Vendocs - a small web-library for your venture

by PricewaterhouseCoopers LLP

Introduction    Understanding the Process    Writing the Business Plan    Preparing the Financials

A message to Entrepreneurs

From James D. Atwell, Global Managing Partner, Private Equity, PricewaterhouseCoopers LLP

Three Keys to Obtaining Venture Capital is designed to help first-time entrepreneurs understand the venture capital process and provides a useful step-by-step tool for creating a business plan. Through this understanding and armed with a comprehensive and thorough business plan, an entrepreneur will have realistic expectations and can concentrate on targeting the financial search for the most promising investment sources.

PricewaterhouseCoopers is experienced in reviewing business plans and financial forecasts. We will help you make contacts and maintain good working relationships with venture capitalists. Our professionals will work with you to target appropriate funds and provide introductions.

Introduction to the Three Keys

1.    Understand the Process

To an entrepreneur seeking venture capital financing for the first time, an understanding of the venture capital process is essential. The venture capital industry includes many firms with substantial funds to invest; however, it is often a challenge to an entrepreneur to tap into this vital source of financing. This booklet is designed to ease the challenge by providing insights into obtaining venture capital financing.

The venture capital process begins with an introduction to a venture capitalist. Cold calling on venture capitalists is a long shot – venture capitalists see many “over the transom” deals, very few of which become investments. Introductions to venture capitalists through referral sources they respect improve the odds of securing financing. PricewaterhouseCoopers, with a leading position in serving the venture capital community, has this respect.

Target a Venture Capital Partner

Choosing the right venture capital firms is an important part of the fundraising process. An entrepreneur that has not researched and targeted venture firms runs the risk of lengthening the search and over shopping the plan. Venture capitalists readily exchange information, so rejection from one firm may influence others.

The criteria for selecting the right venture capitalists to approach include their geographic, industry specialization, stage of development, and size of investment preferences. Also important are whether there are complementary or competing investee ventures within the fund’s portfolio.

The search of a fund’s preferences can be done by obtaining literature from the funds directly, talking to venture backed entrepreneurs, visiting the PricewaterhouseCoopers MoneyTree^TM web site at http://www.pwcmoneytree.com, obtaining the quarterly Money Tree Report from your local PricewaterhouseCoopers professional. PricewaterhouseCoopers professionals are active in the venture community and welcome the opportunity to talk with you.

2.    Write a Business Plan

Often the first step in dealing with venture capitalists is to forward them a copy of the business plan. And, because venture capitalists have to deal with so many business plans, the plan must immediately grab the reader’s attention. The executive summary will either entice venture capitalists to read the entire proposal or convince them not to invest further time.

A good plan is crucial for two reasons: first, as a management tool, and second, as a means to obtain financing. While the plan is an essential element in securing financing, it should also be an operating guide to the business, with the goals, objectives, milestones and strategies clearly defined and well-written. This is the best way to demonstrate the viability and growth potential of the business and to showcase the entrepreneur’s knowledge and understanding of what is needed to meet the company’s objectives. The first reading of a plan is the venture capitalist’s initial opportunity to evaluate the individuals who will manage the business and to measure the potential for return on his investment.

The plan should address the following business issues from the perspective of the venture capitalist:

• Is the management team capable of growing the business rapidly and successfully?

• Have they done it before?

• Is the technology fully developed?

• Is the product unique, and what values does it create so that buyers will want to purchase the product or service?

• Is the market potential large enough?

• Does the team understand how to penetrate the market?

• Do significant barriers to entry exist?

• How much money is required and how will it be utilized?

• What exit strategies are possible?

If the plan is of interest, the entrepreneur will be contacted for the first of what will generally be several meetings, and the venture capitalists may begin the due diligence process. Since venture firms are in the business of making risk investments, one can be certain a thorough analysis of the company’s business prospects, management team, industry, and financial forecasts will precede any investment.

