Capital Questions Do you stand a chance of getting venture capital? Take this test and find out.

The devil of getting venture capital lies in the semantics ofthe situation. While almost every emerging enterprise requires adollop of venture capital to get to the next stage, venturecapitalists are not the source of this funding about 99.44 percentof the time.

The fact is, the vast majority of venture capital comes fromsources other than venture capitalists. Where most BIZ Experiencesserr is in pursuing the latter rather than the former. Thedistinction wouldn't be so important if the six months to ayear most BIZ Experiencess take learning this didn't kill as manycompanies as it did.

There just isn't enough venture capital to go around. The$7.4 billion or so the nation's venture capital partnershipsstarted with last year is just a fraction of the $50 billion to $60billion America's emerging high-growth companies need eachyear, says Jeffrey Sohl, director of the Center for VentureResearch at the University of New Hampshire in Durham.

When you look at numbers like this, it becomes obvious thatprofessional venture capitalists offer limited financingopportunities for a small population of companies. The question,then, is whether yours is among that small minority of enterprisesa venture capitalist will finance.

To find out, run through the following seven-point diagnostictest from John H. Martinson, managing partner of Edison VentureFund, a Lawrenceville, New Jersey, venture capital firm with morethan $200 million under management. And to add more weight to thenumbers we've been talking about, consider a typical year forEdison, according to Martinson: "We see 2,000 business plans,of which we might visit 300, seriously consider and conduct duediligence on 50, and invest in eight to 12." Here's thelitmus test:

1. Are you a technology company? "In general, 80 percent ofa venture capitalist's portfolio is in technology," saysMartinson. Why the relentless focus on technology? Martinson saysthe key may lie in the answer to the next question.

2. Are you capable of being a market leader? "We rarelyfinance a company that is going up against a market leader with asimilar product," says Martinson. The reason? "It'stoo difficult and too expensive to succeed." But here'swhere technology plays a role. Breakthroughs can shatter theestablished paradigm of existing markets or create vast new ones.With low-tech consumer products, such as plastic housewares, orubiquitous services, such as restaurants, it's difficult tochange the rules of the game.

3. Can the company be built inexpensively? In Martinson'snomenclature, that means about $10 million or less. "Venturecapitalists like to build companies on the cheap," saysMartinson, "to limit the downside risk and because theydon't want to have to rely on other sources of capital to pitchin to help the company reach its goal."

4. Is there a clear distribution channel? Many times,entrepreneurs come up with great products, but there's no clearor easy way to sell them, says Martinson. And consistent withventure capitalists' focus on overall cost containment, theyalso want to know that the distribution channel can be accessedfairly inexpensively.

For instance, the existence of mass-market retailers appears tooffer inexpensive and wide distribution for many consumer products,and even some technology products. However, there are often hiddencosts that make these channels prohibitive, such as inventoryrequirements, the stores' right to return unsold product,"slotting" fees or mandatory cooperative advertisingcosts. Martinson says companies that have joint venture marketingopportunities--that is, the opportunity to move product throughsomeone else's distribution channel--or otherwise have directand proven access to the market are typically more attractive toventure capitalists than those that must invent their owndistribution systems or pay high fees to use someoneelse's.

5. Does this product require significant support? Complexproducts or services usually require customer support organizationsthat are expensive and sometimes difficult to establish andmaintain. For instance, a relatively low-tech home alarm systemsold through mass-market distribution channels might seem appealingto an investor given Americans' rising concerns over security,says Martinson. But can customers install it themselves, or does athird party have to get involved? "If a third party isrequired, it's much less appealing because of the costsinvolved and their impact on the margins," he says.

But the need for customer support doesn't have to kill adeal. Sometimes a third party wants to get involved because itspells opportunity for them. For instance, SAP America Inc., aworldwide applications software company based in Germany, reliesheavily on Big Six accounting firms to install and support itsproducts. For SAP, funds that might otherwise go to a massivecustomer support organization go instead to the bottom line.

6. Can the product or service generate gross margins of morethan 50 percent? "For business owners who are trying to carveout a salary and a living," says Martinson, "grossmargins of 30 percent are fine." But for professionalinvestors who need to make a return, 30 percent margins are toothin. Why? "First," says Martinson, "that marginleaves little room for error." Second, and more important, hesays, "my return depends on an acquisition of the company oran initial public offering. With thin margins, the prospect foreither becomes dimmer because the next owner of the companydoesn't want to face all the attendant risks associated withtrying to overcome those thin margins."

7. Can the company grow to $25 million in five years, with theprospect of growing to $50 million to $100 million? At $25 millionin sales, a company is just beginning to generate the kinds ofprofits that make it worth enough so venture capitalists can getthe kind of return they are looking for. Say, for instance, that a$25 million enterprise was bringing $5 million to the bottom line.Valuing the company as a multiple of its earnings--a standardbenchmark--and using a multiple of 10 just to keep the math easysuggests a value of $50 million. If the venture capitalist invested$10 million, then the return on this hypothetical company would befive times the investment in five years--a middle-of-the-roadtarget return for most venture capitalists.

On this final point, Martinson is firm. "If there's nopossibility you're going to hit the $25 million benchmarkwithin five years," he says, "it's simply a waste oftime to pursue institutional venture capital." But once thishurdle is passed, Martinson offers encouragement: "If thebusiness can really be cranked up fast, I would encourageentrepreneurs to give venture capitalists a try, because you justnever know until you do."

Contact Sources

Edison Venture Fund, 997 Lenox Dr., Lawrenceville, NJ08648, (609) 896-1900, ext. 18.

David R. Evanson, a writer and consultant, is a principal ofFinancial Communications Associates in
Ardmore, Pennsylvania.