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You have a 'million dollar' idea, but need a lot of money to 'make it happen'. After doing your homework and investigating touted financing programs, you will probably find yourself facing an unsettling reality. As an unproven business, it is extremely difficult to secure funds through traditional debt financing, such as bank loans or a line of credit, and government grants and loans for businesses are not only limited, but they are often very difficult to secure.
If this scenario sounds familiar, then you are not alone. Everyday entrepreneurs look for solutions to their financing challenges. For many, equity financing becomes an important option that can enable a risky business to secure the funds needed to get underway or grow further.
In the coming months, CanadaOne will look at the ins and outs of equity financing options for small and medium-sized businesses. To get things started, we recently interviewed Karen Grant, the executive director of Toronto Venture Group. Here are the transcripts of our interview.
| CO |
The Toronto Venture Group website says that your organization facilitates connections between entrepreneurs and investors. How do you do this? |
| Karen |
Toronto Venture Group has conducted venture capital networking breakfast meetings for the past 11 years. At these meetings, we provide name badges, colour coded to help everyone identify who are the investors, the entrepreneurs and the service providers. We also invite members of the audience to stand up and introduce themselves. It is amazing to watch venture capitalists announce that they have a fund of X amount looking for good investments in the software infrastructure field or angel investors who represent their family's interest looking for start up opportunities.
Toronto Venture Group is also a member of the Canadian Technology Network. As such, we will review business plans and determine its acceptability for private equity investors. We can then provide some guidance to the entrepreneur regarding qualified sources of capital.
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| CO |
Outside of the Toronto area, what are some of the most effective ways that an entrepreneur can connect with investors? |
| Karen |
We often recommend to entrepreneurs that they follow the following list.
- Friends and family for the first round (supported by credit cards and any other source of cash flow). Start selling product as soon as possible. In general, the days of raising money without a proven management team and market are gone.
- Look up and down your supply chain. Customers or suppliers who understand your marketplace and your potential are a good source of smart capital.
- The toughest place to raise money is with total strangers. The professional venture capitalists are looking for big returns from people who know how to grow a company.
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| CO |
Based on your experience, what are some of the most common misunderstandings that entrepreneurs have when they go out to raise capital? |
| Karen |
Probably the hardest thing for an entrepreneur to understand is that it is better to have the capital injection to grow the company and own 30-40 percent of it than to not have the money and own 100 percent. That is to say, many entrepreneurs overestimate the value of their company and underestimate the value of the money being invested and sometimes they completely ignore the value the investor can bring as a partner in the growth of the business.
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| CO |
One study determined that U.S. Venture Capital firms invest in roughly 7 out of every 1,000 companies that contact them (see http://www.capital-connection.com/survey-chances.html). Do similar ratios exist in Canada? (Do you have any comparable Canadian stats?) |
| Karen |
I do not know of a comparable study, but some of my venture capitalist friends have suggested that they are investing primarily in companies and management teams they already know and trust. This is substantiated by the Canadian Venture Capital Association's 2000 third quarter report. They stated that 2/3 of all financing transactions were follow-on financings in existing portfolio companies.
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| CO |
Many Canadian entrepreneurs believe that it is easier to get financed in the U.S. than it is in Canada, and believe that it's easier to get a larger investment for a similar equity stake when a company is financed out of the U.S. Is this a myth, or is there some truth to this idea? How is the Canadian venture capital market different than the U.S. market? |
| Karen |
While some of this may have been true during 1999 and early in 2000, I do not believe it is true now. Again, it comes down to the maturity of the management team and the realistic opportunity the company can offer investors. For a great company with a strong management team and a good market opportunity, Canadian venture capitalists invested $3.4 billion in 1,013 rounds of financing from January – September 2000 with $1.12 billion going to new financings. These companies would include the likes of Q9 Networks, which raised $26.5 million in seed capital. Don't be fooled though- the founders and management team of Q9 are proven and successful entrepreneurs.
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| CO |
Why do such a small number of the companies looking for venture capital get financed? What are some of the key differences between those that get the money, and the majority that do not?
