Why Your Company Won't Get Venture Capital Financing
A few weeks ago, I discussed several different methods of financing a new business or providing for the ongoing capital requirements of an existing business (click here to read the blog). I touched on the difficulties inherent in trying to get bank or venture capital (“VC”) financing, and promised to discuss those issues further in a future blog. Not one to break a promise, this is that blog.
Let’s start with bank financing before we get to VC financing. I’ll be blunt: generally speaking, most start-ups aren’t bankable (meaning they’re not good candidates for a bank loan). Banks tend to require an operating history, several years of audited tax returns, net operating income at a specific multiple of the anticipated debt service, accounts receivable or hard assets that can be pledged as security, and spectacular credit scores by the principals. Not to mention personal guarantees. If your company (or you, as the case may be) isn’t/aren’t able to produce most or all of these things, guess whose house is going to be mortgaged as collateral on the loan (assuming you’ve got equity in your house)?
That said, there are certainly lending programs at most banks that are geared towards specific types of startup businesses. Dental and medical practices come to mind, which are bankable for a variety of reasons that are beyond the scope of this blog. However, most new businesses simply won’t qualify for bank financing, particularly in light of the new-found lending conservatism brought on by the latest recession.
Which brings us to VC, and why your odds of getting VC financing are slim.
Venture capital financing is, for the most part, limited to Silicon Valley technology wonks whose companies can deliver scalable businesses, proprietary technology (i.e., patented or patentable), and a minimum 35% pro forma return on equity with an ironclad exit strategy in 5 years or less. In other words, unless you’ve got a biotech, software, or alternative energy company with a defensible patent (VCs hate competition), you’re unlikely to be attractive to a VC firm.
Additionally – and I can’t overemphasize this – VCs are looking for stellar management whom they trust implicitly. The way they get to trust you is by knowing you. And the way they get to know you is by being introduced to you by someone they already trust. So if you’ve got a couple Wharton MBAs and a Stanford electrical engineer with 4 fuel cell patents to his credit on your executive management team, and you know a guy who works for Draper Fisher Jurvetson, congratulations! You might actually stand a chance of getting a VC firm to actually read your business plan. Continuing the theme, it also wouldn’t hurt if you’ve run and successfully sold or gone public with a previous company. And made lots of money for your previous investors in the process.
Finally, it’s useful to recognize that most VC investments don’t occur at the startup phase, but rather in a later round of financing, and most often in an amount equal to several million or tens of millions of dollars. This means that even if you do eventually get VC financing, you’d still need to rely on the 3 F's in the earlier stages of financing your business. Now, I realize that the idea of getting an infusion of capital amounting to several million dollars from a VC would make the principals of most small to medium sized businesses salivate, but consider this: could you produce a realistic business plan and a full set of pro forma spreadsheets demonstrating to the VCs how you plan to turn an $8,000,000 investment in your construction framing business into a $4,000,000 profit, PLUS return of their initial investment, PLUS a successful IPO or sale of your company, all in 36 months? Probably not.
The simple math of the matter is that very few people, or companies, will qualify for VC financing. Factor in the sheer volume of business plans and elevator pitches that the typical VC sees and hears in a given year, and the fact that the volume of all VC financing has been severely reduced as a result of the recession, and the odds of a successful VC investment in your company become slimmer still. Which is why I pointed out in my last blog that the most likely source of funds for your business is the 3 Fs.
Questions? Comments? Concerns? Raise it for discussion on Facebook, Twitter, or LinkedIn.
But I digress. “Corporate formalities” is a term with which you ought to become familiar if you intend to run, or are already responsible for running, a business.