The Reality of Venture Capital - Part 1

There is a good reason why interest in venture capitalism has increase during the last decade. Ten years ago, venture capitalists were managing about $3.5 billion in assets. By the end of 1989, about 650 venture capital firms were managing well over $30 billion. The industry is currently raising and investing capital at the rate of about $3 billion annually.

But this source of financing is not for everyone. Many entrepreneurs are reluctant to work with venture capitalists because these investors typically ask for a high percentage of the equity. It is not unusual for first- and second-round investors to take 30 percent to 70 percent of the equity shares; succeeding rounds may leave the original owners with as little as 5 to 20 percent of the stock.

Another barrier is the degree of difficulty in finding receptive venture capitalists in the first place. On average, venture capitalists actually finance only one percent of the investment opportunities that they review. They choose only those firms that have excellent prospects for substantial payoffs.

It is no longer true that startups (as opposed to established businesses) are the primary users of venture capital. According to the 1990 edition of Pratt's Guide to Venture Capital Sources, less than one third of the industry's annual rate of new investment goes into startup situations. Pratt's estimates that professional venture investors back less than 1,000 startups annually.

That is a startlingly small number, especially since we all have heard alluring stories about venture capital deals that have led to the creation of now-famous businesses. Even though you may never work with a venture capitalist yourself, you may still be interested in finding out more about this growing industry.

Background

Queen Isabella backed Christopher Columbus. Pierre DuPont invested in General Motors. Our history includes many examples that show how instrumental venture capital was in he building of America. The institutionalization of this industry, however, did not begin until after World War II.

Two important milestones were the formation of the American Research and Development Corp. (ARD) in Boston in 1946, and the passage in 1958 of the Small Business Investment Company Act, which led to the creation of small business investment companies (SBICs) as vehicles for small business financing. SBICs were the first vestige of an organized venture capital industry, and they had tax advantages and potential government lending for leverage.

Today, there are basically six types of venture capitalists:

Investment partnerships and syndicates This group once consisted primarily of wealthy families, but now is often managed by professionals.

• Public and private investment pools This group is funded by money, such as pension funds, endowments and foreign institutions.
• Investment banking venture funds These funds are created by investment banking firm clients.
• Corporate venture companies Often, these are the large insurance and industrial corporations that seek diversity in their portfolios. Traditionally, they have been active In early stage ventures.
• Small business investment companies (SBICs) The branch for minority enterprises is called MESBIC. They were originally created for small businesses seeking less than $500,000.
• State governments Some state governments offer modest investment programs (typically in the $100,000 to $500,000 range) and are frequently motivated by social goals.

How venture capitalists work:

All groups of venture capitalists have one trait in common: they typically are not passive investors. They are distinguished by their ongoing involvement in their investment. They expect to enhance the value of their investment by assisting with long-range planning; financial assessments and arrangements; management evaluation and recruitment; relations with outside technical consultants and vendor/suppliers; relations with shareholders and provisions for the eventual liquidity of ownership positions.

Of course, the degree of involvement can vary greatly. Many entrepreneurs are advised to look for investors who can bring experience and expertise—as well as money—to the venture. At the same time, it is worth noting that venture capitalists are not certified or licensed in any manner; there is no guarantee that their advice will be sound.

Brook H. Byers, a venture capital investor since 1972, described four examples of how his firm (Kleiner, Perkins, Caufield & Byers of San Francisco) worked with small businesses:

Tandem Computers, Inc.

According to Byers, Tandem is an example of extreme involvement on the part of venture capital investors. His firm recognized a market opportunity for fault-tolerant computers and "incubated" the company internally in 1974. Two of the partners left to become president and vice president of finance, and a third became chairman of the board. All three partners had extensive management experience in the computer industry. It is arguably one of the most successful venture capital investments in history. Tandem became a publicly held company in 1977 and continued to grow. The stock is now worth over 100 times the initial investment.

Hybritech, Inc.

Byers said that Hybritech was a situation where a brilliant scientist saw an opportunity but needed management assistance immediately. One of the venture capital partners launched the company in 1978 as acting president in order to prove the commerciality of the process and to recruit a permanent president with experience in the industry. After the partner assembled the management team, he became chairman of the board and continued to advise on strategic and policy matters, but left operating issues to the managers. The partner then returned to full-time venture capital activity. Hybritech went public in 1981 and the value of the firm's holding has appreciated over 100 times the initial investment. Hybritech was subsequently acquired by Eli Lilly for a substantial premium.

Caremark (formerly Home Health Care of America, Inc.)

Byers said that this company is a case where an excellent management team needed capital in 1978 to exploit an unusual market opportunity within a narrow "time window." Their strategy called for a very rapid buildup of the venture and an aggressive geographic expansion. Two partners joined the board of directors to help execute the plan. The venture encountered some difficulties, including a founder who was not compatible with company goals, emergence of competition, and stresses of rapid growth. The venture capitalists' role was to assist in key strategic decisions, recruit officers, and finance the successful buildup. The company went public in 1982 and the holdings appreciated over 50 times the initial investment. Caremark was subsequently acquired by Baxter International.

