Advice to business owners: Forget landing venture=20 capital

Despite glamorous reputation, VCs are risk = averse

Michael Brocks

After a four-year absence of any meaningful venture capital success = stories,=20 Google has every entrepreneur dreaming of grandiose wealth and VCs = actively=20 seeking the next gold mine.

Google was started six years ago by two 25-year-old graduate students = who=20 came up with a better search engine. After the IPO, each founder's stock = holdings was worth more than $3 billion.

Arguably, without the backing of a few venture capitalists (one of = whom was=20 the founder's professor at Stanford, who parlayed his $200,000 = investment in his=20 protege students into $100 million), Google may not have gotten off the = ground.=20 At a minimum, slower financing would have delayed the founders for = years,=20 perhaps even long enough to miss their market opportunity.

Google has paid off exceptionally well for its early-stage investors, = but the=20 Google story is the exception, not the norm. The norm is much less = glamorous.=20

VCs, in spite of their "cowboy" reputations, are actually quite risk = averse.=20 In order to make up for the probability of failure of their portfolio = companies,=20 they try to bet on "sure things." So, who qualifies for VC?

Star-quality leadership. The market defines a star as someone who has = taken a=20 startup from zero to $50 million in revenue.

Proprietary technology. The technology must provide a competitive = advantage=20 in an industry with very strong growth prospects over the next five = years.

A top-tier management team. Before Google had its IPO, it hired a = cadre of=20 very seasoned executives who had a history of successful IPOs. The CEO = of Google=20 is 18 years older than the founders.

A large potential market. The target market must have the potential = of=20 generating at least $1 billion in revenue.

Proven market adoption. The best companies will have made sales to = blue clip=20 customers before they are funded.

If you do not meet the above criteria, you should seriously = reconsider the VC=20 route.

There are a number of little-known statistics that entrepreneurs = should be=20 aware of before approaching VCs for investment.

Chasing outside capital is an unpleasant and drawn-out ordeal. You = will spend=20 hours polishing and presenting business plans and, more times than not, = the plan=20 will not be read by the VC before the initial meeting.

Surveys consistently report that only one company in 500 submitting = business=20 plans sees any funds from VCs. The odds are not good.

In over half of early-stage VC companies, the founders are fired = within the=20 first year. Historically, even if their companies go public, founders = have=20 difficulty selling their shares anywhere near the IPO price, because of = trading=20 restrictions and the inevitable inability to meet projected income = projections.=20

Even if you are one of the lucky few that succeed in obtaining VC = funding, it=20 is very expensive money. Let's do the math: say a VC invests $1 million = for 50=20 percent of the equity in your company, resulting in a post-funding = valuation of=20 $2 million. Three years later the company is sold for $5 million, a a=20 two-and-a-half-time increase in value.

Does the founder get $2.5 million? No. VCs will often have a = liquidation=20 preference that allows them to take out one to three times their initial = investment before any other investor receives funds. VCs will also = receive an=20 attractive dividend rate (typically, 8 percent to 10 percent per annum) = on their=20 preferred stock.

Let's assume the liquidation preference is two times and the = accumulated and=20 unpaid dividends are $ 300,000. The VC would receive $2.3 million before = funds=20 are disbursed to equity holders. The balance of $2.7 million ($5 million = less=20 $2.3 million) would be split 50 percent to the VC and 50 percent ($1.35 = million)=20 to the entrepreneur.

In this case the entrepreneur's investment has appreciated 16 percent = per=20 year and the VC, over 90 percent per year.

The decision to chase venture capital is tempting, and on the surface = is more=20 intriguing than the mundane work of building a company, and funding = growth=20 through profits and cash flow.

Clearly, the best way to finance a business is from cash flow. If you = can=20 meet expansion needs without resorting to VC funding, you should do it. = That way=20 you'll keep more of your business down the road.

MR. BROCKS is a CPA and a senior member of the American Society of = Appraisers. His firm is Michael Brocks and Associates. Contact him at=20 mbrocks@michaelbrocks.com.