Demystifying Venture Capital

Posted by: Today's Tip Contributor on October 26, 2010

Venture capital became a darling asset class for institutional investors throughout the 1990s. More and more capital flowed into rapidly growing funds. Many venture firms attempted to take on the new capital while still making early-stage venture investments. It didn’t work. The overall returns for the industry over the last 10 years have been poor as a result, and now the industry is in a state of flux.

Venture capital remains a lucrative investment category and is based on a fairly simple model. It’s been distorted by groups trying to apply it to larger fund sizes and to industries where it does not fit. In general, if you’re raising venture capital, your company should meet the following criteria:

• Have the potential to develop into a $50 million revenue business within five to seven years of initial funding.

• Have the potential for healthy profit margins and operating cash flows.

• Require a modest amount of external capital.

• Be able to provide shareholders with liquidity through exit in a reasonable time frame (approximately five to seven years).

• Provide multiple exit options (initial public offering potential and numerous companies that are logical and capable acquirers).

In order to meet these criteria, here are the qualities that companies absolutely must have:

• Strong leadership with the ability to set strategic vision, attract strong talent, and build a sizable business.

• Potential to be a leading player in a rapidly emerging market and ultimately grow into a business with revenue of $500 million or more.

• Differentiated technology/knowledge or special competitive advantage.

• Scalable sales model.

If these criteria are not met, your company can still develop into a successful business, but it may not meet the needs of the venture capital investor. It makes sense to approach a venture firm once you have validated your solution with potential or actual customers. A demonstrated ability to reach early revenue without raising institutional capital shows that an entrepreneur is resourceful and will maximize the probability of an outstanding return on capital.

Matt Fates
Partner
Ascent Venture Partners
Boston

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