LSI Logic Corp.

According to Byers, LSI was a "typical situation" where the venture capitalists participated in the 1981 startup financing of an exciting venture along with other venture capital firms. One of the partners joined the board of directors, as did another venture capital investor. The company pioneered a revolution in the semiconductor industry through the creation of design development tools to make the application specific integrated circuits. The venture capitalists' involvement was advisory in nature with specific assistance in financing and customer situations. LSI Logic became a success and went public in 1983—two years after the venture capitalists' initial involvement at a price of 25 times the initial Investment.

Though these four examples do a good job of showing a range of involvement that venture capitalists may have, they may be a little misleading in one important respect: it is the exception, not the rule, that investments pay off as well as these four have done. Most experts say that only about seven percent of venture capitalist investments have a return of ten or more times the initial investment. In fact, about a third of all investments result in a total or partial loss.

The four examples provide a good illustration of the range of the stages at which venture capitalists may become involved with an investment. There are three basic stages of financing: Early-stage, Expansion, and Acquisition/Buy out. A more detailed outline of the stages of financing follows.

Early-Stage Financing

Seed Financing
A relatively small amount of capital used to prove a concept so that startup capital can be obtained.

Research and Development Financing
A tax-advantaged partnership set up to finance product development for startups or for more mature companies.

Startup Financing
For companies completing product development and initial marketing. Typically, the product has not been sold commercially yet.

First-Stage Financing
For companies that have expended their initial capital (often in developing and market-testing a prototype) and that currently require funds to initiate full-scale manufacturing and sales.

Expansion Financing

Second-Stage Financing
Working capital for the initial expansion of a company that is producing and shipping, but may not yet show a profit.

Third-Stage or Mezzanine Financing
For major expansion of a company whose sales volume is increasing.

Bridge Financing
For the times when a company plans to go public within six months to a year. Often bridge financing is designed so that it can be repaid from the proceeds of a public underwriting.

Acquisition/Buyout Financing
Acquisition financing for financing an acquisition of another company.

Management/Leveraged Buyout
For an operating management group to acquire a product line or business.

What do venture capitalists typically look for? According to Pratt's Guide, there are three fundamental questions that venture capitalists ask:

Given the above guidelines, entrepreneurs who believe that their companies would be attractive to venture capitalists should evaluate the time it may take to construct the deal, the costs and the risks involved. After the entrepreneurs have put a business plan together and submitted it to venture capitalists, it could easily take six months to get a "yes" or a year to get a "no." As you could easily imagine, young companies can go broke while the founders are trying to get capital to fund the next growth spurt.

It may be impossible to calculate the cost of lost or delayed opportunities. The costs of developing a business plan vary considerably also. One business (as described in the Harvard Business Review) spent $100,000 developing a business plan that 25 venture capitalists turned down. Even successful searches for venture capitalists can cost a lot, there are always fees for lawyers, accountants, printers and regulators.

What about the risks? The chance the information will get into the wrong hands is an inherent risk and is one reason to make sure you really need the money and are getting it from highly reputable sources.

The process takes a long time, costs a lot, and is a real invasion of privacy because it is so thorough. One of the most widely known venture capitalists in the country, A. David Silver, recommends that no fewer than 20 references on each of the entrepreneurs and senior managers and six references on the middle management should be checked, along with key documents such as college and graduate school transcripts.

The process, which Silver calls "due diligence," also includes exhaustive audits of the business plan, the market size, the people, the financials and the legalities.

Surviving the Process

Given the fact that the process is long and expensive, what should entrepreneurs bear in mind while they are in the thick of it? The following is a small sampling of advice from a variety of sources:

Be prepared, "Before looking for capital, it's important that you have the fundamentals covered. You can't simply rely on sales techniques," says Peter Standevan, a principal with the Toronto-based firm, North American Ventures Management Ltd.

Two problems can result from being unprepared. First, once an investment opportunity is rejected, it is very difficult to get it reconsidered, even with a proper introduction. Second, if your proposal is rejected by a number of firms, it may get an "over-shopped" reputation. Venture capitalists trade information quite freely and a turndown by one firm may influence others.

Show you can compete globally. Says John Puddington, president of the Association of Canadian Venture Capital Companies, "Products must be able to fit into a global niche. Specialization is the key."

Don't go to a venture capitalist empty-handed "You've got to show your commitment to risking everything you own," warns David Dvorchick, a partner at Royal Oak Securities Corp. Don't ask for more than you unquestionably need. Gary Fife, project manager for the Federal Business Development Bank, says,

"Don't ask for $5 million if all you really need is $50,000. Venture capitalists aren't fools. They can spot an overestimate right away. For that matter, they can also spot any other attempt to pull the wool over their eyes.

