Categorized | venture capital

A beginner’s guide to venture capital: the players

Shoestring Venture aims to be helpful to anyone and everyone starting a business, from solopreneurs operating a venture from their kitchen table to bricks-and-mortar small business owners to your standard, Sand Hill Road entrepreneur looking to score some big start-up money and create the next Twitter. Going the venture capital route is not for everyone — particularly since the recession has made venture capitalists far more cautious and less inclined to be bamboozled by future phantom revenues and profits.

But if you’re considering raising some capital and you’ve never really gone the venture capital route, you probably think of venture capital as this monolith, when in fact, like Transformers, it takes several different forms relative to the nature of the investment and the investors. I hear it all the time in my consulting practice, “I’m thinking of approaching venture capitalists, but this is what I heard . . .” To which I answer, “Why just limit it to VCs? It seems that an SBIC would be more appropriate and easier to pitch in your situation.” To which they say . . . as you probably are saying right now . . . “huh?”

So we offer this humble little introduction to the forms and species that venture capital funding takes, along with some helpful links to the folks who do this stuff. So if you’re thinking about rolling the die in the venture capital casino, you’ll have some idea how these various players work.

Private equity
All venture capital funding is private, as opposed to public, equity funding. Simply put, private equity is simply buying and owning stock in a non-public company. Private equity investors typically make the investment with the understanding that the company will at some point in the future offer stock for public sale, at which point the private equity investors can cash out some or all of their shares at a substantial profit.

Because of the enormous risk private equity investing poses to the general investing public, the SEC carefully regulates who and what can invest in private equity. Only “accredited” investors can participate in private placement.

What distinguishes the various types of “venture capitalists” or “venture capital funds” is how creatively they get around the SEC restrictions in private placements. But while the central difference between entities such as venture capital funds, SBIC’s, and BDC’s are how investors buy into private equity, these differences do mean that each type of private equity investor differs in the types and amounts they invest as well as the types of businesses they’ll invest in.

A substantial amount of venture capital funding comes from the business owner, spouses, sisters, cousins, parents, and friends, a group generally lumped under the FFF rubric (for “friends, family, and fools”). This funding can take several forms including something as simple as open-ended non-equity investment (simply throwing money into the business). Startups and small businesses can usually raise only a few tens of thousands to the low hundreds of thousands of dollars from FFF sources. Because of the small size of these investments, FFF private equity and investment is not regulated by the SEC.

Angel investor
While the term is often used loosely, technically an angel investor is the simplest, most basic form of private placement, that is, an individual who invests capital in a business for either equity or convertible debt. Angels invest their own money and so they’re subject to SEC accreditation rules if the amount they invest is high enough. An angel investor usually provides startup or seed money, and typically invests more than FFF (a couple hundred thousand dollars) but less than a venture capital fund (one to two million dollars). Angel investors are typically a second-round investor (after FFF). They represent about half of startup funding in this country.

Angel investors typically take a large share of the company because of the high risk they bear. Angel investors are looking for investments that promise to return anywhere from 10x to 30x the original investment in five to seven years; the only way to secure returns like that is to gobble up as much equity as possible. (The typical angel investor portfolio returns around 20% to 30% over 5 years). There are about a quarter million angel investors in the U.S.

Angel investor groups
As the name says, angel investors have in the last few decades pooled their resources and formed groups — most of these groups are regional groups of angel investors. Groups allow investors to share due diligence and make larger investments in startups with pooled money, as well as provide needed mezzanine financing. Some of the larger angel investor groups have professional staff and working investment funds, approximating something like a venture capital firm. But the basic angel investor logic still holds: these are individuals looking to take a large stake in a company by providing capital funding. There are slightly more than 300 angel investor groups with more than 12,000 angel investors participating.

Venture capital funds
These are the folks that are constantly in the news (even though they represent a minority percentage of startup funding). While angel investors are subject to SEC accreditation rules, venture capital funds get around these rules by offering investors small stakes in several startup companies, thus limiting their exposure to any one company. They do this by creating venture capital funds in various formats, usually a limited partnership. Investors typically purchase shares in the partnerships and the funds are used to make equity (and some debt) investments in startup companies. Still, most venture capital funds tend to be institutional investors and affluent individuals. Unlike angel investors, venture capital funds have professional staff with a focused set of skills (such as biotechnology or software). They typically fund startups within their core areas of investment competence and that have the potential for breakthrough products or technology. Because of this, it’s incumbent on the startup managers to target their pitch to the right sorts of funds.

Since the typical VC fund has a limited lifetime, it goes through its own lifecycle. At the beginning of the fund, investments are made in startups. As the fund matures, the investment strategy focuses on growing and helping the startups already funded to realize their maximum potential. As a result, VC firms take a heavy hand in the management of portfolio companies. A VC fund’s minimum investment comes in at about $1-2 million, so venture capital funds are typically a second or third round of funding after FFF and angel investors. But it has happened — but it hasn’t happened often — that a bright young thing with a good idea scratched on a napkin has scored.

Business Development Company
Although largely ignored by the mainstream press, BDC’s are a significant source of startup financing — over $2 billion last year alone. Although BDC’s make the same sort of private equity investments as venture capital funds, they raise the capital by selling publicly-traded shares in their own company. In this way they can get totally around SEC regulations, since there are no investor restrictions on buying stock in a publicly-traded company. In order to avoid corporate taxes (as “Regulated Investment Companies”), BDC’s typically distribute 90% or more of their profits to shareholders (so only the shareholders get taxed). Their portfolios are also highly diversified in a way that VC funds typically are not. BDC’s work with a permanent capital base, offer loans as well as equity investments, and usually offer mezzanine financing, as well (VC funds will help with mezzanine funding, but typically don’t provide it themselves).

But because they are working with permanent, but limited, capital, they take an enormous interest in making sure the companies they invest in grow to their fullest potential. As a result, a BDC typically exerts much control over the business. They focus almost entirely on ongoing small or middle market businesses.

Small Business Investment Company (SBIC)
SBIC’s, as the name implies, provide equity capital, long-term loans, and management assistance to small businesses as defined by the Small Business Administration. SBIC’s must be licensed by the SBA, but they are profit-seeking enterprises. While many are excellent sources of SBA loans, SBIC’s are required by law to devote a certain amount of their capital to equity investments in small businesses (but without assuming the legal and financial responsibilities of a General Partner). Many “start-ups” I’ve worked with are in reality ongoing small businesses; where they’ve failed with venture capitalists and angel investors, they’ve come up roses with an SBIC.

Specialized Small Business Investment Company
An SSBIC is an SBIC that targets entrepreneurs and small business owners that, on account of racial, social, or economic disadvantages, don’t have the same opportunities as other entrepreneurs.

An incubator has nothing to do with funding, though many VC’s and SBC’s also serve as incubators. An incubator simply provides consulting, facilities, and services to startups to help them grow — about half of incubated companies set up operations in an incubator facility. Most incubators are non-profits — they are able to invest their time, expertise, and facilities because of donations and public money. Because of this, incubators often require a rigorous application process. Incubators typically serve a startup at its very inception; the incubation period averages around 32 months and requires that the business meet rigorous benchmarks. (While 90% of startups fail in the first five years, only 13% of incubator-graduated businesses fail). There are about 1,200 incubators in the U.S.

Small Business Development Centers (SBDC)
Like incubators, SBDC’s do not offer funding, but they do provide many of the same services incubators do for small businesses rather than start-ups. While incubators require an application process, SBDC’s are legally required to provide help to any small business that asks for it. It’s not unusual for incubators to team up with SBDC’s and offer complementary services.

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