Prepare for the Negotiation Process

Following due diligence, the successful venture will then enter into the negotiation process, where the structure and terms of financing will be determined. The entrepreneur must carefully prepare for this next step by becoming familiar with the various structures of venture capital financing and preparing a bargaining position after consulting with an attorney who has extensive venture capital experience. Attorneys will give guidance on the issues worth fighting for. Issues to consider are: vesting, salary, stock restrictions, commitment to the venture, debt conversion, dilution protection, downstream liquidity and directors. The negotiation will involve most or all of these issues in addition to price per share. However, price-per-share concerns should not be overriding interest; the end result of this process must be a win/win situation in order for the relationship to progress successfully. The last step is to document and close the transaction, resulting in a term sheet, investment agreement(s) and, finally, the closing.

3.    Prepare the Financials

Realistic financial forecasts within the business plan are important to attract investors and retain their interest to participate in future rounds of financing. The financials must accurately reflect the various product development, marketing, and manufacturing strategies described in each section of the plan.

The First Key: Understanding the Process

1.    Profile of a Typical Venture Capital Fund

Professionally managed venture capital funds provide seed, start-up and expansion financing as well as management/leveraged buyout financing. In addition to these distinctions, funds may also specialize in technology sectors such as life sciences, while others invest in a wide array of technology and non-technology arenas.

Venture capital firms are typically established as partnerships that invest money of their limited partners. The limiteds are usually corporate pension funds, governments, private individuals, foreign investors, corporations, insurance companies, endowment funds, and even other venture capital funds. When venture capital firms raise money from these sources, they group the money committed into a fund. A typical fund might close at US$ 75 – US$ 200 million and actively invest for three to five years. Since investors in venture capital funds have specific return-on-investment requirements, a venture capitalist must evaluate potential investments with a similar return on investment consideration.

Since the return on investment is critical, venture capitalists invest with certain criteria in mind. Many funds invest between US$ 4 – US$ 8 million in any one venture over a three- to five-year period and look for companies with market potential of US$ 75 – US$ 200 million. Since a venture fund typically invests in only 20-30 companies, each investment must be screened carefully. Venture capitalists will be looking for a 30% to 40%, or more, annual return on investment and for total return of 5 to 20 times their investment.

Venture capitalists are not passive investors and become involved as advisors to management, usually as members of the company’s board of directors. By actively participating in investments, venture capitalists seek to maximize their return.

Just as venture capitalists perform due diligence, and entrepreneur must evaluate the benefits that a particular venture firm can provide the company.

• Do the venture capitalists have experience with similar types of investments?

• Do they take a highly active or passive management role?

•  Are there competing companies in their portfolio?

•  Are the personalities on both sides of the table compatible?

• Does the firm have strong syndication ties with other venture firms for additional rounds of financing?

• Can they help provide contacts for distribution channels and executive search?

2.    The Valuation Process

It is critical for an entrepreneur seeking venture capital to assess the value of the company from the perspective of the venture capitalist and to appreciate the dynamics of the entrepreneur/venture capitalist relationship. This relationship revolves around a trade-off. Funds for growth are exchanged for a share of ownership. The entrepreneur will be asked to give up a large share of ownership of the company, possibly a majority stake. The venture capitalist seeks to value the venture to provide a return on investment commensurate with the risk taken.

Entrepreneurs seek to raise as much money as they can while giving up as little ownership as possible. Venture capitalists strive to maximize their return on investment by putting in as little money as possible for the largest share of ownership. Through the negotiation process, the two parties come to agreement. Entrepreneurs understand that excess funding costs them equity. Venture capitalists must leave company founders with enough ownership to provide incentive to make the business succeed. To balance their individual goals, both parties should agree on one mutual goal – to grow as a successful enterprise.

The first step in the negotiation process is to determine the current value of the company. The most important factor in determining this “pre-money valuation”, or the value of the venture prior to funding, is the stage of development of the company. A business with no product revenues, little expense history, and an incomplete management team will usually receive a lower valuation than a company with revenue that is operating at a loss. This is because the absence of one or more of these elements increases the risk of the venture’s not succeeding. Each successive stage commands higher valuations as the business achieves milestones, confirms the ability of the management team, and progresses in reducing fundamental risks.

Stage I

Ventures have no product revenues to date and little or no expense history, usually indicating an incomplete team with an idea, plan, and possibly some initial product development.