Many venture capitalists are leery of status-spenders. Brian Marshall, merchant banking vice-president for Royal Bank Venture Capital in Toronto, says he's turned off by candidates wearing flashy clothing or driving costly sports cars. "I'm particularly leery of guys who have memberships in three or four expensive clubs and who tell you that they just can't face going through life without them," he says. Harry Mortimer, a managing partner with the Toronto-based Ven-Growth Capital Funds, jettisoned a deal with an entrepreneur who flew first-class when Mortimer himself was traveling economy .

What about "camp followers?" There are two types of camp followers. The first is a series of smaller investors who "seed" the deal to establish prices and credibility. The second type is the well-known person who becomes an advisor or a director, primarily to establish credibility. This second type may or may not make a small investment to confirm faith in the project.

In most cases, it may be best to avoid adding camp followers to your project if there is not an operational benefit from doing so. Small investors can complicate a larger venture by making compliance with securities laws more difficult, by balking at the seemingly onerous terms of the professional financing, by "helping" negotiate the terms, and by presenting an unstated but always present risk of suit in the future.

Should you require signed secrecy agreements? They may be an impediment to obtaining financing. Before you decide to ask for them, make sure that the secret is really worth all the effort. It should be an easily definable entity - like the formula for Coca-Cola.

Choosing a firm:

How do you go about finding the right firm? Let's turn again to Pratt's Guide. According to Pratt's, there are five ways of choosing a venture capital firm:

Geographically

This may be the single most important factor today. If you are unable to attract a "local lead" investor, you will have a more difficult time raising capital. The closer the venture capitalist is to the investment, the easier it is to "add value" to it.

Stage of Development Many investors have a stage-of-development bias. There are some who prefer the seed capital arena, while others are only interested in later-stage investing. Make certain that your company's stage of development meets with the preferred stage of development of the venture capitalist firm.

Amount of Capital Needed

Many venture capital firms have an upper and lower limit to the size of the investment. If your project falls far outside a firm's range, it is better not to approach them.

Industry Specialization

The venture capital industry is witnessing greater specialization than ever before. Some Investors specialize their investments in medical technology, communications, consumer products and distribution.

Venture Capital Leadership

It's advisable to find the lead venture capital investor first. Let this venture capitalist complete the syndication, rather than starting with smaller investors first.

Approaching the Investor

How do you approach the venture capitalist? Many authorities say that the best way is through a quality introduction. Venture capitalists are more likely to turn down an unsolicited business plan without giving it much attention.

Your banker, a lawyer, an accountant or even another venture capitalist can make the introduction. If these people are unwilling to provide the introduction, their hesitancy may indicate doubts about the financial ability of you and/or your product, which explains why they do not want their name associated with your venture.

If your contact does not know any venture capitalists, you may have the wrong banker, lawyer or accountant. The best introduction may be from a successful entrepreneur who has received funding from a specific venture capitalist.

The first contact after the introduction should be by telephone. The purpose of the call should be to get the venture capitalist to request your business plan and be willing to read it. The sole purpose of the business plan is to get a meeting. If one out of 100 investment opportunities ultimately gets funded, probably no more than 30 of those hundred get meetings. If you are invited to a meeting, you have increased your odds by a factor of three.

As we noted in the introduction to this article, venture capital certainly isn't for everyone. Getting it requires time, money and a certain amount of exposure. The vast majority of those who seek it never receive funding. And of those who do, the arrangement is not always satisfactory. The reality of venture capital is rarely as glamorous as it may seem to those who have read stories about the stars of the industry. But isn't that the way it often is?

For further reading, I recommend:

Pratt's Guide to Venture Capital Sources, (Needham, Massachusetts: Venture Economics, Inc., 1990). A. David Silver, Venture Capital: The Complete Guide for Investors (New York: John Wiley & Sons, 1985). 0914470973

National Venture Capital Association, 1655 North Fort Myer Drive, Suite 700, Arlington, VA 22209

National Association of Small Business Investment Companies, 1156 15th Street, N.W., Suite 1 101, Washington, D.C. 20005

American Association of Minority Enterprise, Small Business Investment Companies, 915 15th Street, NW, Suite 700, Washington, DC 20005

The author would like to thank Gia Esposito for her assistance with this article.

Industry Highlights

Average returns on venture capital investments (industry-wide)

• 11 percent are a total loss.
• 23 percent are a partial loss.
• 30 percent return 1-2 times the initial investment
• 20 percent return 2-5 times the initial investment
• 9 percent return 5-10 times the initial investment
• 7 percent return 10 times or more the initial investment—the real "Home Runs"

A common misperception is that most venture capital goes for early-stage financing: for seed-stage and startup businesses. But nationwide, only 6 percent of the companies that get venture capital financing are seed-capital stage, and these companies only get 2 percent of the dollars. If startups are included in that figure, the total is only 13 percent of the dollars.

Reasons:

Early-stage investing is the highest risk stage—a higher percent of those companies will be a total loss. Also, venture capital investing takes time, and the funds always realize their losses before their gains. To avoid substantial early losses, funds typically do expansion financing and leveraged buyouts—which are lower in risk—rather than seed-stage investing.

