29 Apr Is Your Company Risk Appropriate?
The Big Question
I have often said: The problem is that too many companies are out seeking risk capital that isn’t appropriate for them.
How can I support this statement? After all, entrepreneurship is the primary driver of growth and job creation in the US. From 1979 to 1995, the Fortune 500 shed 4 million jobs, while entrepreneurial firms created 24 million jobs¹. I’m not suggesting we need less entrepreneurship; I’m stating that risk capital isn’t right for every entrepreneur.
From 1999 through 2001, venture capitalists invested $200 billion in high-risk ventures². This continues to have repercussions for early stage financing.
During the bubble, valuations went through the roof. We heard stories about venture capitalists chasing deals – start-up entrepreneurs in California with nothing more than an idea and a small team offered millions of dollars by multiple VCs. The over-valuation of ideas and opportunities quickly filtered down to the angel investing realm, especially since VCs were often financing deals traditionally left to the angels.
Availability of capital led to over-valuation in the angel arena and to the entry of non-venture deals looking for venture capital. There will always be companies seeking venture capital that shouldn’t receive it. This is normal, statistically speaking. But by 2000, a seemingly endless swell of start-up companies were seeking risk capital, and although the tide has ebbed, I don’t believe we’ve yet returned to pre-tidal wave levels. Too many companies were told they could, or actually did, receive risk capital from 1999-2001. Many of those companies, cash-starved, are still seeking a new infusion. Entrepreneurs, given the wrong expectations, are still waiting for “the market to come back.”
Without question, the US capital markets will emerge from the current slump. I must confess that I am an unabashed supporter of Malkiel’s “Random Walk” theory – the long-term trend of stock prices will be bullish. At the same time, entrepreneurs who expect capital to flow the way it did in 2000 will probably be waiting, based on NVCA data, at least 10 years. That market isn’t coming back anytime soon.
When should an entrepreneur seek risk capital? The vast majority of entrepreneurial ventures shouldn’t seek risk capital. Professor Bob Pricer used to say that family and friends fund 99% of small businesses. This is not risk capital. This is just the standard mechanism for financing entrepreneurship in America.
Companies appropriate for risk capital have a very specific set of characteristics. First, the opportunity offers growth potential that justifies high rates of return. Compound annual growth rate (“CAGR”) is a tiger lurking in the shadows: if a VC wants a 25% total return over 5 years, and expects half of her investments to fail, then each successful investment has to return six times what she put into it. And this is the low end . When you accept risk capital, you are usually suggesting that for every dollar invested, you hope to return ten times (or more) that amount in a 5-7 year timeframe.
In other words, when you take risk capital, you are making a commitment to grow your company very rapidly, usually by at least 100% per year, every year , for the indefinite future. That’s not a prescription for relaxing evenings home with the family.
Risk capital targets need to have a clear competitive advantage, preferably on a national basis, and potentially sustainable for 5 years. In other words, just being the best firm in town in your industry isn’t going to cut it. And being first to market is only an advantage while you can invest to remain first to market. At the extreme, we ask software entrepreneurs how long it would take Microsoft to copy or engineer-around their product.
If you are looking for risk capital, be prepared to talk about the evolution of your company. After all, the person who is CEO now, while the company has four employees, is pretty unlikely to be the CEO when the company is growing rapidly and has a hundred employees. If you are the CEO now, are you prepared to give up the reins?
Too often, I find that entrepreneurs develop a sense of embarrassment if they haven’t utilized risk capital. In my opinion, this is yet another side effect of the bubble. Accepting risk capital, from angels or VCs, involves giving up ownership and control. There’s nothing wrong with entrepreneurs who bootstrap their business without relinquishing either.
Don’t get me wrong: we need risk capital. Wisconsin needs more than most states, given the dearth of venture capital available based on any measure you choose. And some “new economy” business models, especially in the life sciences, consistently require risk capital.
At the same time, no economy depends 100% on a specific industry area. Healthy economies are diversified. The boom/bust cycles in Silicon Valley and Austin attest to the potential dangers of overspecialization.
We want high-tech companies because they provide fulfilling, high wage employment. But not all high-tech companies need risk capital.
The vast majority of businesses capitalize using founder money and assets, secured and unsecured loans, supplier and customer financing, and good-old-fashioned cash flow management. Each of these offers a variety of creative options to consider. Variations on these, combined with investor capital, offer hybrid mechanisms that may look like risk capital but don’t make the same demands of the business (i.e., an affiliated angel puts up assets to secure a low-interest loan from a bank and receives warrants in return). Crafty entrepreneurs can create win-win short-term financing opportunities without taking on the onerous responsibilities of risk capital.
If you’re thinking about risk capital, take the time to really think about how you’ll use it. Here are some questions to ask yourself (try to answer honestly):
Does your business have the potential to double (or triple) every year for the next 5-7 years?
Can your business survive competing with firms around the state? Around the country?
Are you prepared to bring in additional management to oversee this rapid growth? Are you prepared to give up some or all of your control if necessary?
Are you prepared to put in the effort required to generate the returns demanded by your investors? Even if this includes the possibility that they will end up making more money from the business than you do?
Obviously, while these may appear to be yes-no questions, the likely answers are more complicated. Few business decisions are truly black or white, and the decision to seek and accept risk capital is no different. Make the decision to seek risk capital as deliberately and carefully as you would make any other fundamental decision about your company.
(1) J Freear, J Sohl, and W Wetzel, Jr, (2000). “The Informal Venture Capital Market: Milestones Passed and the Road Ahead,” Entrepreneurship 2000, Sexton & Smilor ed. Upstart Publishing, Chicago.
Adam J. Bock is the research manager for Early Stage Research, an angel network, and a regular contributor to the Wisconsin Technology Network.