Stage II

Ventures still have no product revenues, but some expense history suggesting product development is underway.

Stage III

Ventures show product revenues, but they are still operating at a loss.

Stage IV

Companies have product revenues and are operating profitably.

The best way to build value in a company is to achieve the goals and milestones within the timeframes designated in the business plan. As milestones are achieved, risk is reduced and subsequent rounds of financing can usually be raised at more attractive valuations.

3.    Pricing and Control: The Investor’s Perspective

Pricing venture capital deals involves the estimated future values of the entity being financed and if highly subjective.

Theoretical approaches can be used to estimate the company’s future value and the corresponding percentage ownership that the investor requires – in other words, estimated future value based on the venture’s expected profitability and estimated earnings multiplies. The estimated percentage ownership the investor must receive can then be calculated to derive the desired return on investment.

As noted, venture capital investors expect an annual rate of return of 30% to 40% or more. The table below shows the percentage investment a venture capitalist would need to realize to support a 30% return on investment at various estimated market values. As shown, to realize a 30% return on an investment of US$ 4 million, a venture capitalist would need to own 32% percent of a company with an estimated future market value of US$ 60 million after six years. If the estimated future market value is higher, US$ 100 million for example, a smaller percentage ownership (19%) will provide the required rate of return.

Ownership Required to Support a 30% Return

N/A = investment would not be made if the present value of the company’s estimated future market value is less than the investment requested.

The Second Key: Writing the Business Plan

1.    Why Is a Business Plan Needed

A quality business plan is an important first step in convincing investors that the management team has the experience to build a successful enterprise. The plan also provides measurable operating and financial objectives for management and potential investors to measure the company’s progress.

2.    Executive Summary

Business plans should be summarized into a short two- to three-page synopsis called the executive summary. The summary is used to capture the essence of the plan and generate interest so the reader further studies the full proposal. It is the most important section of the business plan and should be written last, ensuring that only vital information is included.

At many of the largest venture capital firms, fewer than 5% of the hundreds of plans received are reviewed beyond the executive summary. While sometimes this is because the business does not fit the type of investment favored by that firm, more often because the executive summary is not written convincingly or clearly enough. The summary must stand out and be noticed, and to do this it must be of the highest quality. The summary must be persuasive in conveying the company’s growth and profit potential and management’s prior relevant experience.

The effort taken in researching investor preferences and preparing a quality summary will set the plan apart and assure that it receives further consideration by venture capital firms.

3.    Executive Summary Outline

Company Overview

Generally, the investor wants to know – in a hurry – what product the company is developing, the market/industry it serves, a brief history, milestones completed (with dates), and a statement on the company’s future plans. If the company is an ongoing business seeking expansion capital, the entrepreneur must summarize the company’s financial and market performance to date.

Management Team

List the key members of the management team and technical advisors, including their age, qualifications, and work history. It is important to emphasize the team’s relevant, proven track record. Note key open positions and how you intend to fill them.

Products and Services

Provide a short description of the product or service and highlight why it is unique. Discuss any barriers to entry that prevent further competition (e.g. patents). Mention the product’s direct or indirect competition. If possible, briefly mention future product development plans such as upgrades or product line extensions in order to show the investor that the venture is not a one-product/service company.

Market Analysis

Define the target market to be served using recent market data and analyst’s estimates of current and projected size and growth rates. Also note what percent of the market the company plans to capture. Mention the names of your largest current, well-known customers who have either purchased your product or given you letters of intent. It is important to discuss who will buy the product and why. Briefly note the distribution/selling strategies used in the industry and explain which one(s) you plan to use to penetrate the market.

Funds Requested and Uses

State the amount of money required and be specific in the description of the uses of the funds sought. Avoid such general terms as “working capital”.

Summary of Five-Year Financial Projections

This section should summarize key financial projections through breakeven. Only projected revenues, net income, assets and liabilities should be listed. It is also useful to note additional expected rounds of financing needed.

Body of the Plan

1.    Company Overview

In this section one should fully describe the reason for founding the company and the general nature of the business. The investor must be convinced of the uniqueness of the business and gain a clear idea of the market in which the company will compete.