Secondly, seed-stage companies demand a lot of the venture capitalist's time; there is a limit to the number of companies a firm can handle. The average firm has four full-time professionals and if it is managing $100 million, the firm must invest its money in larger chunks, ranging from $1 million to $5 million. Leveraged buyouts and expansion financing are opportunities for multi-million dollar investments. Seed-stage financings are usually smaller.

Approximately 12 percent to 13 percent of the total number of venture capital firms manage 58 percent of the total amount of funds under management. These are the largest firms, with $100 million under management per firm. The smaller firms, with less than $10 million under management, make up one third of the total number of firms and manage 2.5 percent of the total dollars.

Geographically, the greatest concentrations of venture capital firms are on the East and West Coasts, in the Bay Area and the Boston area, with the dollars broken down as follows:

North East: 50 percent of total dollars.
West Coast: 28 percent of total dollars
Midwest/Great Plains region: 11 percent

Source: Venture Capital journal, compiled by John Neis of Venture Investors of Wisconsin, Inc.

Dr. Christopher Capelli is the president and one of the founders of Biolnterface Technologies, Inc., a pharmaceutical development firm in Madison, Wisconsin, that is financed with venture capital money. Dr. Capelli has a BS degree in engineering from the Massachusetts Institute of Technology and a medical degree from the University of Wisconsin-Madison.

We use venture capital in its true form. We're a startup—not in the classic sense, because we are four years old—but in the sense that we have new technology that we're looking to exploit.

BioInterface Technologies (BIT) is a medical research and development company that develops new core technologies for the medical marketplace. One of the primary technologies that we are developing is new pharmaceutical agents—specifically, antimicrobial polymers that would have topical uses in treating infections or that could be incorporated into medical implants, such as catheters and heart valves, to prevent infections. It's neat stuff.

BIT started four years ago and is housed in a research and development incubator, Laboratory Associated Businesses, with seven or eight other companies. We have four people working here, but our size can vary quite a bit. If we have a lot of projects going on, we have more people. I'm the boss, I listen to everyone and coordinate the research efforts.

I've always been involved with research. At the University, I was co-inventor of a blood glucose sensor with Mark Schultz, MS, and Stuart Updike, M.D., in Updike's lab. At the same time, I was involved with some small comparisons, doing a lot of research. Four years ago, I separated from Updike's laboratory and we started this company.

We had been funded through a number of sources including R&D contracts, government grants, option and licensing fees and things of this sort, when we started looking for venture capital in 1988. I had been involved with venture capital prior to this, with another company on the East Coast in the late 70s when venture capital and new companies were all the rage. So I was very familiar with it.

There are two basic reasons we chose venture capital:

First of all, we are an R&D company developing new technologies, and that's risky. And developing medical products is extremely risky. So we felt that we needed sophisticated investors who could understand that we're trying to develop technologies and then products, for the purpose of either licensing these products or actually introducing the products ourselves, to grow the company into pharmaceutical manufacturing. And that means using venture capital, because that's their job; they're paid to assess these risks and then make decisions.

Second, we are a small company and can't hire all the people we'd love to hire, so we need more than money from our investors. We need management input, legal input, the ability to have connections, etc. I've always felt comfortable working with them, because they offer more than just money.

By early 1990, BioInterface had received two offers from two different venture capital firms. One was in Chicago and one was Venture Investors of Wisconsin, here in town. We found Venture Investors, or they found us, when we gave a presentation at the Venture Fair in Milwaukee, sponsored by the Wisconsin Innovation Network.

We chose to go with Venture investors because they were local and we knew they had a good reputation. I felt they had a very good ability to do technical assessments and the vision to see where the technology goes, which is very important for a research development company. They also have a very good relationship with the University of Wisconsin. That's a major plus—at least it was in our decision to go with them. The Chicago fund was another excellent group, but again, it is a decision that we had to make.

So how do you find a venture capitalist? I take my business plans all around the country, and I've been in contact with most of the big venture firms. At first my proposal was a thick document that was probably very boring to read. Since then we've done two or three major revisions. From my experience, looking for venture capital is a constant process.

Ultimately, the proposal that provided us with the highest response rate from venture capital firms was a very small, simple document of about 20 pages. Most venture capitalists receive a ton of these proposals a week, and you have a very short time to catch their interest.

There are some other important points about trying to approach a venture capitalist. Always have an introduction, either from another venture capitalist, a consultant or somebody who knows a venture capitalist. You need an introduction. Cold calls rarely work.

But you don't want to put a lot of time into writing this big business plan until you know who you're approaching—what they are looking for, how they think. If they're interested, they'll request more information. If they're not, there's no reason to send them a 200-page business plan. And I think it's important to try to get together as quickly as possible, because having them read the proposal versus selling it to them is a whole different story.

In other words, if you send a large business plan, they'll skim through it and it will either catch their interest or not. But it's very hard to translate your excitement or what the real technology is via paper. So you send them a very short selling tool to get them to say, "Yes, I think this is worth checking out." If you do that, then you talk to them on the phone and find out how interested they are. And after talking to them, if they're more interested, it's a matter of getting there and presenting to them what your business is all about. And then, if they want a business plan, you can prepare one or provide them with something. But this way, they're already set up and they're in the right mind frame, and everything isn't riding on how they interpret the initial document. I've learned all this from trial and error and advice from other people.

