Category: Financing Decisions

Reprint from the Harvard Business Review: Do You Know Your Cost of Capital?

Written by Michael Jacobs and Anil Shivdasani. Click here to see the original publication in the Harvard Business Review.

With trillions of dollars in cash sitting on their balance sheets, corporations have never had so much money. How executives choose to invest that massive amount of capital will drive corporate strategies and determine their companies’ competitiveness for the next decade and beyond. And in the short term, today’s capital budgeting decisions will influence the developed world’s chronic unemployment situation and tepid economic recovery.

Although investment opportunities vary dramatically across companies and industries, one would expect the process of evaluating financial returns on investments to be fairly uniform. After all, business schools teach more or less the same evaluation techniques. It’s no surprise, then, that in a survey conducted by the Association for Financial Professionals (AFP), 80% of more than 300 respondents—and 90% of those with over $1 billion in revenues—use discounted cash-flow analyses. Such analyses rely on free-cash-flow projections to estimate the value of an investment to a firm, discounted by the cost of capital (defined as the weighted average of the costs of debt and equity). To estimate their cost of equity, about 90% of the respondents use the capital asset pricing model (CAPM), which quantifies the return required by an investment on the basis of the associated risk.

But that is where the consensus ends. The AFP asked its global membership, comprising about 15,000 top financial officers, what assumptions they use in their financial models to quantify investment opportunities. Remarkably, no question received the same answer from a majority of the more than 300 respondents, 79% of whom are in the U.S. or Canada. (See the exhibit “Dangerous Assumptions.”)

That’s a big problem, because assumptions about the costs of equity and debt, overall and for individual projects, profoundly affect both the type and the value of the investments a company makes. Expectations about returns determine not only what projects managers will and will not invest in, but also whether the company succeeds financially.

Say, for instance, an investment of $20 million in a new project promises to produce positive annual cash flows of $3.25 million for 10 years. If the cost of capital is 10%, the net present value of the project (the value of the future cash flows discounted at that 10%, minus the $20 million investment) is essentially break-even—in effect, a coin-toss decision. If the company has underestimated its capital cost by 100 basis points (1%) and assumes a capital cost of 9%, the project shows a net present value of nearly $1 million—a flashing green light. But if the company assumes that its capital cost is 1% higher than it actually is, the same project shows a loss of nearly $1 million and is likely to be cast aside.

Nearly half the respondents to the AFP survey admitted that the discount rate they use is likely to be at least 1% above or below the company’s true rate, suggesting that a lot of desirable investments are being passed up and that economically questionable projects are being funded. It’s impossible to determine the precise effect of these miscalculations, but the magnitude starts to become clear if you look at how companies typically respond when their cost of capital drops by 1%. Using certain inputs from the Federal Reserve Board and our own calculations, we estimate that a 1% drop in the cost of capital leads U.S. companies to increase their investments by about $150 billion over three years. That’s obviously consequential, particularly in the current economic environment.

Let’s look at more of the AFP survey’s findings, which reveal that most companies’ assumed capital costs are off by a lot more than 1%.

See how terminal value growth assumptions affect a project’s overall value with the interactive tool: What is Your Cost of Capital?

The Investment Time Horizon

The miscalculations begin with the forecast periods. Of the AFP survey respondents, 46% estimate an investment’s cash flows over five years, 40% use either a 10- or a 15-year horizon, and the rest select a different trajectory.

Some differences are to be expected, of course. A pharmaceutical company evaluates an investment in a drug over the expected life of the patent, whereas a software producer uses a much shorter time horizon for its products. In fact, the horizon used within a given company should vary according to the type of project, but we have found that companies tend to use a standard, not a project-specific, time period. In theory, the problem can be mitigated by using the appropriate terminal value: the number ascribed to cash flows beyond the forecast horizon. In practice, the inconsistencies with terminal values are much more egregious than the inconsistencies in investment time horizons, as we will discuss. (See the sidebar “How to Calculate Terminal Value.”)

The Cost of Debt

Having projected an investment’s expected cash flows, a company’s managers must next estimate a rate at which to discount them. This rate is based on the company’s cost of capital, which is the weighted average of the company’s cost of debt and its cost of equity.

Estimating the cost of debt should be a no-brainer. But when survey participants were asked what benchmark they used to determine the company’s cost of debt, only 34% chose the forecasted rate on new debt issuance, regarded by most experts as the appropriate number. More respondents, 37%, said they apply the current average rate on outstanding debt, and 29% look at the average historical rate of the company’s borrowings. When the financial officers adjusted borrowing costs for taxes, the errors were compounded. Nearly two-thirds of all respondents (64%) use the company’s effective tax rate, whereas fewer than one-third (29%) use the marginal tax rate (considered the best approach by most experts), and 7% use a targeted tax rate.