The entrepreneur's vision for the company's future production and operations strategy should also be described. An investor needs to be assured that the company is built around more than a product idea. The entrepreneur needs to demonstrate that a profitable business can be built based on the strategies detailed in the plan.

2.    Products and Services

The business plan must convey to the reader that the company and product truly fill an unmet need in the marketplace. The characteristics that set the product/service and company apart from the competition need to be defined. It is also important to describe each of the end-user segments that will be targeted. A full profile of the end-users and the key potential applications of the product will demonstrate to an investor that the entrepreneur has done his/her marketing homework.

A description of the status of patents, copyrights and trade secrets is very important. It is equally imperative to describe barriers to entry. Keep in mind that patents are only as good as they are defensible.

The plan should list all major product accomplishments achieved to date as well as remaining milestones. This will give an investor a comfort level, knowing that the entrepreneur has tackled several hurdles and is aware of remaining hurdles and how to surmount them. Specific mention should be made of the results of alpha (internal) and beta (external with potential customers) product testing. If alpha or beta tests are upcoming, mention how these tests will be conducted.

Single product companies can be a concern for investors. It is always beneficial to include ideas and plans for future products/services. If the plan demonstrates the viability of several products, an investor will see an opportunity to grow a successful business.

3.    Market Analysis

The analysis of market potential separates the inventors from entrepreneurs. Many good products are never successfully commercialized because their inventors don't stop to understand the market or assemble the management team necessary to capitalize on the opportunity.

This section of the business plan will be scrutinized carefully; market analysis should therefore be as specific as possible, focusing on believable, verifiable data.

• Market Research should contain a thorough analysis of the company's industry and potential customers.

• Industry Data should include growth rates, size of the market, recent technical advances, government regulations, and future trends.

• Customer Research should include the number of potential customers, the purchase rate per customer, and a profile of the decision-maker.

This research drives the sales forecast and pricing strategy, which relates to all other strategies in marketing, sales and distribution. Finally, comment on the percentage of the target market the company plans to capture.

4.    Management and Ownership

Venture capitalists invest in people - people who have run or who are likely to run successful operations. Potential investors will look closely at the members of the company's management team. The team should have experience and talents in the key disciplines:

• technological development

• marketing

• sales

• manufacturing, and

• finance

This section of the plan should therefore introduce the members of your management team and what they bring to the business. Detailed résumés should be included in appendix.

The management team in most start-up companies includes only a few founders with varied backgrounds and an idea. If there are gaps in the team it is important to mention them and comment on how the positions will be filled. Glossing over a key unfilled position will raise red flags. Often, because venture capital investors have access to networks of management talent, they can provide a list of proven candidates appropriate for these crucial positions.

Include a list of the board of directors or advisors: key outside industry or technology experts who lend guidance and credibility. This is another area where empty positions may be filled from suggestions of a well-networked investor.

5.    Marketing Plan

The primary purpose of the marketing section of a business plan is to convince the venture capitalist that the market can be developed and penetrated. The sales projections made in the marketing section will drive the rest of the business plan by estimating the rate of growth of operations and the financing required. The data should include an outline of plans for:

• Pricing

• Distribution channels, and

• Promotion

Pricing

The strategy used to price a product or service provides an investor with insight for evaluating the strategic plan. Explain the key components of the pricing decision, i.e., image, competitive issues, gross margins, and the discount structure for each distribution channel. Pricing strategy should also involve consideration of future product releases and future products.

Distribution Channels

A manufacturer's business plan should clearly identify the distribution channels that will get the product to the end-user. For a service provider, the distribution channels are not as important as are the means of promotion. Distribution options for a manufacturer may include:

• Direct Sales, such as mail order, direct contact through salespeople, and telemarketing;

• Original Equipment Manufacturing (OEM), integration of the product into other manufacturer's products;

• Distributors or Wholesalers; or

• Retailers.

