Reprint permission from worldlyinvestor.com.
No longer can venture capitalists throw a few bucks at a start-up, and confidently wait for the IPO. And that unavoidable reality continues to dampen venture capitalists' enthusiasm for new deals. By some accounts, VC investment dropped another 25% in the third quarter from the second this year, and most of that investment represents follow-on funding.
But venture capitalists remain on the prowl. Although tempered by the flat-lining of the dot-com sector, they still can be coaxed to take equity stakes in technology-focused, high-growth entrepreneurial companies. And with prevailing interest rates lower than they've been in most venture capitalists' lifetimes, they're still hungry for higher risk-adjusted returns.
The difference is that now they care about quality more than they ever did before.
They need to. When VC investments were made at unjustifiable valuations, the strategy was to count on a quick flip at an obscene profit. Now they know that the greater fool theory doesn't work forever, and the rule of reason needs to be reckoned with.
An unacceptable number of business failures and a toughening economy have coalesced to force venture capitalists to rethink their business models. From now on, they'll be more cautious and settle for nothing less than senior preferred stock in the companies they fund. They'll set higher reserves. And they'll budget more money to stay committed to a deal for the long-term.
They'll also demand more of entrepreneurs who are seeking capital. And the things they'll demand will prove to benefit entrepreneurs enormously.
Venture capitalists just won't be interested anymore if entrepreneurs can't clearly justify the financing they're after and exactly how it's going to be used. And venture capitalists simply won't but money at risk unless a strong, credible management team runs the target company and can sell realistic revenue projections and conservative burn rates.
A Flair for the Old-Fashioned
Many successful entrepreneurs have bootstrapped themselves to enormous profitability, plodding along the old-fashioned way. They max out their credit cards, tap family and friends, forgo big salaries, and accept slower growth rates. And they're perfectly content to do so.
Even entrepreneurs who decide to pursue the opportunities of venture capital need to understand that, in the post-dot-com, post-Sept. 11 world, venture capitalists are less likely than ever to be the first ones to jump in the pool. They'll insist that an entrepreneur has successfully secured grants or loans from other sources that have vetted the company.
Entrepreneurs will also need to have a real product, ideally one already protected by patents. As important, they will have landed commitments from strategic partners and inked cost-effective marketing and distribution arrangements.
Talent, Tenacity and Time
So positioned, the entrepreneurial company will need to demonstrate what advantages it has over the competition. How the company realistically plans to make money -- or, better yet, how it already does. And how its investors will earn the highest rate of return in the shortest possible time. Since the new-issue market is far from robust, the exit strategy will probably involve a strategic sale to an industry powerhouse willing to pay a hefty premium for the privilege.
Just as companies which go public first need to clean up their balance sheets and clean up their acts, so too will companies which pursue venture capital become tougher, sharper and stronger.
The venture capitalist and the entrepreneur share a daunting, but surmountable challenge, and their symbiosis is real. The shrewd venture capitalist knows that genuine value can be created in down cycles by sticking with a talented entrepreneur who has developed a compelling business plan and has the tenacity to build a successful company. And that entrepreneur knows that the money he's after is really out there, and so are the support and experience he needs to realize his dream.
Marc J. Lane is a business and tax attorney and a Master Registered Financial Planner. His Chicago-based law firm, The Law Offices of Marc J. Lane, and its financial-services affiliates offer entrepreneurs and investors a strategic, multi-disciplinary approach to financial, tax, investment, corporate, estate and insurance planning. Twice a recipient of the Illinois State Bar Association's Lincoln Award, Lane is an Adjunct Professor of Business at the University of Illinois College of Business Administration's Institute for Entrepreneurial Studies and an Adjunct Professor of Law at Northwestern University School of Law. His 30th book, Advising Entrepreneurs: Dynamic Strategies for Financial Growth, was published this year by John Wiley & Sons.
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