Turned down by a venture capital fund? Is it time to pack it in? Probably not, it might just mean you’re normal.

You have no doubt heard about the classic high-tech startup where an entrepreneur saw a real need in the marketplace, wrote a smart business plan and raised several million dollars in venture capital to launch the company. These are the Facebooks, the Palms, and the YouTubes of the world and they are fascinating stories of great success; yet, these are incredibly rare situations.

What about the cabinetmaker that worked on your home? A medical device distributor? A drug testing service or an automotive performance parts manufacturer? These are all good businesses, but chances are, they did not receive any venture capital to start their ventures — why not?

The fact is, most companies start up without a dime of venture capital. In reality, according to the Kaufman Foundation, 99.9 percent of companies started in the United States never receive any venture capital. If your company has not received venture capital, you are in a not-so-exclusive club and it is not time to worry yet.

The following information is intended to help you to self evaluate your situation and save you some frustration if your company has been considering funding, but may not fit the venture capital model.

Let’s look at the typical venture capital (VC) model to see why most companies would never be candidates for VC funding even though they may be great companies.

In general, a venture capital company wants to invest in a company that can fit the following criteria:

·>> Can return 10x on the investment within five to seven years.
·>> Addresses a substantial market (often defined at $1 billion).
>> Has a substantial barrier to competitive entry.
·>> Requires $5 million to $10 million in investment.

Let’s look at each of these criteria with some examples to help illustrate.

10x Return
Can your company realistically return the investors 10 times their money in five to seven years? This simply means that if a VC gives you $1 million, it expects to get $10 million back when your company is sold or goes public in five to seven years. This is a huge hurdle and rules out most companies immediately. An ATV rental shop is a great business but most likely cannot realize these kinds of returns in this short time frame. So you ask, why wouldn’t a VC just be happy with a 3x or 5x return? Are they greedy? No, they operate in a high risk environment where most of their investments will return nothing or very little and a few will meet or exceed 10x and make the fund. Thus, every deal must have the potential for these kinds of returns to even be considered. Why the short time frame? Simply because VC funds generally have a 10-year total lifespan so they must get the money back within this timeframe.

Billion Dollar Market
Why must my company address a billion dollar market to be considered? There certainly are exceptions to this rule but it really comes down to a numbers game. Let’s say that a VC wants to put $5 million to work in your company (we’ll talk about why it’s $5 million in a bit). VC’s generally don’t like to invest alone so let’s assume that others matched the $5 million for $10 million total investment and for that they received 50 percent of your company. Your company is now worth $20 million so for the investors to receive the return they need, the company must be acquired for at least $200 million. If you had started in a market that was only worth $100 million, it would be very difficult to sell a company for $200 million. But, a $200 million sale is possible in a $1 billion market. This is an over simplification but you get the idea.

One other thing to note on market size — it must be sufficiently large that you don’t have to capture the majority of the available market to be successful. This is an incredibly difficult task that is seldom accomplished. Even the very best companies rarely own a majority of the available market, just look at PepsiCo.

Barriers to Entry
What are barriers to entry and why are they important? You must have some way to differentiate your offering and keep competitors from knocking it off. It can be a trade secret like Coca Cola, it can be patents like Gore-Tex or it can be an exclusive supplier agreement. These are just a few options but just make sure that you have some way of defending your position. Be certain that what you offer cannot be duplicated by large amounts of money and a team of smart engineers because that devastating scenario can and will happen if you are not protected and the product is a real hit with large market potential. The key point here is a large market. Lots of good companies grow in small niches with strong focus and excellent customer service.

$5 Million - $10 Million Investment
Requiring $5 million to $10 million in investment confuses many people until it is explained. Again, as with the market size, it comes down to simple numbers. Let’s look at it from the perspective of the VC and use a $100 million venture fund for our example. A typical fund of this size will have about five principals. This means that each principal will invest about $20 million of this fund. Should she or he invest it in $1 million increments spread over 20 companies acquiring 20 board seats in the process and raising the number of portfolio companies in the fund to 100? Of course not! Ideally, VCs only want about four new companies per partner, which means the partners need to invest about $5 million per company.

So where does the $10 million mark come from? This can get a little more complicated but it makes sense if you follow it through. It is good to note that this does not mean the company must take $5 million in the first round. Most funds want to keep about two thirds of their money available to follow on in subsequent rounds of funding along with other venture funds. Continuing this example, this means the company will take in $5 million from the first VC and additional money from other VC’s, which can push our example up to $10 million total. Most small companies will never need $10 million in investment capital to get going. What would you do with $10 million if you were going to start a small tax preparation company?

You will notice that excellent management was left off of the list above though you will likely see it listed on every investment philosophy page of venture capital firms. This is because every VC firm has a rolodex of top management that they can put into place if the founder does not perform. Don’t take this the wrong way, the VC’s do not want to kick you out and take over your company. To a person, every VC would much prefer that you are the right person for the job and can take the company from nothing to a multi-billion dollar public company but this is very rare. There are very few like Bill Gates or, locally, Josh James, in this world. Most founders reach their limit at some point and the company needs new leadership to continue to grow.

Let’s say you are a very good engineer and you created the finest new technology and the team to deliver it. When it comes time to switch from R&D to marketing and sales, this may not be your forte and it might be time to bring in somebody with that experience. In the best cases, the founder continues in the role that he fits best such as CTO, or maybe business development. This also illustrates why some companies may not be VC candidates — control. There are lots of great family or lifestyle businesses (my favorite is a bike shop) that are passed from generation to generation but this is not possible under the VC model.

Other Options
Is this meant to be all doom and gloom now that you have realized that your company is not venture ready? Absolutely not! It just means that you need to finance your startup like everybody else (statistically speaking). Most are funded by friends and family, savings, credit cards, home equity lines, sweat equity, seller financing — to name a few.

There have been many very creative ways to fund a startup. There are other sources that may suit your needs as well such as angel investment, which comes from individuals who invest personally in businesses; factoring, which is where a business sells its accounts receivable (invoices) at a discount; and of course, venture debt, which is a loan from a venture capital firm that you must repay, as opposed to a traditional equity investment in which you sell a portion of your company and are under the aforementioned obligations.

Kent Madsen, managing director with the venture capital firm Epic Ventures says, “When looking at financing it is important to understand the investor’s criterion and focus on those that align with your needs. For example, at Epic Ventures we focus on early stage technology companies, while firms like InnoVentures focus on early stage growth companies, and funds like Sorenson Capital, on later-stage old economy companies. Each fund has different goals, objectives, and needs that may or may not be appropriate for your company.”

If your company fits the VC profile, great, that is a fantastic way to fund and grow your business and Utah has many excellent funds to choose from. If your company doesn’t fit this profile, don’t worry, you are in the majority.

Damon Kirchmeier is managing director at InnoVentures, which provides venture debt funds for growing early-stage high tech, service and manufacturing companies. When not behind the venture capitalist’s desk, he finds himself competing in national downhill mountain biking competitions.