Each of these methods has its own advantages and disadvantages and financial impact, and these should be clarified in the business plan. For example, assume the company decided to use direct sales because of the expertise required in selling the product. A direct salesforce increases control, but it requires a significant investment. A venture capitalist will look to the entrepreneur's expertise as a salesperson, or to the plans to hire, train and compensate an expert salesforce. If more than one distribution channel is used, they should all be compatible. For example, using both direct sales and wholesalers can create channel conflict if not managed well.

Fully explain the reasons for selecting these distribution approaches and the financial benefits they will provide. The explanation should include a schedule of projected prices, with appropriate discounts and commissions as part of the projected sales estimates. These estimates of profit margin and pricing policy will provide support for the decision.

Promotion

The marketing promotion section of the business plan should include plans for product sheets, potential advertising plans, Internet strategy, trade show schedules, and any other promotional materials. The venture capitalist must be convinced that the company has the expertise to move the product to market. A well-though-out promotional approach will set the business plan apart from the competition.

It is important to explain the thought process behind the selected sources of promotion and the reasons for those not selected.

6.    Competition

A discussion of the competition is an essential part of the business plan. Every product or service has competition; even if the company is first-to-market, the entrepreneur must explain how the market's need is currently being met and how the new product will compete against the existing solution. The venture capitalist will be looking to see how and why the firm will beat the competition. The business plan should analyze the competition, giving strengths and weaknesses relative to the product. Attempt to anticipate competitive response to the product. Include, if possible, a direct product comparison based on price, quality, warranties, product updates, features, distribution strategies, and other means of comparison. Document the sources used in the analysis.

7.    Operations

The operations section of the business plan should discuss the location and size of the facility. If one location is selected over another, be sure to include justification. Factors such as the availability of labor, accessibility of materials, proximity to distribution channels, and tax considerations should be mentioned. Describe the equipment and the facilities. If more equipment is required in response to production demands, include plans for financing. If the company needs international distribution, mention whether the operations facility will provide adequate support. If work will be outsourced to subcontractors, eliminating the need to expand facilities, state that, too. The investor will be looking to see if there are inconsistencies in the business plan.

If a prototype has not been developed or there is other uncertainty concerning production, include a budget and timetable for product development. The venture capitalist will be looking to see how flexible and efficient the facility plans are. The venture capitalist will also ask such questions as:

• If sales projections predict a growth rate of 25% per year, does the current site allow for expansion?

• Are there suppliers who can provide the materials required?

• Is there an educated labor force in the area?

These and any other factors that might be important to the investor should be included. The sales projections will determine the size of the operation and thereby the funds required both now and in the future. Include the sources and uses of financing in the business plan, and be certain the assumptions are realistic. The timing and the amount of funds will be derived from the sales estimates.

The Third Key: Preparing the Financials

1.    The Purpose of Financial Forecasts

Developing a detailed set of financial forecasts demonstrates to the investor that the entrepreneur has thought out the financial implications of the company's growth plans. Good financial forecasts integrate the performance goals outlined in the plan into financial goals so that return on investment, profitability and cash-flow milestones can be clearly stated. Investors use these forecasts to determine if

1. the company offers enough growth potential to deliver the type of return on investment that the investor is seeking, and

2. the projections are realistic enough to give the company a reasonable chance or attaining them.

2.    Content of Financial Forecasts

Investors expect to see a full set of cohesive financial statements, including a balance sheet, income statement, and cash-flows statement, for a period of three to five years. It is customary to show monthly statements until the breakeven point or profitability is reached. Thereafter, quarterly statements should be prepared for two years, followed by yearly data for the remaining timeframe. It also imperative that the forecasts include a footnote section that explains the major assumptions used to develop revenue and expense items. It is not advisable to "ramp up" sales and expenses is sequential fashion - this gives the impression that the financial implications of the plan have not been fully thought out. Prepare the financial projections as the final step in putting together the plan.

3.    Examples of Financial Forecasts

The financial forecast illustrated below represent a fast-growth, technology-oriented manufacturing company. The forecasts are shown on a yearly basis. An actual business plan, however, should show monthly figures until breakeven and then quarterly statements for subsequent years. The assumptions are included as a guide and may not apply to all start-up companies. Be sure to consult your financial advisor.