Here’s how dark things have been. The National Venture Capital Association has made available an analysis by Cambridge Associates of the internal rates of return for the average venture-capital fund that normally has a 10-year life.
Simply put, VC has been underperforming the average stock index since venture returns peaked in 1999. In the decade ending in 1999, the average VC generated a whopping internal rate of return of 83.4%. By 2010, the typical VC fund was a big money-loser, generating an internal rate of return of -5.2%. But by the mid-2012, the typical VC fund had recovered to generate a positive internal rate of return of 5.3%.
In the past two years, I have interviewed about 200 entrepreneurs from venture-backed companies. From what I can tell, issues such as a possible recession, rising raw-material costs and unstable capital markets that seem to bother big companies do not seem to trouble many start-up CEOs. What keeps them up late is worrying about how they’ll turn their vision into a reality. But they don’t see macroeconomic forces as the impediment.
They are concerned with keeping enough cash in the till to pay their suppliers and their people. For that, they rely on a ladder of cash sources: customers who pay enough for them to make a profit, suppliers who extend generous payment terms, their own frugality when it comes to items that don’t add value to customers, friends, family, angels, and venture capitalists – many of whom can be supplying cash at the same time.
The capital is mostly for paying talent chart-topping salaries. When it’s in short supply, they must mint their own emotional currency to continue hiring and motivating their industry’s top stars. Given the war for talent, this means start-up CEOs are concerning themselves with how to craft a vision that persuades the best job candidates that they will be missing out on a great opportunity unless they join their start-up.
In the past several years the battle for that talent has intensified because so many individual investors have become fabulously wealthy in recent years. According to a start-up chief executive officer I interviewed recently, these wealthy investors have been pouring seed capital into start-ups at the earliest stages of development without sufficient discipline.
These investors expect only one in 10 of these companies to succeed. But the availability of the seed capital is driving up the salaries of top technical talent.
And that means entrepreneurs cannot compete for that talent unless they can pay top dollar and offer a compelling mission. Not only that, but the rise in seed capital has been accompanied by a plunge in the availability of Series A funding. This means that unless a start-up can become cash-flow positive after using up its seed capital, it will struggle to get the next stage of funding – cheques in the $5 million to $10 million range.
Silicon Valley insiders will be closely following:
- Breakthrough products: At trade shows such as the Consumer Electronics Show and others, from time to time there are big surprises that become game-changers. When they appear, venture investors could be motivated to place more capital in those companies and related businesses.
- Quarterly NVCA reports: If the NVCA reports show rising VC-fund internal rates of return of higher than 8%, it could become be easier for the funds to go to their limited partners and raise fresh capital. And it would be particularly useful for entrepreneurs if those reports show high single-digit returns for Series A investors.
- The Startup Visa Act: This proposed measure would change U.S. immigration laws to create a new visa for immigrants who can raise $250 000 for their start-up company. Another possible legislative change would be to expand the existing EB-5 visa program for immigrant investors.
These changes, should they occur, could point the supply of venture capital in a new direction. The supply of talent would rise and start-ups would be better off.
Winners and Losers
Winners in 2013 will be owners of enterprise information-technology companies that go public, while losers will be those who bought consumer Internet companies at their initial public offering prices and investors in clean tech.
Start-ups in enterprise IT are also more likely to come out ahead, whereas start-ups in the consumer space are likely to have a harder time getting funding.
For the New Generation of Venture Capitalists, Their Advice Is More Valuable Than Their Money
For example, SugarCRM, an enterprise software company, is expected to go public in 2013. And if it follows in the footsteps of another enterprise software IPO winner, Workday, an enterprise software-as-a-service provider whose stock popped from $28 to $50 on its first day of trading in early October and is now at $55, more such start-ups will go public in 2013.
It’s the consumer-tech companies that seem to be having more trouble. As of December 20, people who bought Facebook, Groupon and Zynga at their IPO prices are underwater to the tune of 11%, 81%, and 75%, respectively.
An NVCA survey of 600 entrepreneurs and venture capitalists conducted between 26 Nov and 7 Dec 2012, reveals that many believe a shift in VC investment is underway that will benefit some sectors and hurt others.
More specifically, capital is expected to flow into start-ups that provide information technology to businesses. More specifically, 61% of respondents expected increased investment in business IT, while 57% predict a rise in investment in health-care IT.
Consumer IT investment appears to have peaked out, with only 35% of respondents expecting an increase in that field. But pessimism reigns for investment in other sectors: 61% see a drop in clean-technology investment, 53% see a drop in medical devices backing and 40% expect biopharmaceuticals funding to decline.
