Adventures in Venture Capital
Part 1

By LouAnn Lofton (TMF Lou2)
February 22, 2000

The world of venture capital sometimes can seem almost mystical to individual investors. Even a casual glance at the stock market recently reveals Internet company after Internet company "going public" -- all seemingly brought to the stage by people hidden like the Wizard of Oz behind curtains in Silicon Valley. Today, let's pull back those curtains and explore this enigma known as "venture capital," what start-ups seeking money do to get it, and what trends are developing in the venture capital area.

Venture capital (VC) is defined as money provided to young companies to help them develop. The needed funds are anted up by professionals, who in providing the money to help the budding start-ups get off the ground (or to help more established young companies move forward) get equity, or ownership, in the company. Venture capital funding is an important source of cash flow for young companies. Any company of any type can receive venture capital funding, though according to a Pricewaterhouse Coopers survey just released, technology companies accounted for over 90% of venture capital investments in 1999.

New, growing companies also need guidance, help, and contacts to ensure that they develop according to plan. Venture capitalists (VCs) can provide all this in addition to the money they front. Venture capitalists only invest in a tiny number of the total companies that come knocking at their door for help. It's in the interest of the VCs, and in the interest of the company receiving funding, to do all that's necessary to make sure the company grows to meet the expectations that have been set.

Venture capitalists can help a young company find a chief executive officer, for example. Or they can ensure that the company's production lines are as efficient as possible by bringing in outside advisors to reorganize its facilities. The VCs really act as partners in the business to help it grow. Of course, the aims of the VCs are not altruistic. They understandably seek to get the maximum return on their investment, since they are assuming some of the risk inherent in investing in a young company. The unknown variables that can affect the future of a new company are many, therefore venture capital is really a game of high risk offset with reasonable expectations in an uncertain environment.

Who are these "professionals" who swoop down and offer money and help to infant companies? In the 1950s and '60s, most venture capitalists were individuals who invested their own money in small companies. This type of venture capitalist is also known as an "angel investor." Today, though, most venture capitalists are firms, typically organized as limited partnerships. They are usually independent and have no affiliations with any other financial institutions. The firm pools money from many sources -- individuals, corporations, or endowments, for example -- and invests that money into young companies. The firm can effectively decrease its risk by developing a portfolio of start-up investments into a single pool, or fund, of money. It's akin to diversifying risk in your stock portfolio.

Need Some Cash for Your Company?

When a young company finds itself in need of venture capital, it must go out and seek it. This process involves having a complete and coherent business plan, as well as a reasonable vision for the future of the company and knowledge of what risks stand in the way of achieving that vision. The start-up has to sell itself to the venture capitalists. The company has to show the VCs why investing in it, as opposed to the many other offers on the VCs' table, is the way to go. It must demonstrate that a high rate of return for the VCs' investment is likely. Without making this point crystal clear, most start-ups will have a hard time finding funding.

Usually, the start-up will go to several VC firms to pitch itself. If a VC firm responds positively and wants to invest, then the valuation battle begins. In order for the VCs to invest, a valuation for the young company must be determined. Since the company is not yet publicly traded, and may never be, determining valuation is a nebulous process. The VCs will want the valuation to be less than the start-up does, so that they will get more for their money. The start-up, logically, will want the valuation to be higher so that it gets more money to work with. For example, if a VC firm decides to buy 10% of a company, the lower it can get the valuation the better (for it) -- 10% of $300 million is vastly different than 10% of $150 million.

Further, valuation is tied to when a company receives venture capital financing. The earlier in the game the money comes in, the more conservative the valuation will be, because of the extended length of the investment. It's a time-money trade off for the VCs. The more time they have to put into an investment, the less money they want to spend. Later-stage VC investments, especially those with an eye towards going public, can justify higher valuations.

Part 2: Going Public, the Downside, and New Trends »