Venture capital firms are a great source of financing for high-growth companies. But they also can be among the pickiest of financiers.
In the absence of venture funds, a number of alternatives exist for start-up and later-stage companies to get financing when the venture firms say “no.”
There are more conventional funding sources, such as bank loans, credit card debt and funds borrowed from family members or friends.
In addition, a number of less conventional sources have been appearing with greater frequency, as investors and corporations thrive in the nation’s booming economy. Some of those less conventional sources include corporate partnering and investment by wealthy individuals, also known as business “angels.”
The typical venture firm funds only one out of every 30 or 40 deals it sees, meaning most companies that pursue the venture capital route come away empty-handed, said Jim Freedman, managing director of Barrington Associates, an investment bank in Brentwood.
“If you’ve got the latest or greatest biotech device or something that’s very unique or proprietary, (venture capitalists) may be interested,” Freedman said. “But they get a lot of requests for financing and can afford to be very selective and particular.”
Many L.A. entrepreneurs who fail to get venture capital turn to personal savings and to friends and family, Freedman said.
“The advantage to friends and relatives is that they know you, presumably trust you and have confidence in you. Also it’s relatively easy going to them, compared with venture capitalists who grill you and require all kinds of presentations,” he said.
Friends and family funding are also typically less costly than venture capital funds, usually because friends and relatives are less sophisticated about valuing a company and more likely to believe the owners’ assessments, Freedman added.
Of course, the big drawback to funding from friends and family is that the entrepreneur risks alienating those people if the venture fails something that happens to 80 percent of start-up companies, he said.
“If you lose their money and there’s an 80 percent chance you will you don’t have a lot of happy friends and relatives,” he said.
Another alternative when venture capitalists say “no” is having a business angel, said Peter Griffith, managing director of Wedbush Morgan Securities.
“You’re seeing more and more angels now because you’ve got rich men and women running around who’ve sold their businesses or made money in the stock market,” he said.
Business angels offer the advantage of one-stop financing for entrepreneurs, said Griffith, compared with multiple friends and family members usually required to raise the same amount of money.
However, angels can be more burdensome if they take too much of a hands-on approach, said Freedman. A business angel could quickly become a business nightmare if the venture fails, and the angel resorts to litigation to recoup some of his or her investment.
Borrowed money from a bank or from credit cards is one more alternative to venture capital.
The problem is that start-up firms can rarely obtain bank loans without collateral, which puts the entrepreneur’s assets if any at risk if the venture fails, said Neil Dabney, chairman of Dabney Group LLC, an investment bank in West Los Angeles.
Credit cards offer interest rates that are generally higher than those of conventional loans and allow only a limited amount of funding. In addition, credit card borrowers must continually pay down their debt, unlike venture capitalists who are much more patient about waiting for returns, Dabney said.
Borrowed funds aside, one relatively new financing option for cash-strapped entrepreneurs is corporate sponsorship, said Griffith of Wedbush Morgan.
“We’re seeing a lot of corporate partnering now (with smaller firms in search of growth capital),” Griffith said. “Some big corporations have very aggressive programs these days.”
Griffith believes the partnerships are being driven by shorter and shorter cycles for many new products especially high-tech products. To handle the shorter cycles, many major firms have found it more effective to co-invest with outside partners for various forms of production rather than do everything in-house, he said.
“The problem with corporate partners is the corporation is not committed to being in that business (with the entrepreneur) for any period of time,” Griffith said. “Venture capital firms are generally committed for 10 years.”
Lastly, an initial public offering is always an option for more-mature companies. But keep in mind the IPO option is generally limited to firms with a valuation of at least $5 million.
The IPO route also carries with it the added scrutiny of hundreds or thousands of shareholders, who are often less patient than venture capitalists about realizing satisfactory returns on their investments.
“The biggest disadvantage to an IPO is you’re totally open, and you’re subject to intense quarter-by-quarter scrutiny,” said Freedman. “If your company stumbles for just one quarter, the market will decimate your stock price and you could lose half the value of your company overnight. It also increases the chance for litigation. It’s a lot riskier, though the cost of funds is much cheaper.”