My sense is that these expectations are based on the returns to investors in these sectors. For example, Facebook’s disappointing IPO and a flood of money into consumer IT have created something of a bubble aftermath. Meanwhile, VCs expect companies to spend more heavily on enterprise IT, thus boosting the prospects for start-ups that sell IT to business.
And the absence of attractive investment returns in clean technology, medical devices and biopharmaceuticals is also dimming expectations in these areas.
When it comes to liquidating their investment, VCs are more optimistic than CEOs in 2013. Of those VCs who responded to the NVCA survey, 40% expected a boost in 2013 IPO volume, while 52% envision a boost in IPO quality. Start-up CEOs are less optimistic: 29% see an increase in IPO volume and 37% envision IPO quality to improve.
Moreover, VC optimism for IPOs is higher for those sectors, such as business IT, where they expect to see more capital and lower for life sciences and clean technology where they see a drop in capital.
The coming year promises to be a mix of old and new for VCs. The old: Entrepreneurs will execute on strategies to boost market share, raise capital and attract top talent, while VCs will try to maintain their slow upward trajectory after more than a decade in the desert.
The new: That success will depend on whether VCs are right that enterprise IT will generate high internal rates of return after disappointments from consumer Internet, clean tech. and medical devices.
Financing That Backs Entrepreneurs
The SME landscape is fast and flexible. It requires financing that understands how entrepreneurial businesses operate. Through its unique processes and assessments, Spartan’s finance solutions are geared to do just that.
It takes an entrepreneur to know entrepreneurs, which is why Kumaran Padayachee and his team at Spartan are dedicated to financially backing an often-underserviced sector: SMEs.
“We’re fast, we’re flexible, and we’re understanding,” says Kumaran. “Every single person who works here is SME-centric. We hire for fit, looking for empathy and alignment in every position. All of our processes and assessments are done with empathy and understanding towards SMEs.”
Becoming funding ready
Thanks to these systems, processes and the team’s unique way of assessing SMEs, Spartan typically grants finance within seven days, although the fastest approval has been six hours, with the longest 15 days.
“How quickly we can approve finance is determined by how prepared the business owner is,” explains Kumaran.
“Do they have all their basic documentation ready? These include financials, management accounts, debtors age analysis and creditors age analysis. From a working capital context, this information makes it easy to assess the health of the business. Every business owner and financial director should be on top of these figures.”
Finding a funding fit
Not every business needs funding. Some can grow organically and draw on their own cash reserves. Others choose an equity route.
Spartan is a debt funder. However, even as a debt funder, the team’s aim is to back entrepreneurs and help them grow their businesses. They evaluate what the finance will be used for, and if the return is greater than the repayments.
“There are numerous ways that finance can be applied incorrectly by SMEs,” says Kumaran. “One of the first flags we look for is debtors age. If the industry norm is payment in 30 days, but a business is typically paid by its clients in 60 or 120 days, then we know there is something wrong with their internal processes. Either the company is too shy to be assertive with clients, or it lacks the capacity or capability to invoice clients and collect cash efficiently. Either way, the result is a shortage of cash.
“Business owners in this situation apply for a loan in order to be able to pay the bills, when they should be reviewing their own business, pulling one or two levers, and improving their cash flows.
“A customer project or contract is an example of an expansionary and positive need for finance. These cases are ideally suited to bridging finance. The problem is that there’s a lead time gap. You need to start the project, spend cash to hire people or purchase equipment, build internal capacity, deliver on the project and then the customer only pays you. Working capital and bridging finance allows the entrepreneur to do just that, and the company grows as a result.”
Bridging finance, in particular, is high risk and requires a large amount of flexibility, which is why more traditional funding institutions shy away from it. Spartan, on the other hand, offers revolving bridging loans to customers the team has worked with. “We understand this space, and our aim is to support the entrepreneurs within it,” Kumaran concludes.
Alternative finance solutions
Spartan is a 36-year-old Non-Bank Finance Company — that specialises in financing Small and Mid-sized businesses by providing:
- Growth Finance [structured finance for expansion]
- Specialised Asset Finance [equipment/machinery/technology/software/office fit-outs/energy/etc.]
- Working Capital Finance [bridging finance & medium term loans].
Bridging Finance is available for one to three month terms and is ideal for contract or project-based businesses. It is a solution that assists businesses with solving cash flow issues due to growth related challenges in their business and is either for a once-off need or for revolving business use.
Spartan is an Authorised Financial Services Provider 47631 and Registered Credit Provider NCRCP8669.
Is Venture Capital Right For You?
Take this online test to find out if venture capital is what your business needs.
