What are VCs, anyway? Are they right for me?

Q: I have a business idea on running a cafe. I was thinking of going to a venture capitalist for funding. Problem is, I don`t know how they work. Can you shed some light on some of their practices?

A: VCs are money managers who make high-risk, high-return investments. They raise a fund, usually $10 million to hundreds of millions, from private and institutional investors. They then invest those funds in startup and pre-public companies (their “portfolio companies“), hoping for a substantial return. The VCs are paid a percentage of the fund’s value as a management fee. They also have a “carried interest”—they get a percentage of any profits above a certain point.

VCs get their money back (“harvest” their investment) when a portfolio company sells shares to the public in an initial public offering (IPO) or when it is acquired by another company. Despite all the late-90s publicity around IPOs, there really aren’t very many of them–maybe a couple hundred in a good year, in contrast to several thousand companies invested in by VCs.

VCs want opportunities that have a huge market, tremendous growth potential, a competitive advantage in the marketplace, and experienced management teams. Financially, they often evaluate investment opportunities expecting a minimum return of 40-60% per year on their investment. Since they are required to return money to their investors on a certain timetable, they also want the possibility of harvest in a certain number of years. And depending on the size of the fund, they may only invest in companies raising more than a minimum (e.g. $2-$5 million).

You raise money from VCs by putting together a business plan (see bizplanhints.htm) and arranging for that plan to be given to a VC with a referral from someone they know. Unsolicited plans almost never get funded. Your plan must lay out the market for the business, how the business will operate, who the management team is, etc. See my Entrepreneur.com column “Formatting Your Plan” for a typical plan outline. I also recommend Palo Alto Software’s “Business Plan Pro” (www.paloalto.com) as a good source for guidance in writing a plan.

To return to your situation…a cafe does not meet most venture capital requirements. Most cafes aren’t a new idea, don’t have the growth potential to return 40-60% to their investors, have no obvious harvest strategy [a chain of cafes can go public-a single cafe can’t], and don’t have clear competitive advantages strong enough to outweigh the risks. A cafe furthermore probably takes a few hundred thousand dollars to start, rather than the millions most VCs want to invest.

For smaller businesses, private investors or bank loans are your best bet. Many banks offer small business loans to people starting businesses that aren’t appropriate for high-growth investors. If you’re in the US, check out the Small Business Administration at http://www.sba.gov. They can help you find funding opportunities more appropriate to a cafe.

Best of luck!

What are Venture Capitalists? (What are VCs, anywa…

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