Venture Capital Overview
Created by FindLaw's team of legal writers and editors | Last reviewed September 23, 2022
In the late 1990s, the Internet provided a new frontier in which entrepreneurs could try their hand at plying a trade or developing a new enterprise. While "start-up" madness may have subsided when the dot.com bubble burst in the first few years of the new millennium, it hasn't gone away. Whether on the Web or in traditional brick-and-mortar businesses, entrepreneurship is alive and well, and the problem of obtaining start-up capital for new business ventures is usually topic number one when the idea for a new business is born.
The following is an overview of the venture capital process and what you can expect if you are thinking about starting a new business.
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Sources of Venture Capital
So, you think you've got a great new idea? You believe that everyone would want your product, if only you could produce it. Where do you begin? Unlike in the past, obtaining funding today is a complex and formal dance of give and take. It is important to be aware of the patterns and progressions before stepping onto the dance floor. A venture-capital funded entity, generally, will go through four stages of development. Sources for funding will vary depending on where the company is on this time-line.
- The "Start-Up" Phase
During the first stage, appropriately called "start-up," foundation money and seed capital funding is needed. Usually, the first line of attack during this phase is the entrepreneur(s)'s family and close circle of friends. It is important to get at least one financial partner from this inner circle. Outsiders often will not have faith in a project where the entrepreneur has no demonstrable faith from close associates and family. However, the entrepreneur must be sure that this first offering complies with exemptions from federal and state registration requirements. This is to assure that the business does not give initial investors any rights that will encroach upon the venture's ability to attract other investors in the future.
Next, the "angel investor" is a remarkable boon to any company fortunate enough to attract one. Angel investors are individuals with large net worths who have a desire to invest seed money in start-up companies. The market for angel investors is private and informal. Angels usually are found by word of mouth. However, a trip to the local council on foundations for private donor information could prove helpful. The U.S. Small Business Administration estimates that, nationwide, there are approximately 250,000 active angels investing in about 30,000 companies each year.
Finally, it may be possible to obtain funding directly from your local city and state governments. Cities have become much more interested than before in attracting new companies to their economic base. Therefore, they have become very assertive in offering creative financial packages.
- Development Stage
The second stage of a venture capital funded company is called the "development stage." In this stage, the company is actively attempting to develop its main products or services. Companies in this phase typically seek investment dollars from private sources such as angel investors or venture capitalists. Due to the difficulty of raising capital at this risky stage of a company's development, initial public offerings (IPO's) may be possible as an alternate means of obtaining funding. The downside, of course, is that entrepreneurs lose a great deal of personal control when companies "go public."
- Maturity Stage
The third stage is call "maturity." During this stage, companies with established track records may obtain additional or "expansion" funding from venture capitalists or from conventional banking sources. Also, some investors who come in on the ground floor may establish a plan for investing that progresses in installments. After each installment is paid, the investor will wait to see that predetermined criteria are met before advancing the next installment. In addition, satisfied customers and strategic partners sometimes provide another source of venture capital at the "mature" stage. This is especially true if the company's customers are other institutions with a desire to form a future or continuing business relationship with the new company.
- Growth Stage
The last stage, sometimes called "growth," includes strategies for the investors to exit the enterprise, collecting their financial returns or mitigating their losses as they go. In each of these stages, conventional wisdom counsels against using a "finder." Finders often call themselves venture capitalists, consultants, investment bankers, lawyers, accountants, or business advisers. Sometimes they will help with writing the business plan, management-team recruitment, or in establishing a Board of Directors. However, they can come at high price tag, and the work may be that which the entrepreneur could produce her or himself.
What Do Investors Want?
In order to find venture capitalists or other investors who are willing to invest in a "brilliant idea," it is important to understand the transaction from the investor's point of view. That is, what do they want from the deal? Generally, they want a sound, long-term capital gain on their investment. This translates into adequate rewards for the level of risk they are willing to take. If the investor is a family member or friend, pride in the enterprise might be an intangible side benefit of the deal. Venture capitalists and other investors want a great deal of information prior to signing on to a project. They will want specific guarantees, and often will require contractual language that allows them to "take over" if the project does not proceed according to plan. In return, they contribute capital, business skills and expertise to the enterprise.
Selling the Plan
To be able to convince an investor that a company is an economic winner, one must have several factors firmly in place: First, the company will need an excellent business plan that gives a clear description of the product or service offered and of the targeted purchasers. The business plan must describe the size and nature of the projected market and must provide a detailed discussion of the business operations needed to reach that market. It should include biographies of key management personnel, executive compensation schemes and option plans, as well as a discussion of other staffing needs. The assistance of an experienced attorney may be helpful when developing this very important document.
Investors also look for the following factors: a solid management team; competitive, strong muscle in relation to existing and foreseeable industry challengers; and a business venture with divers and sustainable product offerings, as opposed to a "one-note Charlie" type product line. It is also important to have revenues that demonstrate the existence of a real business, not simply a brilliant idea. Investors also want to see a solid corporate entity with a committed set of business professionals already on board, ethical legal practices, and safeguards to protect copyrights, patents, trademarks and other proprietary information.
In sum, when starting a business the new entrepreneur should surround him or herself with knowledgeable business associates. This will go far in preventing that original brilliant idea from being tarnished by the complexities of finding sources of venture capital. In addition, legal assistance will become indispensable when negotiating agreements and, will be especially necessary if the company chooses to go public. With proper management and attention to detail, starting a new business venture can be an exciting journey.
How a Business Law Attorney Can Help You
If you are seeking the assistance of a venture capitalist to fund your new project, speak to a business law attorney today. Business law attorneys are knowledgeable about the complicated details that go into funding negotiations and will be able to guide you through the process.
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