Finding a venture capitalist is just the beginning. And that brings up the next point; don't ever expect quick action. It's always been my impression that venture capitalists work in a different time frame. They don't own watches. A prime example—this is the greatest thing—you give them a call and the secretary will say the venture capitalist is on the phone and he'll call you back. A quick callback means that it'll be within two weeks. It's not that you're bothering him; that's their quick response. It's always been a mystery. And that's just a callback. For getting any action done, you have to think in terms of months, quarters, half- years or a year.

But the reason for this is that you're really trying to develop a relationship. And this answers the question, Should somebody get involved with venture capital? When you get venture capital, you get more than money. You get a partner. It's more of a marriage. As a result, getting the money involves dating, courting and, eventually, the ceremony. If you think in those terms, then you'll have no problem with how venture capital works.

Again, you have to feel comfortable working closely together and understand that they've put their money in, and they're very concerned about it—the way for them to see their money grow is to see how the company grows—and it's all interpersonal. If you're not comfortable with that, you shouldn't get involved with venture capitalists. With private investors or rich doctors, they'll invest money and you can just talk to them every year or quarter, whenever you have your stockholders' meeting. But venture capitalists, in my experience, have been a lot different. And that's one of the pluses we've seen with them

Another exciting technology we're working on is magnetic resonance imaging. We want to manufacture this for ourselves. And here the need for money grows. We (and Venture Investors) are looking toward having other co-investors, other venture capital groups, come in. Our interest is to grow into a large company and make money—a lot of it—for everybody involved.

When we started the business, this was always part of the game plan—if there was an opportunity to develop our own products, one of the routes would be venture capital. We're not developing a widget where you can have a nice time line. There's a real risk factor here that is involved with any product development; it's not like setting up a factory and producing things and then hopefully having a return and looking at the marketing research figures. This is to become a very large company in a quick amount of time and investors can take their returns if they want to.

Venture capitalists are not going to go away with the cheap end of the pie. They do take a big bite, and you have to understand that. It's a matter of understanding their needs. Their needs are atrocious, but nevertheless, they're there.

If you're aware of what venture capital money is and how it works and where they get their money, it's not a surprising thing. If you're concerned that they're going to want to get out in five years, then that's not the source of money that you should look for. Private investors may be better for you. Venture capitalists definitely have to have their exit. You just have to be aware of that.

I always look at people. You always look for how much money they have, of course, but you also look at people, and we rank Venture Investors very highly. By and large, there are pretty good people in the venture community. Each firm has a different flavor and they have a different approach, but most of the people we've met have been pretty reasonable.

So many people read about Apple Computer or some of these other hot companies; they read they were venture financed and all of a sudden they've gone public and made a zillion dollars. You only read about the breakout ones and people don't understand the early seed phases. But the reality is really a slow burn until you break out, and most companies don't break out. Most companies start very small and then, as things progress, they start to get more money and expand quickly.

We've been very pleased with our dealings with Venture Investors and, again, they've been behind us all the way. We've been very impressed with how they've worked.

- Kathleen Loftus, Associate Editor

Editor's Note: One of the most highly-respected resources in the venture capital industry is Pratt's Guide to Venture Capital Sources. The following is a sample entry from the 1990 edition.

About a third of all investments result in a total or partial loss.

OBS VENTURES, 111 5 Sansome Street, San Francisco, CA 94104. Phone: 415-391-9555 Fax: 415-391-7707

Management: Jeffrey Stein, Mng- Gen. Ptnr; Tom Cohan, Ptnr.

Type of Firm: Venture capital subsidiary or affiliate of industrial corporation

Affiliation: OBS Companies

Project Preferences

Role In Financing: Prefer role as deal originator but will also invest in deals created by others

Type of Financing:

• Startup
• First-stage
• Second-stage
• Mezzanine
• Leveraged Buyout
• Minimum investment: $250,000
• Preferred investment: $500,000-1 million

Minimum Operating Data:

• Annual Sales - $500,000
• P&L - Losses (profits projected after 2 years)
• Annual Sales (LBO) - $25 million

Geographical Preferences: None

Industry Preferences

• Communications
• Cable television Data communications
• Telephone related
• Computer related
• Computer services Software-applications
• Software-artificial intelligence Software-systems
• Consumer Consumer products
• Consumer services
• Franchise businesses
• Distribution
• Computer equipment
• Industrial products
• Electronic components and instrumentation
• Semiconductors
• Other Billing services
• Finance and insurance
• Fulfillment services
• Subscription services

Additional Information:

• Year Founded - 1981
• Capital Under Management - $30 million
• Method of Compensation - Return on investment is most important, but also charge for closing fees, service fees, etc.

Reprinted with permission from Pratt's Guide to Venture Capital Sources. Copyright 1990.