This seemingly innocuous decision about what tax rate to use can have major implications for the calculated cost of capital. The median effective tax rate for companies on the S&P 500 is 22%, a full 13 percentage points below most companies’ marginal tax rate, typically near 35%. At some companies this gap is more dramatic. GE, for example, had an effective tax rate of only 7.4% in 2010. Hence, whether a company uses its marginal or effective tax rates in computing its cost of debt will greatly affect the outcome of its investment decisions. The vast majority of companies, therefore, are using the wrong cost of debt, tax rate, or both—and, thereby, the wrong debt rates for their cost-of-capital calculations. (See the exhibit “The Consequences of Misidentifying the Cost of Capital.”)

The Risk-Free Rate

Errors really begin to multiply as you calculate the cost of equity. Most managers start with the return that an equity investor would demand on a risk-free investment. What is the best proxy for such an investment? Most investors, managers, and analysts use U.S. Treasury rates as the benchmark. But that’s apparently all they agree on. Some 46% of our survey participants use the 10-year rate, 12% go for the five-year rate, 11% prefer the 30-year bond, and 16% use the three-month rate. Clearly, the variation is dramatic. When this article was drafted, the 90-day Treasury note yielded 0.05%, the 10-year note yielded 2.25%, and the 30-year yield was more than 100 basis points higher than the 10-year rate.

In other words, two companies in similar businesses might well estimate very different costs of equity purely because they don’t choose the same U.S. Treasury rates, not because of any essential difference in their businesses. And even those that use the same benchmark may not necessarily use the same number. Slightly fewer than half of our respondents rely on the current value as their benchmark, whereas 35% use the average rate over a specified time period, and 14% use a forecasted rate.

The Equity Market Premium

The next component in a company’s weighted-average cost of capital is the risk premium for equity market exposure, over and above the risk-free return. In theory, the market-risk premium should be the same at any given moment for all investors. That’s because it’s an estimate of how much extra return, over the risk-free rate, investors expect will justify putting money in the stock market as a whole.

The estimates, however, are shockingly varied. About half the companies in the AFP survey use a risk premium between 5% and 6%, some use one lower than 3%, and others go with a premium greater than 7%—a huge range of more than 4 percentage points. We were also surprised to find that despite the turmoil in financial markets during the recent economic crisis, which would in theory prompt investors to increase the market-risk premium, almost a quarter of companies admitted to updating it seldom or never.

The Risk of the Company Stock

The final step in calculating a company’s cost of equity is to quantify the beta, a number that reflects the volatility of the firm’s stock relative to the market. A beta greater than 1.0 reflects a company with greater-than-average volatility; a beta less than 1.0 corresponds to below-average volatility. Most financial executives understand the concept of beta, but they can’t agree on the time period over which it should be measured: 41% look at it over a five-year period, 29% at one year, 15% go for three years, and 13% for two.

Reflecting on the impact of the market meltdown in late 2008 and the corresponding spike in volatility, you see that the measurement period significantly influences the beta calculation and, thereby, the final estimate of the cost of equity. For the typical S&P 500 company, these approaches to calculating beta show a variance of 0.25, implying that the cost of capital could be misestimated by about 1.5%, on average, owing to beta alone. For sectors, such as financials, that were most affected by the 2008 meltdown, the discrepancies in beta are much larger and often approach 1.0, implying beta-induced errors in the cost of capital that could be as high as 6%.

The Debt-to-Equity Ratio

The next step is to estimate the relative proportions of debt and equity that are appropriate to finance a project. One would expect a consensus about how to measure the percentage of debt and equity a company should have in its capital structure; most textbooks recommend a weighting that reflects the overall market capitalization of the company. But the AFP survey showed that managers are pretty evenly divided among four different ratios: current book debt to equity (30% of respondents); targeted book debt to equity (28%); current market debt to equity (23%); and current book debt to current market equity (19%).

Because book values of equity are far removed from their market values, 10-fold differences between debt-to-equity ratios calculated from book and market values are actually typical. For example, in 2011 the ratio of book debt to book equity for Delta Airlines was 16.6, but its ratio of book debt to market equity was 1.86. Similarly, IBM’s ratio of book debt to book equity in 2011 stood at 0.94, compared with less than 0.1 for book debt to market equity. For those two companies, the use of book equity values would lead to underestimating the cost of capital by 2% to 3%.

