Overview
A venture capital firm talks about their selection criteria and unwritten rules for selecting new ventures for investment.
Introduction to Venture Capital
Funding is a critical element for the establishment and growth of a business venture. Whether it’s from a personal savings account or a large corporation’s public offering, money is always a concern of the entrepreneur or corporate monarch. A seasoned business person said that, “Entrepreneurs’ never fail, they give up!” A lack of money often results in a company’s failure.
A venture’s resourcefulness locating investment capital is vital for its development. The first place entrepreneurs usually look for funding is FFA – Family, Friends, and Associates. Asking Mom or Dad for $5,000 to buy circuit board components is not unheard of; some notable entrepreneurs have made their start this way. Ted Waitt, the founder of Gateway 2000 Computers, started from a farmhouse workshop with a loan secured by his grandmother. However, there is the added emotional burden to repay the loan because it has come from a relative or friend.
Another funding option is a loan from a financial institution, although they are typically reluctant to finance new ventures. For an established company with a proven track record or an upstart company with tremendous earnings potential, an Initial Public Offering (IPO) may be the answer to their funding needs. An IPO provides an investor an opportunity to buy the initial public issuance of stock in a company. Netscape Communications’ IPO was heavily subscribed because of investors belief in the company’s Internet technologies and products.
Venture Capital(VC) has grown since the late 1980’s as a funding resource for emerging businesses. VC firms are usually private investment organizations that finance new companies. The firms want their investments to have a rate of return commensurate to the high risk. There are a variety of VC firms, each with different investment goals and preferences, for aspiring entrepreneurs to solicit for seed money. Some VC companies focus only on particular industries, while others have diverse holdings. The funding range is from $20 million to $800 million according to this article’s expert.
For a new business, arranging a finance deal with a VC firm is as much an art as it is a science. The entrepreneur’s concept and business plan are scrutinized by business and financial experts. They also assess the entrepreneur’s personality and business savvy. If the VC firm decides to fund the venture, it wants a substantial investment return and usually a seat on the company’s board of directors. The EM visited with Bob Crowley, Executive Vice-President of the Massachusetts Technology Development Corporation, to see how this VC firm evaluates a new opportunity and what advice Bob has for the finance seeker.
Massachusetts Technology Development Corporations – MTDC
The MTDC is a unique VC corporation because it is owned by the Commonwealth of Massachusetts. According to Bob, the typical VC firm is a privately-held partnership that lasts about ten years. The MTDC was founded in 1978 from an initial grant of $3 million from the Federal Government under the Economic Development Administration Program. An additional $5 million was granted by the Commonwealth. The charter of the MTDC defines its investment criteria and restrictions. The most significant restriction on the MTDC – it can only fund companies within Massachusetts. The reasons for this mandate are as follows: job creation ; nurturing entrepreneurs; fostering long-term economic development; and helping companies become technological leaders within their industries. The firm has made eighty investments since 1978, and today, its fund has a net worth of $20 million.
“The fact that we are a State owned corporation differentiates us from the traditional VC firm in two distinct ways. The first is that since we are a corporation we theoretically have an unlimited life span. Therefore as long as we continue to make investments and earn a return that goes back into the corporation, we can continue to stay in business. The typical VC firm is a limited partnership that lasts about ten years. Although this VC firm may have an aggressive investment philosophy by funding early stage companies that are typically riskier, as the age of the firm approaches its intended life-span they will cease to invest in such opportunities as the return from such an investment will go well beyond the life of the fund. We have the ability to invest in such long-term investments continually.” An interesting consideration affecting the decision-making process of a VC firm. Because the MTDC is state-owned, it is not structured to earn a return for private investors.
The MTDC has funded numerous companies that have become commercially successful, and even several that have become publicly-held. Some of its notable alumni includes Powersoft Corporation, Xylogics,Interleaf, Zoom Telephonics, and Aspen Technologies. The current portfolio of thirty-three companies includes Endogen, Voicetek Corporation and PixelVision (featured in the third issue of The EM). Overall, fifteen of the MTDC’s companies have gone public, seven were acquired for a profit, seven were acquired for no profit, and twelve have gone out of business with no return to the firm.