Interview With John Neis - Part 3

John Neis is vice president of Venture Investors of Wisconsin, Inc., a venture capital firm with offices in Madison and Milwaukee. He has a B.S. in finance from the University of Utah and an M.S. in marketing and finance from the University of Wisconsin-Madison. For six years, in between degrees, be owned a furniture-manufacturing business, along with two retail operations.

Forum: What does your firm specialize in?

Neis: We are truly a unique firm in the state of Wisconsin because we focus toward the early stage opportunities. We certainly do other sectors as well, to have a portfolio balance, but we really focus on early stage investments.

Forum: Why?

Neis: It's a small fund. We have just under $8 million for management. But we get in there early on and get very actively involved with the companies. We chose this niche of the market—being based here in Madison, in the shadow of a great research university—because we felt we were going to get a disproportionate number of early stage investment opportunities—we're another route for technology transfer. We're trying to fund the creation of entities that are going to be doing business here and creating jobs here. And certainly our primary orientation is investing in companies that are going to provide an outstanding return on investments. Of course, we're going to have a higher percentage of our investments that are not going to work out. But we also hope that by getting in there early, we can get in at an attractive enough valuation where there is the opportunity for those home runs.

Forum: And do those balance out the strikeouts?

Neis: That's the plan.

Forum: How long have you been in business?

Neis: We're a relatively young fund. We made our first active investments in 1984. So, we're really just getting to a point where we're going full-cycle in some investments. And we have had some exciting companies in our portfolio that have done very well, and we've also taken a few lumps. That's part of the business. Office Solutions was a company where we were the first institutional investor and we ultimately sold it to Software Publishing. And made a very nice return on it.

Forum: So you don't typically work with someone who wants to start a family business and just hold on to it ...

Neis: Right. And I think, when we make an investment, we really want to have a true sense of partnership with the entrepreneur. We're not like a lender. We are an active participant who is going to share in the upside and the downside. We want to bring more than just money to the table. We want the entrepreneurs to be candid with us about their strengths and weaknesses. We try to fill those gaps and round out their team, whether it's through day-to-day contact or at least on a board level. We're making equity-based investments, and so we do want to share in that upside. Our goal, over a period of three to seven years, is to see a significant growth in value of the business and then realize some sort of liquidity, whether it's through a public offering, or an acquisition by a larger firm, which was the case with Office Solutions.

Forum: So you have found a market niche with the University?

Neis: That's certainly a significant part of our niche. Investment opportunities spin out of there, either directly or indirectly. And often the University can tell us whether a company's technology is truly innovative. It can also provide expertise in particular areas. A good example is a company we have in our portfolio—a seed stage company called Biolnterface Technologies. It is developing two areas. One is antimicrobial polymers for coatings for wound dressings and implanted devices. The other area is in magnetic resonance imaging. We have had tremendous assistance from people at the University in helping this company get off the ground. It's still a seed-stage company, but we feel we're very close to establishing a strategic relationship with a major pharmaceutical company.

Forum: And that would be for acquisition?

Neis: Probably not. They will probably provide dollars to our company in exchange for development work and for marketing rights for certain products. So it's really going to be a strategic relationship. The company will remain independent.

Forum: Do you work solely in medical technology?

Neis: No, we're a very diversified investor. In terms of hi-tech investments, we have invested in medical polymers, a couple of software companies, and a company here in Madison that produces the highest resolution mass spectrometers in the world. In our very low-tech investments, we have funds in two publishing companies: NorthWard Press, in Minocqua, and Gareth Stevens, in Milwaukee, both of which have had phenomenal growth since our investment. We've also invested in a company called Romance, in Kenosha, that produces fresh pasta products, that you can find in most major grocery chains around the country. They have shown tremendous growth.

Forum: What exactly do you look for when you do make an investment?

Neis: I'd say probably the most important factor is the people. A good rule of thumb is that you'd rather invest in a grade A manager with a grade-B product than the other way around. You want people who are experienced in that industry, who have demonstrated their ability to manage. You want people who are very receptive to outside input, who know their own strengths, but also recognize their limitations, and have the ability to attract good talent to their company. You want someone who really has that sense of partnership, who has common goals with you, to make the company grow substantially, and who is also seeking the same type of liquidity you are. That's important. But in terms of the market and product, we're looking for a proprietary product or service that gives a company a distinct competitive advantage.

Forum: Proprietary?

Neis: Something unique to their product, that they have the exclusive ability to produce. It could be something that was patented or a trade secret or a unique distribution mode. Essentially, it's an innovative idea or product they have that gives them a distinct competitive advantage. Something that's not easily replicated by competition, but where they can establish a niche and hang on to that niche over time. We're looking for very significant growth potential.

Forum: Can you translate that into percentages, in returns on investment, that you look for in a proposition?

