Adventures In Venture Capitalism

One of the biggest challenges faced by toy business owners is the need for capital. And while some owners are able to generate sufficient capital from personal funds and from the cash flow of the business, most have to look to outside sources for certain needs. This is particularly true for high growth and/or new toy businesses.

The owner of a rapidly growing business can be easily frustrated in the quest for capital. While banks will provide conventional loans for asset purchases and some working capital needs (i.e. inventory buildup), they sometimes shy away from providing all of the financing needed by the high growth small business. “High growth” usually means high volatility in performance and inadequate collateral to back up loans, and this simply doesn't fit the risk parameters of most commercial banks.

There are other capital sources available for the rapidly growing or startup business. In fact, CCH Business Owner's Toolkit online columnist Alice Magos (www.toolkit.cch.com/advice) says that every small business owner should try to find “smart” money for the business. “Small businesses usually need more than just cash: they need smart money,” advises Magos. “By smart money we mean financing that helps your business in the way that you want it to, where the financier provides not only capital, but support and expertise to your business.”

Magos goes on to point out that the capital market for small businesses (as opposed to the market for large public companies) is imperfect with “a great variety of under-publicized and poorly organized financing sources.” Still, these sources are out there if you know where to look. There are an increasing number of venture capitalists in the marketplace that are willing to invest in high growth and/or new small businesses. In 2006 alone, it is estimated that venture capitalists pumped more than $25 billion into U.S. companies.

Venture capital firms generally gather capital from a number of different sources to be invested in various business ventures. These funds come from private sources and are invested in high growth businesses. In exchange for providing needed capital for growth, the venture capitalist expects a high rate of return. Venture capital providers can be grouped into three main categories:

1. Traditional Institutional VC Firms: A traditional VC firm raises money from private sources such as insurance companies, hedge funds, pension funds, endowments, banks and individuals. These firms agree to invest in less than 10 percent of the deals that they consider. The minimum investment level generally is at least $250,000 for a traditional VC firm, and they expect an annualized return on investment of at least 20 percent over a three to seven year period.

2. Small Business Investment Corporations (SBICs): The SBIC program is a public venture capital initiative that is sponsored by the federal government. “An SBIC is a privately owned and operated small business investment company that partners with the federal government to provide venture capital to small businesses,” explains Magos. SBICs are federally licensed, and they are scattered throughout the country. Magos says that these venture capital organizations use a combination of private funds and federal government dollars to provide three important needs for eligible small businesses: equity capital, long term loans (of up to 20 years) and management assistance. While SBICs operate in a similar capacity to traditional VC firms, they will consider smaller investments (as low as $50,000 in some cases) and may offer more flexible terms.

3. Angel investors: “Angel” investors are individual capital providers for small businesses. Angels tend to provide more flexibility than do venture capital firms, but they are looking for a high return on investment nonetheless. Angel investors typically are entrepreneurs who like to help small business owners to achieve high growth in exchange for a share of the profits from the business. Angels might invest anywhere from $50,000 to $1 million or more in a business. The typical profile of an angel is a family member, friend or small business owner in the community. And this can be both a positive and a negative according to Mark Edwards, director of SBA Lending at BB&T in Atlanta. “Angel investors generally are well known by the business owner,” advises Edwards. “So you had better be prepared to bare your business soul to the angel if he decides to provide capital for your business.”

If your experience in raising capital for your toy venture has been confined to personal resources and bank loans, you need to understand something important about venture capitalists. They are in it for the money. “Banks generally are confined to a fairly low risk/return paradigm,” says Edwards, who has over 24 years of experience in the financial services industry. “Venture capitalists are willing to take a lot more risk than banks, but they also expect a much higher return. Likewise, while a bank will generally work with you if you are a few days late on a loan payment, venture capitalists frown on a small business that misses performance measures. They stick very closely to formal agreements, so you had better pay very close attention to the fine print.”

Venture capital money typically is found in start up entities and early stage companies, but VC providers sometimes invest in later stage companies that are growing rapidly. And while venture capital agreements will vary from company to company, there are some characteristics that are commonly found in every VC transaction. The term of the investment will range from three to seven years. The VC provider will take a significant ownership stake in your business of 30 to 50 percent or more. The venture capitalist will insist on daily strategic involvement, including at least one seat on the board of directors of your company.

One very important issue that you need to understand regarding VC structure is the exit strategy. Every VC provider (traditional VC firm, SBIC or angel) will be looking for a liquidity event to be completely paid out of the investment in your business. This liquidity event could come from a refinance with a bank or asset-based lending company, but it is often triggered by the sale of the subject company. This is particularly true if the venture capitalist takes control of more than 50 percent of the stock of your company. It is advisable to pay very close attention to the fine print in your agreement with the VC provider to ensure that you maintain control over the eventual liquidity event that will constitute the exit strategy of the investor.

You may be interested in seeking venture capital for your rapidly growing business, but you aren't sure where to find it. If you are looking for traditional VC sources, a good suggestion is to start with your attorney, accountant or banker. They should be able to refer you to some potential VC providers. Another good resource is the website of the National Venture Capital Association found at www.nvca.org.

To find a list of SBICs in your area, try the government's Small Business Administration website found at www.sba.gov.

Angel investors can be found within your own personal contacts of friends, family and local business owners. Another good potential source for angel investors can be found at The Smart Startup website (www.antiventurecapital.com/angels.html).

Once you have found potential capital providers, it is imperative that you do your part to convince them to invest in your toy business. This will require a lot of preparation. Remember that most venture capitalists choose to invest in less than 10 percent of the businesses that they consider, so you will need to do an exceptional job of convincing the prospective investor to put money into your business instead of another one. In order to attract VC funds, you should seek to convince the investor that your high growth business offers the potential for a higher return than at least 90 percent of alternative investments.

Put together a business plan to pitch your business. You don't have to replicate War and Peace in this plan. In fact, a well thought out, concise plan will be better received than a long plan that offers much ado about nothing. A good business plan should include:

• Executive Summary
• General Background of the Business
• Management Background and Resumes
• Products and Services
• Marketing Plan
• Operations
• Milestones
• Historical Financial Information
• Financial Projections

Edwards emphasizes the importance of the business plan with a particular focus on the Executive Summary. “The business plan is a vital component for the entrepreneur seeking venture capital financing,” says Edwards. “And you need to capture the attention of the reader in the executive summary. If this section is not well done, the rest of the plan probably won't be read. Make sure the executive summary gives the investor a reason to continue reading the rest of the plan.”

If your business is growing rapidly and in need of capital to sustain your plans for continued expansion, then venture capital may be just what you need to accomplish your goals. Venture capitalists are willing to take a higher level of risk than other providers of capital in exchange for a high rate of return on investment. If you are willing to accept these parameters, then venture capital may be just the right tonic to fuel the high growth rate in your successful toy business.