The majority of start-up and early-stage businesses require capital in order to flourish. A significant difficulty is that many of these enterprises are unable to secure regular bank loans or do not wish to make the personal guarantees often required to gain those loans. As a result, they must resort to alternative sources of funding, such as venture capital. Such money can be difficult to get and is sometimes subject to federal and state legal limitations.

What Is Venture Capital and How Does It Work?

Venture capital is a type of finance provided by investors to enterprises, the great majority of which are start-up businesses. It is often most readily available for companies who have demonstrated a significant ability to quickly scale their business and exhibit long term growth potential. Typically, investors are seeking both short- and long-term benefits, and they frequently give business advice to firms in addition to providing cash in order to optimize their return on their investment. Transactions can be structured in a variety of ways and there is no “one size fits all” for your business or the venture capital you are pursuing.

In considering the best practices for setting up and maintaining a venture capital business, keep in mind the following three categories: structural, operational, and environmental considerations. They are listed below.

Structural Considerations

• Funds should be of sufficient size to provide both initial and follow-on financing, allowing new, high-growth enterprises to expand and scale their operations.
• The sector experience of investment partners should allow for more effective transaction sourcing, in-house due diligence, and value-adding operations.
• Taking a risk and investing early in the seed stage, maybe in a syndicate with other venture capitalists, may result in exceptional returns.
• Investing in better-known local geographical areas may result in improved overall fund performance as a result of tighter networks and in-depth understanding of local prospects.
• Partnering on transactions allows for more efficient sharing of information and expertise between parties.

Operational Considerations

• The use of milestone financing, sometimes known as “drip-feeding” investments, can serve to reduce the amount of risk associated with a particular investment.
• A theme-based approach to investing trends, as well as an emphasis on disruption in terms of technology, market, or business model, may lead to greater performance; though it also exposes you to increased risk in the event of a market downturn or industry disruption from another direction.
• In-house due diligence by investment executives who are experts in a particular area may be more successful and less expensive than due diligence performed by external advisers.
• It is preferable for investment choices to be made by the investment team rather than by persons who are not involved in the process. Interestingly, some research has shown that using consensus in decision-making can lead to more conservative decision making, thereby remove outlier investments and reducing overall returns.
• Investment outcomes and fund performance are enhanced by the use of a metrics-based strategy to monitor portfolios and filter out low-performing assets as soon as possible.
• Exiting from an investment too soon can greatly reduce overall returns on the portfolio.

Environmental Considerations

• A culture of “thinking big” and being ambitious, combined with a stronger proclivity for risk, can result in greater financial rewards. However, overly concentrated risk can exacerbate losses.
• In contrast to a more closed and proprietary strategy, open networks foster information exchange and, as a result, improved understanding of new technological breakthroughs and markets.
• Luck is a component of success in venture capital investment; nevertheless, a significant component of VC success may be ascribed to the ability to recognize and capitalize on a fortunate opportunity when it arises.

Conclusion

Entrepreneurs and investors in early-stage enterprises stand to gain significantly from venture capital investment. However, these deals can be complicated and involve significant risks. Consulting with knowledgeable legal counsel will assist in ensuring that the parties make well-informed decisions and that the transaction is uniquely structured to the particular investment and accordance with all applicable regulations.

DISCLAIMER:  This Advisor is one of a series of business, real estate, employment, estate planning and tax bulletins prepared by the attorneys at Fauver, Large, Archbald & Spray, LLP. This Advisor is not exhaustive, nor is it legal advice. You should discuss your particular situation with us or with your own attorney. Our legal representation is only undertaken through a written engagement letter and not by the distribution or use of this Advisor.