Neis: Return expectations will vary widely from investment to investment. At the low end, you might have a company that's established, profitable, but maybe is looking for expansion financing for a new product offering—something that they can't finance through the bank. Or another situation might be a low-risk buyout. In these cases, if the new project doesn't work out, you still have your core business and you still have a viable entity—you expect at least to get your money back. In those situations, you might be targeting a return on investment of 25 to 35 percent per annum. And that's not an interest return - we're looking for capital gain, some sort of interest or preferred stock dividend would be a portion of our return. The bulk of our return would come through growth value of the equity. At the other extreme, if you're looking at a seed-stage company, you might be targeting 70 to 100 percent per annum, which would translate into 15 to 30 times your money. But those are targets. And in reality, the industry has experienced, on an average, about a 15 percent rate of return per annum, and that's over, say, the past 25 years. In the past decade or so, returns in the industry have been poor - a lot of the returns have been single digit.

Forum: This is a percentage of firms that are surviving.

Neis: Actually, what has happened over the past two years, is that the amount of new money invested into the venture capital industry has dropped tremendously. This is money invested from pension funds into venture capital firms.

Forum: Is that the source of your working fund?

Neis: That is the primary source of investment dollars for the industry, and for us it's about 60 percent of our money.

Forum: Public and private pension funds?

Neis: Yes. Our largest shareholder is the State of Wisconsin Investment Board. But we also have a few other pension fund shareholders. But, as returns dropped, pension funds and others have slowed down their investments into the venture capital industry and, in turn, the venture capitalists have fewer dollars to invest in new companies.

Forum: Now, how many proposals do you see in a week, month or year, and what percentage of those do you look at seriously or invest in?

Neis: That's a good question. We probably see 300 to 400 proposals a year, and they range from one- to two-page inquiries to four-volume business plans.

Forum: Four-volumes?

Neis: Those are rare and they usually don't get read in their entirety. We get a lot of business plans, and the larger venture firms get that many more. I'd say about 70 percent of them or more, in all honesty, don't go beyond a five-minute reading—if you can't generate excitement about your opportunity in the executive summary, the first three pages, it's all over. But most of them are discarded at that point for a pretty significant reason. We'll get a proposal that's more of a Ma and Pa business and just doesn't give the type of growth potential we're looking for. Or it may be coming from within our state—we tend to look for things that are closer to home.

Forum: Is that typical of venture capitalists?

Neis: In general, they'd certainly prefer for it to be in the backyard. The really large firms will invest all over the country, but you still have an inside track if you're in their backyard. If you're in Menominee, Michigan, I can assure you, your chances are going to be a lot less than if you're in Boston. So, out of those 300 to 400 business plans, we might really start to look into about 30 to 40 a year. Then we'll spend some time reading the whole plan, and making a few phone calls, and say, Does this make sense? or I need a little more information here. And of those, I'd say about half fall by the wayside after just a little investigation. We ultimately get to a point where we're making investment recommendations in about a half dozen firms a year. And we might invest in three or four new ones.

Forum: Now, you say investment recommendations. Is this to your board?

Neis: Yes. And of the ones that we make investment recommendations for, it may be that after further discussion, we decide we don't want to proceed on it or, in the process of trying to negotiate terms with the company, they either decide they don't want our money or we decide we're not as sure we want to work with them.

Forum: Personalities come out when you start talking money, don't they?

Neis: Absolutely. We try to have some of those discussions fairly early on, because the whole evaluation process, the due diligence process, will typically take three months. We're making 100 phone calls to various parties and really trying to thoroughly understand the industry and the people and make sure we know what we're getting into. We want to understand the risks associated with the business and the opportunity.

Forum: Now how many are there working in your company?

Neis: We have three full-time people who are working on deals.

Forum: So that does keep you busy.

Neis: Yes. And then we also have a part-time investment analyst, who's working on an M.B.A. at the University and has a Ph.D. in biochemistry, so he understands a lot of technology opportunities, and he helps us do some of the investigative work. After we've made an investment, we may draw upon the others to bring some expertise to the table, but typically one of us will work closely with that company thereafter

Forum: It sounds like you go over a proposal and the business itself with a fine tooth comb.

Neis: We certainly do. We ask a lot of questions. Our process typically starts out on a computer database, doing a keyword search to find a lot of articles on the industry in order to get some background information on emerging technologies and emerging trends in that industry. Then we'll spend weeks making contacts with customers, suppliers, key people in the markets, industry experts, university technology experts, on and on. Ultimately we try to structure an investment agreement that makes sense, that provides natural incentives for everybody to work in each other's best interests. Throughout the process, we meet monthly with our investment advisory committee and then, ultimately, go to our Board of Directors.

Forum: How long does it usually take?

Neis: Typically, 60 to 90 days. A lot of it depends on the completeness of the business plan and on whether it's a deal that we're going to do by ourselves or whether we're going to be co-investing with other venture firms.

Forum: How often do you do that?

Neis: Quite commonly. There's a great deal of cooperation among firms within the industry and a lot of times there's a desire to spread the risk, bring broader expertise to the table, and there may be needs for additional rounds of financing—planned and unplanned. And you'd like to have deep enough pockets around the table so that you have the capacity to put more dollars in if you feel it's the right move. We, being an early stage investor, very commonly will be the first investor in and then will bring in other investors in another round of financing. It's a little riskier, and you need to be a little more tenacious, but we are willing to do that in the right situations.