Project Risk Adjustment

Finally, after determining the weighted-average cost of capital, which apparently no two companies do the same way, corporate executives need to adjust it to account for the specific risk profile of a given investment or acquisition opportunity. Nearly 70% do, and half of those correctly look at companies with a business risk that is comparable to the project or acquisition target. If Microsoft were contemplating investing in a semiconductor lab, for example, it should look at how much its cost of capital differs from that of a pure-play semiconductor company’s cost of capital.

But many companies don’t undertake any such analysis; instead they simply add a percentage point or more to the rate. An arbitrary adjustment of this kind leaves these companies open to the peril of overinvesting in risky projects (if the adjustment is not high enough) or of passing up good projects (if the adjustment is too high). Worse, 37% of companies surveyed by the AFP made no adjustment at all: They used their company’s own cost of capital to quantify the potential returns on an acquisition or a project with a risk profile different from that of their core business.These tremendous disparities in assumptions profoundly influence how efficiently capital is deployed in our economy. Despite record-low borrowing costs and record-high cash balances, capital expenditures by U.S. companies are projected to be flat or to decline slightly in 2012, indicating that most businesses are not adjusting their investment policies to reflect the decline in their cost of capital.

With $2 trillion at stake, the hour has come for an honest debate among business leaders and financial advisers about how best to determine investment time horizons, cost of capital, and project risk adjustment. And it is past time for nonfinancial corporate directors to get up to speed on how the companies they oversee evaluate investments.

Learn more about Jacobs Capital.

How Much Should I Borrow?

What is the proper amount of debt for your company to borrow?

  • None
  • as much as the banks will lend you
  • neither of the above

The correct answer is c. In fact, for every company, there is an optimal amount of leverage that results in the highest return on the shareholders’ investment. The trick is to figure out what your company’s appropriate capital structure.

To determine how much your company should borrow, it is imperative to understand an esoteric financial concept known as the cost of equity. We all recognize the cost of debt, which is the interest rate. But contrary to popular belief, equity capital is not without cost.

Understanding this concept can have an enormous impact on the returns a business owner achieves. Roberto Goizueta increased the stock price of Coca-Cola over tenfold during his tenure as CEO, and much of this appreciation can be attributed to the fact that he understood the financial merits of appropriate leverage.

In layman’s terms, the cost of equity for your company is the return that you would demand from an “arms-length” investment in another company with a similar risk profile. From an academic standpoint, you can estimate your company’s cost of equity as follows:

Begin with the return that is available on a long-term, risk-free security. The best proxy for this is a long-term Treasury bond, which currently is yielding about five percent.

Then, add the premium over long-term Treasuries that has historically been required to invest in stocks, which is approximately eight percent. If your industry is more cyclical or volatile than average, this premium will be higher, say 10 percent to 12 percent.

Finally, academic studies show that small companies are inherently riskier than larger companies, and that businesses with revenues less than $100 million require an additional premium of four percent to attract investors.

The sum of the above factors in today’s market approaches 20 percent. But that is the return rational investors would require on a marketable interest in the equity of a small company. If your company is privately owned, its stock is probably not readily marketable. When you add an appropriate premium for lack of marketability, the cost of equity in a typical private company is somewhere in the range of 25 percent. Clearly, equity is a lot more expensive form of capital than borrowing from the bank.

If a rational investor would require a 25 percent return to invest in your company, why shouldn’t you? One possible answer is that you are not rational. Or, more likely, until now you were not cognizant of the return you should expect from your investment in your business.

Computing your return on capital

The performance measure that approximates the cash flow that a business generates which is available to shareholders and lenders, is earnings before interest and taxes, or EBIT. This assumes that you have to reinvest an amount in capital expenditures to maintain your current competitive position that is roughly equivalent to the current amount of depreciation and amortization, which are non-cash charges to your profits. It also assumes that you add back to earnings any monies paid to the owners in compensation, perks or otherwise that are in excess of what you would pay a nonowner to perform the same duties with the same proficiency.

To quantify the return on capital your company produces, a back-of-the-envelope approach is achieved by dividing EBIT by the amount of equity in your company plus interest-bearing debt. If your return on capital is below your cost of capital, then continuing to own stock in your company is not a prudent investment unless you take some action to either increase the cash flow the company produces or to lower your cost of capital. I have valued and sold dozens of companies that routinely failed to produce adequate returns on capital, so it is not unusual, just unfortunate. In truth, very few business owners have ever performed this analysis; therefore, they don’t realize whether ownership in their business is a good investment or not.