Bob’s functions as the Chief Investment Officer which means he reviews all of the plans submitted to the firm. All deals must be approved by the Board of Directors that meets every five weeks. Bob and his team analyzes and summarizes the company’s business plan, meets its management, and then gives their recommendations to the Board. The Board reviews and evaluates the opportunity. “Our relationship with the board is very good, and although they are by no means a rubber stamp, they approve 9 of the 10 deals that we submit.” A testament to the thoroughness and skill of Bob and his team.
Bob has over thirty years experience in the financial industry as a loan officer and president of both small and large commercial banks. He has been with the MTDC since 1978. The rest of the professional staff consists of six people with backgrounds in accounting business development, law, investment banking, and other corporate capital work. Their roles are opportunity assessment, corporate analysis and due diligence, and portfolio management.
The typical outlay by the MTDC to emerging companies is approximately $250,000 to $300,000 of an entire need of $1 million to $1.5 million. The balance is provided by partner firms such as banks or other VC firms. The firm tries to build six to eight deals a year. While this amount may appear small compared to the investments of other VC firms, it meets the needs of a growing number of companies that fall in the “capital gap.” “Back when I started in 1978 a good size fund was $20 million. It is now anywhere from $200 million to $800 million. The problem with that is that the companies now that are seeking $1 million to $2 million will not get a hearing from these large funds because it is a decimal point to them. This is what is known as the capital gap and it has gotten more severe because of all the money going into these larger funds. Our job to is look at situations that may be overlooked by traditional VC firms because of their vision to only look at large opportunities where many millions of dollars are required by the venture.” Another facet to the smaller start-up with these modest levels of financial needs is that this level of funding is also tell-tale of the maturity of the company and experience of the founders. “We nurture entrepreneurship where other firms will not invest in companies where the entrepreneur is a first time CEO. A lot of funds do not want to invest in a rookie unlike MTDC which is willing to invest in a Drew Bledsoe rather than a Troy Aikman.”
Meeting the VC Firm – The Evaluation Begins
“One of the interesting things about being in the money business is that people will find you. The product I sell is not a difficult product to sell.” With its sponsoring of business conferences and exhibiting at forums, the MTDC actively markets itself to the business community and to entrepreneurs. “Fortunately for us our restriction to only do business within Massachusetts does not hinder us because Massachusetts is such a strong breeding ground for entrepreneurs. It’s also good in that we don’t spend a lot of time on airplanes.” Whether a company has found the firm through a blind mailing, or by speaking to a staff member at a trade show, there are many ways to establish a relationship with the MTDC.
When Bob receives a business plan, first he reviews its potential. Bob places considerable value on the business plan. It is not the sole criterion for a proposal, but it reflects upon on the entrepreneur’s credibility and diligence. “This is probably true for any VC firm, the business plan is a reflection of how committed somebody is to the idea. I could spend all day chatting with people about an idea. But it is a tool of self selection because if somebody doesn’t want to sit down and put a business plan together, I don’t want to talk with them. It is a reflection of the person’s commitment to the project.” There are different ways to create a business plan and many reference materials available on the subject (see the second issue of The EM , Arthur Andersen’s “Summary of a Business Plan”). Whatever method a company uses, there are key features and information that should be communicated to the potential investor. “I have never seen a perfect business plan and I don’t think one exists. I think the intent is to give some idea as to what the opportunity is. There is nothing wrong in using a business plan in using simple layman’s language. When I evaluate a plan I considers the ‘eyes glaze over factor’ which is how long it takes for my eyes to glaze over when I am reading the business plan. If my eyes glaze after only two pages, that’s bad.”
What message should be conveyed in the business plan? Bob answers this question using a historical analogy, “In 1858 the statement was made that if you build a better mousetrap the world will beat a path to your door. What people don’t realize is at that time mice were a huge problem in the world unlike today.” In other words, marketplaces change, and you have to provide solutions for needs. “Unless you have a market for your product, it won’t work. What I want to know is does the entrepreneur understand the marketplace they are in?” Generally he really doesn’t want to know how a product works. He wants to know what problem does it solve. “If you’re not solving a problem you’re not going to sell much. With technology companies there are feelings that if the consumer doesn’t buy the product it’s the customer’s fault…wrong! There tends to be too much time spent on what the product does and how it does it than why it’s important. I would say that many first time technology entrepreneurs make that mistake and give long doctoral dissertations as to the value of the technology…I couldn’t care less. I want to know what problem does it solve.”