Venture capital or vulture capital?

Venture capital or vulture capital?Venture capital remains an option for businesses in the current economic climate, but watch it doesn’t transform into vulture capital.

In tough times, it’s critical to establish capital formation options and strategies well before funding is required. Expect a six-month lead time from your first meeting to a cheque. A last moment dash for cash probably will fail. Cash requirements driven by success and rapid growth are as critical as cash required to save a failing enterprise from insolvency. Rapid growth results in increasing needs for working capital to fund expanding debtors, inventories and work in process.

Banks, which demand collateral security, have established lending limits on SMEs and generally don’t provide cash to fully fund rapid growth. Cash to avoid insolvency is really only an owner or friends possibility.

Venture capital (VC) does not include business angel (or high net worth individual or family) funding. Business angels provide more funding in most markets than venture capitalists (VCs). There are relatively few VCs in Australia that provide funding for SMEs.

High growth tolerance is essential

VCs expect ten times their money back in a few years, every time they decide to invest. They don’t always achieve such stunning returns, but they always seek them. Founders of companies such as Seek, RSVP, Computer Share and Wotif have produced stunning returns for themselves and any investors they chose to participate.

To achieve very high rates of return on investments, VCs want companies to grow dramatically, and during the high growth period burn the cash invested by the VC. But at a point along the growth curve, most VCs will want the investee to produce profits, particularly in today’s market, where valuations based on revenue are not common. “Volume is vanity–profit is sanity.”

If your business is unable to use a VC’s invested capital to achieve rapid growth, which of course implies risks, then a VC will go elsewhere. And if a VC does invest with the expectation of rapid growth and rapid growth fails to materialise, then there will be disappointment and conflict.

So before taking on a VC investor, SME owners need to carefully consider whether they can cope with an extended period of relentless high growth. ‘Executive burnout’ is not uncommon during a sustained high growth period. If the founder/CEO can’t manage high growth, then the VC will assign them to a lesser role, or ditch them.

Exits are a certainty

SME owners need to clearly recognise that VCs only invest to exit. This principle is enshrined in various provisions of a VC’s shareholders’ agreement. VCs can talk about “patient capital” but most are highly impatient to exit and reap the profits on their investment. So, if SME owners baulk at the certainty that their business will be sold within say five years, VC investment is not an option. It’s possible that a VC will exit an investment by sale of their equity back to the founders, but this is unusual and more of a failure scenario than a success scenario.

VCs will spend time and effort before investing to research and identify exit options before they invest. There will be an exit plan and timing in the VC’s file. This plan will be contingent on market circumstances, the performance of the business (below, at or above an agreed business plan) and the needs of the VC to produce profits for the VC’s investors and the VC’s team, who share in profits achieved.

You should also consider the possibility of the VC exiting at an attractive price for their equity in your business, but leaving you and your team to soldier on. There are typically provisions in VC shareholder agreements that enable the VC to exit alone. A buyer of the VC’s equity may want the other shareholders–particularly if they are the drivers of the business–to remain indentured for years under new ownership. Most trade buyers of businesses will want to buy 100 percent of the equity, including founders’ equity, but not always.

If contemplation of a sale of “your finest work” brings heart palpitations, a VC investment is not for you.

VC’s are intrusive

In the early days of VC operations in Australia, with SME investments of say up to $5million, VCs would pick winners, and watch them run the race from the members’ enclosure. Today, the successful SME VCs ride winners and make winners. You need to test the chemistry between you and the VC executive who will be literally on your back for probably the entire period of the investment, through to the exit.

If the particular VC executive is capable and experienced in your business sector, and has the skills and capabilities to help grow your business, then this is a material value add. If the particular VC executive that manages your company as an investee is “toxic” or incapable, then this will cause major problems. While the VC executive can probably fire you, this right is non-reciprocal. You may be stuck with a toxic or inexpert individual, with significant authority, for years. This could cause you and your business significant setbacks.

If you really want to be master or mistress of your own destiny, then VC investment may not be viable for you–or for the VC.

Finding and selecting a VC

Most VCs are members of the Australian Venture Capital Association (AVCAL). They can provide lists of their members. These provide some useful information, but only engagement with a VC will really provide the information you need to determine suitability and synergies. Quite a few AVCAL members are not actually VCs; they may be advisers of one variety or another. Some AVCAL members appear to be VCs capable of investing, but a closer encounter may reveal that they are a “cashless VC” or “venture catalyst”. You need to ask any VC with which you engage how much money they have available to invest, and who their investors are. As explained above, you also need to ask:

  • Who, specifically on the VC team will manage their investment in your enterprise? You need to spend time testing your relationship with this individual.
  • What is the intended exit timing? How long will the investment allow you to run before an exit? Most VC funds are “closed” funds with an agreed end date by which investments need to be exited and all funds returned to investors. This is very important information for you.
  • What investments has the VC made and what have the results been? The answer to this question will give you some understanding of the VC’s potential value adds. First time VC fund managers may have little track record to assess.
  • Does the VC have track record in your business sector? A VC expert in green-tech investments may have little value add for an internet-based business, for example.

Finally, when embarking on a VC capital journey, consider taking on an experienced, expert adviser, with knowledge of your business sector and privileged access to relevant VCs. Your business accountant or family lawyer is unlikely to have the knowledge, experience and established relationships to fill this role.

–Lou Richard is author of A Practical Guide to Mergers and Acquisitions–Truth is Stranger than Fiction, and CEO of Sydney-based Newport Capital Group (www.newportcapital.com.au).

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