It’s important to know the ins and outs of venture capital before applying for backing as it may not necessarily be the right solution for all entrepreneurs, or for the particular stage your business is at.
To help prospective businesses determine if they are suitable candidates for venture capital funding, Mark Shuttleworth’s local venture capital company, Here Be Dragons (HBD), has compiled a venture capital readiness test. To check your readiness – visit the South African version of the site – Knife Capital below.
Take the VC Test
The HBD test is quick and practical, designed to educate and prepare potential applicants for what they can expect from venture capital.
The test guides applicants through an umber of important decisions and points they will have to consider carefully should they wish to embark on a partnership with a venture capitalist. Consisting of three deal breakers and another 15 questions, it looks at the components of a venture capital investment.
Questions such as: “Will your revenue grow by at least 30% each year?” and“Are you prepared to part with a significant ownership stake in your business which may result in the loss of control?” are tough choices that need to be made ahead of time. Your answers will determine whether you are on the right track for venture capital.
Take the test at Knife Capital.
5 Key Questions To Answer For Raising Funding
As your business grows, should you be raising capital or focusing on organic growth?
There’s a nagging question that lingers in the back of the mind for many entrepreneurs: Should I raise funding? The answer is never simple and the truth is that there is no single answer to rule them all. It all depends on your business, the industry you’re in, how your business is performing and if there are even investors in your field.
Here are some key points to consider as you weigh up the options within your personal growth journey.
Is investment right for me?
The media in larger markets like the US and Europe have turned raising funding into some kind of sport. Funding events are extremely well covered by the media and often glorified as some kind of victory.
I’ve raised money from all kinds of investors over the past decade and can confirm that not all money raised is equal. Money comes with strings attached and a lot of formality that may not have existed in your business before.
Once you’ve taken external funding of any kind you immediately take on a fiduciary responsibility outside of just ‘If I screw this up, I walk away’. You are tied to your company and investors until the money dries up or you make everyone rich. Neither is a simple process.
Don’t get me wrong, there can be a lot of value in the raising of strategic capital, but it is not to be seen as some form of victory. When you raise money you should have a clear path to profit and a clear strategy on how you are going to use the money and what the potential of recouping it is. Without these things you’re just taking other people’s money to spend and pay your salary. That’s not cool.
The Different Kinds of Investment
If you don’t know what’s out there, it’s easy to think that banks are the only institutions with money. They’re not. Often they are the worst kind of money to raise and come with very formal strings attached that you cannot break free from. However, if you have a relatively straight-forward and stable business, banks can be a useful option to get a loan and then pay back the money relatively quickly.
I always suggest that the first port of call for funding should be sales. So if you think you need funding, what you are really saying is you need money and money comes from making sales. The best place to start for sales? The three Fs: Friends, Family and Fools. Sell to everyone and anyone you can find. A lot of young entrepreneurs will raise small amounts of investment from the three Fs too. This is very risky because you are putting your relationships at risk if the business collapses and all of your friends and family lose money because of you.
You can then graduate up into angel investment. Angels are high net-worth individuals who are looking to find very early stage start-ups with small batches of money. Usually this is a round of less than R500 000 for a pretty decent chunk of equity in your business.
Out of angel investors grow institutional venture capital firms. These companies will give you a lot of money for a lot of equity and help you grow. They’ll sit on your board (or formulate one if you haven’t) and they will drive you to grow your business at near-exponential rates. This level of funding is all about return on investment. If they put in R1 million, they expect to get R10 million in five years. It’s your job to make it happen.
Overall, with investment comes pressure and formality, but also the potential to grow something mammoth and meaningful very quickly.
My favourite kind of funding is the oldest kind out there: Profit. If you want to maintain control of your business and grow it, then you need to be profitable and reinvest the money in your company, not your cool new car.
Is there a right time to raise funding?
In my experience there are a multitude of situations when your business might require external funding. The ‘right’ time can only be decided by the person running the show. If you are raising money out of desperation, perhaps it’s not the right time to raise. However, finding funding at this point may save your business.
On the flip side, raising growth capital is perhaps the safest time to raise funding. Your business should have profit and traction, it should be showing incredible value in the market and you should have a very clear plan to increase profits and growth exponentially.
If you take this plan to a variety of investors you are able to shop for the best terms and the best partners. That’s the kind of money you want. But bear in mind, if things take a turn for the worst your investors can become your worst nightmare. Just ask Travis Kalanick at Uber who is being sued by one of his major investors.
Raising funding is an extremely personal decision that business owners should think through carefully and plan for the worst as well as the best-case scenarios.
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