Venture capital primer; where venture capitalists want to invest.

• Author: Horowitz, Alan S.
• Position: Includes related article

Venture Capital Primer

Where Venture Capitalists Want to Invest

Attracting investors to a young business is tough because of the risks involved. Young businesses fail at an alarming rate, so those with money usually are cautious and wary. The most risk-oriented financiers of all are venture capitalists. What they want--and how entrepreneurs should approach them--is the subject of this article.

Venture capitalists are a particularly hard-skinned bunch. Their business is putting money into hope-and-a-prayer-type, start-up, and growing businesses. It's no wonder there's a widely held view that venture capital is classic "risk capital"--capital invested in risky enterprises. These enterprises are risky because they are so new and unproven.

Venture capitalists also want an equity (ownership) stake in a firm. This differs from a bank that lends money (against collateral) and expects to get repaid, plus interest, on a predetermined schedule. Venture capitalists have no set schedule for getting their money back and lack collateral.

"We're not in the business of lending money," clarifies Donald H. Parsons Jr., an investment officer for The Centennial Funds, which manages nine venture capital funds from its Denver headquarters.

Not all venture capital is the same. VCs invest in companies depending on: (1) the company's stage of development, and (2) its industry.

Stage of Development

VCs break down development stages into two main classes of financing. Early-stage financing is the first. This contains seed, startup, and first-stage financing stages.

If all that exists of a business is a gleam in an entrepreneur's eye, and money is needed to prove the concept or start development of the product, then we're talking about seed financing. When final product development is at hand and it's time to create marketing strategies, then the firm is a startup in need of startup financing. At these stages, the company has no sales or commercial production. First-stage financing, the most advanced of the early stages, goes to firms ready to begin commercial production and commence sales.

The second main class is expansion financing. This, too, has three stages. The first, called second-stage financing, is for firms in production, whose sales are ramping up and who need working capital. Third-stage financing is for businesses on a growth curve that need to expand their manufacturing capacity, marketing efforts, working capital, and research and development efforts. The final or fourth-stage (also called bridge or...