Florida Venture Forum,
Inc., which will take place on Jan. 21-22, 1998, at the Biltmore Hotel in Coral Gables.
During this meeting, there is a full day scheduled for entrepreneurs to present their
plans. To register for the forum, contact Jeanne Becker at (305) 446-5060.
A venture capital network can also be a valuable source of information.
These networks give you an opportunity to review deals while remaining relatively
anonymous until you find something that looks interesting. The Jim Moran Institute offers
this service free to both entrepreneurs and angels. For more information, call (800)
821-7515.
Enterprise Florida publishes the Florida Venture Finance Directory. In
the directory, you can also find the names other venture capitalists in your area who may
be a valuable source of information. To get this reference source, call Enterprise Florida
at (407) 316-4646.
The drafting of agreements between entrepreneurs and investors is best
left to an experienced attorney. The Florida Venture Finance Directory also includes a
listing of attorneys who specialize in venture capital deals.
Another great source of deals or deal flow are attorneys and
accountants. These folks are in the communications pipeline and usually know of some
deals.
Jan/Feb 1998 -- Florida Business Insight, PO Box 784, Tallahassee, Fla. 32302
(850)224-7173, insight@aif.com
