News Column

The VC Process

March 2004, HISPANIC BUSINESS Magazine

Joel Russell

Moctesuma Esparza fulfilled two goals in 2002 when he sold his Buenavision Telecommunications. The sale to Adelphia Communications culminated the Hollywood producer's vision of launching a cable TV service for the Hispanic market in East Los Angeles - and also provided an exit strategy for Syncom, the venture capital firm that financed Mr. Esparza's efforts.

But minority companies such as Buenavision that succeed in obtaining private-equity finance remain a rarity. A Milken Institute report found that only 2.1 percent of the money in private-equity markets is managed by companies focused on underserved markets. A recent white paper by New America Alliance (NAA) found that only five private-equity funds in the country target Hispanics. And although a study by the Kauffman Foundation concluded that "minority enterprise venture capital investing is very profitable," only 1.5 percent of private-equity capital goes to minority companies, according to the National Association of Investors Corp.

"Historically, Hispanic entrepreneurs haven't had a relationship with the private-equity world, because it's a clubby world," says Monika Mantilla Garcia, co-chair of the NAA's Capital and Private Equity Committee. "The most immediate solution is building bridges [and] providing training for entrepreneurs."

And fund managers, entrepreneurs, and researchers say there also are strategies that CEOs at established and middle-market Hispanic companies can employ to help improve their chances of success in the hunt for venture capital. Ultimately, they say, the strategies that determine success occur even before a business plan is submitted to a fund.

"This is what separates those who succeed from those who just can't," says Tony Medrano, former CEO of consulting firm SEED/Emerging Growth Enterprise and now general manager of Inflow, a Web-hosting firm backed by $300 million in venture capital. "Don't just start e-mailing your business plan. You must convince someone you know that it's worth half an hour of their time."

To penetrate the private-equity market, Mr. Medrano suggests networking through corporate and charity boards. He estimates that the typical venture capitalist sits on five to 15 boards; if the entrepreneur has just one acquaintance on one of those boards, it provides a connection. Attorneys and accountants who work for the firm also can be used as referrals.

Once a connection has been established, an entrepreneur seeking growth capital should submit an executive summary of five to seven pages, advises David Yarnell, managing partner at BEV Capital. The document should briefly describe the business and its growth strategy, but the most important elements are the management team and the financials. "People who don't send financials don't impress," says Mr. Yarnell.

Mr. Medrano says only about 5 percent of proposals seeking funding make it past the first cut. "A lot of CEOs don't understand why VCs don't want to invest," Mr. Medrano says, "but there is a huge difference between a great company and a great VC investment."

That difference lies in a clear exit strategy. Service companies such as restaurants and law firms "are great for individual business owners," says Mr. Medrano. "They generate good revenue and a good lifestyle. But there aren't great [profit] margins or growth potential, so VCs aren't interested." In contrast, companies in industries such as computer software, biotech, financial services, and media have more established exit mechanisms for VCs such as acquisitions or public stock offerings.

So while an entrepreneur may not consider an exit strategy an imminent issue, VCs have a different perspective. "Exit strategies are evaluated as part of the investment process prior to making an investment," says Marco Rodriguez, managing partner at Palladium Equity Partners, a fund that specifically targets middle-market Hispanic companies. "A key part of our investment analysis considers the potential purchasers of a company and how to create value from their perspective."

A poll of fund managers for the book Inside Secrets to Venture Capital (Wiley) found that "The overwhelming reason why they refuse to invest … was lack of an experienced, complete management team. … The venture capital firm is willing to contribute the expertise of its partners as well as capital, but it will not back companies with glaring weaknesses in management."

Entrepreneurs in the poll tended to minimize the importance of management, however, blaming the "real" reason for rejection on external factors not surprising, perhaps, given that the "lack of management" cited by VCs often points directly at the entrepreneur.

If a company does make it past a VC's first cut on management and financials, the entrepreneur and VC usually then hold a half-hour meeting. At this point, the entrepreneur needs to try to get "an internal advocate" who will make the case for an investment, says Mr. Medrano. Such an advocate is helpful in the next step, which is to gain a hearing at the fund's partnership meeting where the conditional investment decision will be made by consensus.

Once the fund's partners give the go-ahead, negotiations begin in earnest. Now an entrepreneur must provide a full business plan while fund managers conduct research and due diligence on the company. It is during this phase that company valuation often emerges as a key issue.

From the VC's perspective, any investment should yield equivalent value in equity. In a simple valuation, for example, if a company is worth $15 million and the entrepreneur wants a $5-million investment, the VC should get 33 percent of the company's stock. For established middle-market companies, valuation can involve industry-standard multiples of revenues or comparisons to the market value of similar publicly traded corporations.

But investments involve more than just a company's current value. Entrepreneurs expect the company to grow significantly, thus reducing the equity percentage the VC needs to recoup the fund's money. On the other side, "Venture capitalists often calculate what they believe a company will be worth at the time of exit, say three to five years from now. That terminal value is then heavily discounted to reflect the risk. The discount can be as high as 75 percent," states Inside Secrets to Venture Capital.

For entrepreneurs whose company meets the approval of a VC, the hunt for funding can take anywhere from two months to years.

"The Latino entrepreneurs are there, and there will always be capital available for good investments," says Ms. Mantilla of NAA. "But there needs to be a link between the sources of capital and the needs of capital, and historically that link has not existed."



Source: HISPANIC BUSINESS Magazine


Story Tools






HispanicBusiness.com Facebook Linkedin Twitter RSS Feed Email Alerts & Newsletters