Forum: How do people find out about you? You don't put an ad in the Yellow Pages, I imagine.

Neis: No, there are a couple routes. First of all, there's a very good publication out there called Pratt's Guide to Venture Capital Sources. It lists virtually every venture capital firm in the country. It's a wonderful tool, and I highly recommend it. Also, a lot of proposals come to us by referral.

Forum: From attorneys or banks?

Neis: From attorneys, bankers, accountants—those are the primary sources. Also, we've kept a pretty high profile. We've been cosponsors of the Wisconsin Venture Fair since its inception. We speak around the state to various groups and chambers of commerce.

Forum: So those kinds of things do work?

Neis: The Venture Fairs, I think, are a good tool. I think that firms certainly can, by using something like Pratt's Guide, go out and identify firms to approach. But a venture fair is a nice forum for companies—it gives them an opportunity to make a very professional presentation to a room filled with venture capitalists. It saves them a lot of time and effort and enables people to reach a wide group of potential investors very efficiently.

Forum: In what way do your requirements differ from those of business angels?

Neis: I think there are some real differences. I'd even divide the business angels into two categories—the more sophisticated angels and the less sophisticated ones. There are a lot of people out there who, through their profession, are making a good income and have the ability to invest in little companies, and just sort of enjoy doing it but really don't have a lot of expertise. The advantages of venture capital are that you are going to have more knowledgeable money investors who are experienced in dealing with a lot of the growth pains of a young company and who have a strong contact base. There are the more sophisticated angels out there, and they certainly can be a viable source if they bring expertise to the table. It may be someone who's in a very closely related industry or who has a business which is selling to the same customer base but is not a direct competitor. And if you can get someone like that to invest, you can get a lot of value out of them. If it is someone who is very successful, they may want to play a bigger role than you want them to. But that's always something that you have to get comfortable with. The less sophisticated investor may be willing to pay a higher price for the stock and you may have to give less ownership to them. But you may not get as much value and as much help in growing a successful company. You also can potentially end up with the hassle factor. If you have one institutional investor versus ten individual investors, you may find it a lot easier to communicate with the one investor. Another factor is that venture capital firms, institutional investors, are more likely to be consistent in their investment objectives and have capacity for additional investment. Having been through the growing pains of a young company, were not going to panic when everything doesn't go according to schedule. Individual investors may have deep pockets, but they may wear tight pants. They may not have the willingness to put more money into a situation that is not going according to plan. So I think that's clearly one of the tradeoffs someone has to deal with.

Forum: Do you set any limit in your role with the company? Is that drawn out with contracts and such?

Neis: Absolutely. We have a very detailed investment agreement.

Forum: Is that negotiable with the company?

Neis: Oh, it is to a certain degree negotiable, but for the most part, it is a boilerplate agreement, something that's very standard throughout the industry. It states the things you can't do without our approval, the things you must do and really lays out all the groundwork for the relationship. It's very important to spell that out. When you are dealing with individual investors, you typically won't give them the extended rights that a venture capital investor will ask, and some people may consider that preferable. But the individual investors may have a higher expectation of rights than you actually gave them and be disillusioned somewhere along in the process.

Forum: Are there any other things danger signals that turn you off?

Neis: All sorts of things can create red flags. Things in the business plan, or if there have been some negatives that haven't been shared with us—which we discover in our own research - it really raises a red flag in terms of whether we're getting the whole story.

Forum: Or if that person's even aware of the problem.

Neis: Or if they're aware. But it's even worse if they're simply keeping that information from us. If there are some negatives and risks, we should be made aware of those. That is far more preferable than hiding them. Also, we want to see the entrepreneur at risk as much as we are. We like to see a situation where they've made a significant investment in the opportunity—the amount depends upon individual. Someone who doesn't have a great deal of net worth, still, if they've sunk in it and taken out personal loans and borrowed from their family, that would be a good sign. If they had invested $1,00,000 already and they're looking for $500,000 from us, and $1,00,000 of that is to repay them for their original investment, we'd ask the question, "If it's such a good deal, why aren't you keeping your money in there?" So that would be a red flag.

Forum: This has been a fascinating inside look. Thank you.

Neis: Thank you.

Editor's note. This interview was conducted by associate editor Kathleen Loftus.

For further assistance with loan issues, contact a consultant at a Small Business Development Center.

> See also: Venture Capital

Author: Paul Keaton, who has worked with many small businesses as a consultant for the Small Business Development Center at the University of Wisconsin-LaCrosse, where he is an associate professor of management.
Source: The Journal of the Association of Small Business Development Centers
Description: The reality of venture capital

This article is reprinted from the Small Business Forum, the journal of the Association of Small Business Development Centers, which is published by the University of Wisconsin-Extension Small Business Development Center. For information about subscriptions, reprints or submissions, please write 432 North Lake Street, Room 425, Madison, WI 53706, or call (608) 263-7843.

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