INFORMAL RISK CAPITAL MARKET

Introduction The informal risk capital market is the most misunderstood type of risk capital. It consists of virtually invisible group of wealthy investors, often called Business angels, who are looking for equity-type investment opportunities, in a wide variety of entrepreneurial ventures. Typically investing anywhere from $10,000 to $500,000, these angels provide the funds needed in all stages of financing, but particularly in start-up (first stage) financing. Firms funded from the informal risk-capital market frequently raise second- and third-round financing from professional venture-capital firms or the public-equity market. Despite being misunderstood by, and virtually inaccessible to, many entrepreneurs, the informal investment market contains the largest pool of risk capital in the United States. Although there is no verification of the size of this pool or the total amount of financing provided by these business angels, related statistics provide some indication. A 1980 survey of sample of issuers of private placements by corporations, reported to the Securities and Exchange Commission under Rule 146, found that 87 percent of those buying these issues were individual investors or personal trusts, investing an average of $74,000. Private placements filed under Rule 145 averages over $1 billion per year. Another indication becomes apparent on examination of the filings under Regulation D-the regulation exempting certain private and limited offerings from the registration requirements of the Securities Act of 1933, discussed in Chapter 11. In its first year, over 7,200 filings worth $15.5 billion were made under Regulation D. Corporations accounted for 43 percent of the value ($6.7 billion), or 32 percent of the total number of offerings (2,304). Corporations filing limited offerings (under $500,000) raised $220 million, an average of $200,000 per firm. The typical corporate

issuers tended to be small, with fewer than 10 stockholders, revenues and assets less than $500,000, stockholders equity of $50,000 or less, and five or fewer employees. Characteristics of informal investor Demographic pattern and relationship Well educated, with many having graduate degrees. Will finance firm anywhere, particularly in the United States. Most firms financed within one days travel. Majority expect to play an active role in ventures financed. Many belong to angel clubs.

Investment Record Range of investment : $10,000 - $5,00,000 Average investment : $50,000 One or two deals each year.

Venture Preferences Most financing in start-ups or ventures less than 5 years old Most interested in financing o Manufacturing industrial/commercial products o Manufacturing - consumer products o Energy/natural resources o Services o Software

Risk/Reward Expectations Median 5 - year capital gains of 10 times for start-ups Median 5 - year capital gains of 6 times for the firm under 1 year old Median 5 - year capital gains of 5 times for firms 1-5 years old Median 5 - year capital gains of 3 times for established firm over 5 year old

Reasons for rejecting proposal Risk/return ratio not adequate Inadequate management team Not interested in proposed business area Unable to agree on price Principle not sufficiently committed Unfamiliar with area of business

VENTURE CAPITAL
The important and little understood area of venture capital will be discussed in terms of its nature, the venture-capital industry in the United States, and the venture-capital process. Nature of Venture Capital Venture Capital is one of the least understood areas in entrepreneurship. Some think that the Venture capitalists do the early stage financing of relatively small, rapidly growing technology companies. It is more accurate to view venture capital broadly as a professionally managed pool of equity capital. Frequently, the equity pool is formed from the resources of wealthy limited partners. Other principal investors in venture-capital limited partnerships are
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pension funds, endowment funds, and other institutions, including foreign investors. The pool is managed by a general partnerthat is, the venture-capital firmin exchange for a percentage of the gain realized on the investment and a fee. The investments are in earlystage deals as well as second- and third-stage deals and leveraged buyouts. In fact, venture capital can best be characterized as a long-term investment discipline, usually occurring over a five-year period, that is found in the creation of early-stage companies, the expansion and revitalizing of existing businesses, and the financing of leveraged buyouts of existing divisions of major corporations or privately owned businesses. In each investment, the venture capitalist takes equity participation through stock, warrants, and/or convertible securities and has an active involvement in the monitoring of each portfolio company bringing investment, financing planning, and business skills to the firm.

VENTURE CAPITAL PROCESS To be in a position to secure the fund s needed, an entrepreneur must understand the philosophy and objectives of a venture-capital firm, as well as the venture-capital process.
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The objective of the venture-capital firm is to generate a long-term capital appreciation through debt and equity investments. To achieve this objective, the venture capitalist is willing to make any changes or modifications necessary in the business investment. Since the objective of the entrepreneur is the survival of the business, the objectives of the two are frequently at odds, particularly when problems occur. A typical portfolio objective of typical venture-capital firms in terms of return criteria and risk involved is shown in figure below. Since there is more risk involved in financing a business earlier in its development, more return is expected from the early-stage financing (50 percent ROI) than from acquisitions or leveraged buyouts (30 percent ROI), the late stage in development. The significant risk involved and the pressure that venture-capital firms feel from their investors (limited partners) to make safer investments with higher rates of return have caused these firms to invest even greater amounts of their funds in the later stages of financing. In these late-stage investments, there are lower risks, faster returns, less managerial assistance needed, and fewer deals to be evaluated.