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| Karen |
I think that 1,013 rounds of reported private equity financing is a large number. I also think that $3.4 billion is a large number too. These numbers do not reflect angel investment, nor do they reflect smaller, boutique venture capital activities. Venture capitalists and angel investors do not have to report their activities.
But it is the survival of the fittest. Many venture capitalists want to work with an entrepreneur who can take advantage of their contacts and will listen to their recommendations. Also, they want to finance someone with a big but realistic vision of success. Many would-be entrepreneurs do not understand that their business proposition is not sound; they may not have the "right stuff" to grow the company to a size that would be attractive to a venture fund; and they do not create the confidence in their ability to execute their plan or move out of the way for someone who can.
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| CO |
Investors will often say that they are looking for an "investment ready" company. What are the key characteristics of an investment ready company? |
| Karen |
Investment ready means:
- the company has a realistic knowledge of its value
- has a plan in place for growth and has a proven ability to execute on the plan
- is willing and able to report to a board of directors and take advantage of their advice (the board is generally made up of some of the investors and some knowledgeable industry people)
- has some plans for exit strategies for its investors (acquisition, merger or IPO)
- use of proceeds will be primarily to expand sales activities.
My observation is that most VCs want their money used to generate more revenue faster. There is still funding being made available for research and development, especially in biotechnology and new technology development like optical technologies. But again, there are some proven people involved in these ventures – it is not left to neophytes.
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| CO |
There seem to be so many different types of investors: angels, investment bankers, venture capitalists, etc. What are the main types of investors, and how do they differ from one another? |
| Karen |
Angel investors are private equity investors who use their own money to invest in a business. They are sometimes referred to as informal venture capitalists. They are often high net worth individuals, cashed out entrepreneurs, or active business people who have enough liquidity to take high risks with their money. These are the types of investors that should be sought for a first or second round of financing, depending on the amount being sought.
Venture Capitalists are professional investors. They use their own funds and raise additional funds from other sources such as wealthy individuals and institutional investors (i.e.: pension funds) to make an equity and loan (debt) investment in a new and/or existing business. They generally seek above average returns. Venture capitalists are seasoned business and financial managers who look to be able to repeat formulas that have worked for them in previous investments. So they typically stick to specific fields they know well.
Merchant Bankers act as fiscal advisers to entrepreneurs, owners and managers of small to medium-sized public and private companies. They will analyze your financial requirements, advise on how to structure your balance sheets, arrange for sources of capital to finance expansions and acquisitions and help execute reorganizations and divestitures. They will structure a variety of different financial instruments to provide the financing a company needs including:
- Asset-based Financing
- Term Loan
- Operating Loan
- Capital Lease/Operating Lease
- Sale and Leaseback
- Working Capital
- Factoring
- Export Financing
- Non-residential Mortgage
- Quasi-Equity
- Formal Venture Capital
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| CO |
When should an entrepreneur consider looking for an equity investment, whether angel, VC, or some other type? |
| Karen |
Only when they have a high growth opportunity. All investors are looking for a very high return on investment, typically 25% - 50% annually.
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| CO |
Most entrepreneurs are familiar with the saying that it's better to have a small piece of a big pie (in other words, to give up equity for the chance to make it big) than to own a small pie (not giving up equity, and having a smaller, possibly unsuccessful business as a result). The upside is obvious if things work out well. But what about when things don't work out well following a financing round? What are some of the consequences that the entrepreneur might face? |
| Karen |
If an entrepreneur is successful in attracting an investor or a group of investors, there will be performance measurements put in place for the investors to be able to measure the entrepreneur's ability to execute his plan. These performance measurements could include things like revenue and sales targets, cost controls, employee retention and profits. The consequence of not meeting these targets could be that the investors would extract a greater share of the company in the next round of financing. They may suggest the entrepreneur step out of the way and take a supporting role within the company or step out of the company entirely. The worst-case scenario I can imagine would be for the investors to give up on the company completely and recommend to their friends that they not invest in either. In that case, the company will fail. This situation only happens if there are no redeeming qualities to the technology or company and if the entrepreneur works against his investors advise.
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