The venture capitalist does not necessarily seek control of a company, but would rather have the firm and the entrepreneur at the most risk. The venture capitalist will want at least one seat on the board of directors. Once the decision to invest is made, the venture capitalist will do anything necessary to support the management team so that the business and the
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investment prosper. Whereas the venture capitalist expects to provide guidance as the member of the board of directors, the management team is expected to direct and run the daily operations of the company. A venture capitalist will support the management team with the investment dollars, financial skills, planning, and expertise in any area needed. Since the venture capitalist provides long-term investment (typically five years or more), it is important that there be mutual trust and understanding between the entrepreneur and the venture capitalist. There should be no surprises in the firms performance. Bothe good and bad news should be shared, with the objective of taking the necessary action to allow the company to grow and develop in the long run. The venture capitalist should be available to the entrepreneur to discuss the problems and develop strategic plans. The venture capitalist expects a company to satisfy three general criteria before he or she will commit to the venture. First, the company must have a strong management team that consists of individuals with solid experience and backgrounds, a strong commitment to the company, capabilities in their specific areas of expertise, the ability to meet challenges, and the flexibility to scramble wherever necessary. A venture capitalist would rather invest in a firstrate management team and a second-rate product than the reverse. The management teams commitment should be reflected in dollars invested in the company. Although the amount of the investment is important, more telling is the size of this investment relative to the management teams ability to invest. The commitment of the management team should be backed by the support of the family, particularly the spouse, of each key team player. A positive family environment and spousal support allow team members to spend the 60 to 70 hours per week necessary to start and grow the company. One successful venture capitalist makes it a point to have a dinner with the entrepreneur and spouse, and even visit the entrepreneurs home, before making an investment decision. According to the venture

capitalist, I find it difficult to believe an entrepreneur can successfully run and manage a business and put in the necessary time when the home environment is out of control. The second criteria is that the product and/or market opportunity must be unique, having a differential advantage in the growing market. Securing a market niche is essential since the product and the service must be able to compete and grow during the investment period. This uniqueness needs to be carefully spelled out in the marketing portion of the business plan and is even better when it is protected by a patent or a trade secret. The final criterion for investment is that the business opportunity must have significant capital appreciation. The exact amount of capital appreciation varies, depending on such factors as the size of the deal, the stage of development of the company, the upside potential, the downside risks, and the available exits. The venture capitalist typically expects a 40 to 60 percent return on investment in most investment situations. The venture-capital process that implements these criteria is both an art and a science. The element of art is illustrated in the venture capitalists intuition, gut feeling, and creative thinking that guide the process. The process is scientific due to the systematic approach and data-gathering techniques involved in the assessment. The process starts with the venture-capitalist firm establishing its philosophy and investment objectives. The firm must decide on the following: the composition of its portfolio mix, including the number of start-ups, expansion companies, and management buyouts; the types of industries; the geographic region for the investment; and any product or industry specializations. The venture-capital process can be broken down into four primary stages: preliminary screening, agreement on principal terms, due diligence, and final approval. The preliminary

screening begins with the receipt of the business plan. A good business plan is essential in the venture-capital process. Most venture capitalists will not even talk to an entrepreneur who doesnt have one. As the starting point, the business plan must have a clear-cut mission and clearly stated objectives that are supported by an in-depth industry and market analysis and pro forma income statements. The executive summary is an important part of this business plan, as it is used for initial screening in this preliminary evaluation. Many business plans are never evaluated beyond the executive summary. When evaluating the business, the venture capitalist first determines if the deal or similar deals have been seen previously. The investor then determines if the proposal fits in his or her long-term policy and short-term needs in developing a portfolio balance. In this preliminary screening, the venture capitalist investigates the economy of the industry and evaluates whether he or she has the appropriate knowledge and ability to invest in that industry. The investor reviews the numbers presented to determine whether the business can reasonably deliver the ROI required. In addition, the credentials and capability of the management team are evaluated to determine if they can carry out the plan presented. The second stage is the agreement on principal terms between the entrepreneur and the venture capitalist. The venture capitalist wants a basic understanding of the principal terms of the deal at this stage of the process before making the major commitment of time and effort involved in the formal due diligence process. The third stage, detailed review and due diligence, is the longest stage, involving anywhere from one to three months. There is a detailed review of the compan ys history, the business plan, the resumes of the individuals, their financial history, and target market customers. The upside potential and downside risk are assessed, and there is a thorough evaluation of the markets, industry, finances, suppliers, customers, and management.

In the last stage, final approval, a comprehensive, internal investment memorandum is prepared. This document reviews the venture capitalists findings and details the investment terms and conditions of the investment transaction. This information is used to prepare the formal legal documents that both the entrepreneur and venture capitalist will sign to finalize the deal. Locating Venture Capitalist One of the most important decisions for the entrepreneur lies in selecting which venturecapital firm to approach. Since venture capitalists tend to specialize either geographically by industry (manufacturing industrial products or consumer products, high technology, or service) or by size and type of investment, the entrepreneur should approach only those that may have interest in the investment opportunity. Where do you find this venture capitalist? Although venture capitalists are located throughout the United States, the traditional areas of concentration are found in Los Angeles, New York, Chicago, Boston and San Francisco. An entrepreneur should carefully research the names and addresses of prospective venture-capital firms that might have an interest in the particular investment opportunity. There are also regional and national venture-capital associations. For a nominal fee or non at all, these associations will frequently send the entrepreneur a directory that lists their members, the types of businesses their members invest in, and any investment restrictions. Whenever possible, the entrepreneur should be introduced to the venture capitalist. Bankers, accountants, lawyers. And professors are good sources for introductions.