The key to increasing profitability depends on your company’s specific situation and is beyond the scope of this article. But an equally valid, yet often overlooked way to increase the shareholders’ return, is to lower your cost of capital through the prudent use of leverage. If your cost of debt is seven percent and your cost of equity is 25 percent, a company with no debt must achieve a return on capital of 25 percent. Similarly, a company with an equal amount of debt and equity capital must earn a return of only 16 percent (50 percent of capital at seven percent plus 50 percent at 25 percent) for it to be producing a market return to the owners.

Using this logic with no caveats leads to excessive leverage when pursuing the goal of driving up the returns to shareholders, which is what we experienced during the leveraged buyout bubble of the late 1980s. What happens in reality is that as you increase the leverage of your company, you increase the risk of defaulting on your loans and reduce your financial flexibility, both of which drive up your cost of equity because your stock becomes a riskier investment. So the use of debt only makes sense when the benefit derived from lowering your cost of capital exceeds the incremental risk of the associated leverage.

Each company has an optimal capital structure that is unique to that company. This occurs when low-cost debt is used to capitalize your business up to the point where the company can comfortably repay its borrowings without compromising its strategy.

Business owners who have never computed their own cost of capital or evaluated their optimal capital structure are “leaving money on the table” by not capitalizing their business in a manner to achieve the highest return on investment. One excuse I hear often is that if the owner sold his or her business, he or she would put the money in T-bills at a return of three percent or four percent, so their hurdle rate for a return on equity is minimal. This is highly flawed logic, though, because it compares apples and oranges. An investment in T-bills is quite a bit safer and more liquid than an investment in a non-marketable private company’s stock. Just because you have had many consecutive years of growth does not mean your company will grow forever or that owning its stock is without risk.

If you own a business that consistently produces a return on capital in excess of 25 percent, you have the luxury of ignoring this issue altogether. You can operate with no debt simply as a matter of principal and still rest assured that you are achieving a fair return on your investment, which is how I run my business.

​I like knowing I owe nothing, even if it is not the most financially rational position to take. However, you can get away with this attitude only as long as you are not accountable to any other shareholders. Otherwise, you need to run a few numbers to see if you are fulfilling your fiduciary responsibilities.

Learn more about Jacobs Capital

Mezzanine Financing

I recently discussed with my client Keith, the CEO and 50 percent owner of a recycling company, the options for buying out his partner, Bob, who owns the other half of the company. Bob, who put up the initial capital to start the company about 15 years ago, has never been actively involved in the business and views it simply as an investment.

Now that Bob is spending most of his time on his boat in Florida, he wants to cash in on his investments in operating businesses and invest the proceeds into real estate so all he has to worry about is tornados and whether or not the fish are biting. Keith is agreeable to Bob cashing out, particularly as he sees some opportunities to grow the business, which he can’t pursue as long as he has a partner who insists that all available cash be distributed each year.

I explained that the most efficient way to achieve both parties’ objectives would be to raise mezzanine financing, but neither of the owners was familiar with the concept.

In a nutshell, mezzanine debt is a form of capital that is between equity and debt, as its name implies. Mezzanine debt has some of the qualities of debt (it has to be repaid and it carries an interest charge) and certain qualities of equity (generally options or warrants to purchase stock are granted to the lender.) Mezzanine debt is an appropriate financing option when a company has borrowed all the traditional debt that banks will lend and they still need additional capital to expand their operations, make acquisitions or cash out a partner.

I valued Keith and Bob’s company at about $10 million; therefore, Keith would need to come up with $5 million to buy out his partner. The company generates about $2 million in cash flow each year, which means that in today’s tight credit markets it could only borrow about $4 million from a bank and it already had about $1 million in operating debt. Consequently, Keith needed to come up with an additional $2 million. When I explained to Keith that he would not be able to borrow the entire $5 million needed from his bank, he responded: “Then we will have to go to another bank to get the difference.” Unfortunately, it doesn’t work that way.

While banks come in many shapes and sizes, they all generally approach lending from one of two perspectives. The amount they will lend is either: 1.) a percentage of the hard assets you own, or 2.) a multiple of your annual cash flow. In today’s market, cash flow lenders (which have become virtually extinct since 2001) are generally extending credit equal to about two times annual cash flow. In the headier days of the stock market bubble, that multiple was nearly twice what it is today.

So, if you want to borrow more than twice your annual cash flow now, you most likely will have to turn to a mezzanine lender.

The benefit of using mezzanine debt is that it allows you to raise capital beyond what banks will lend, without relinquishing the same percentage of ownership you would have to if you simply sold stock in your company. However, it comes at a price; the interest rate is substantially higher than bank debt. According to Brent Burgess, of Triangle Capital Partners, the interest rate associated with mezzanine debt generally ranges from 10 percent to 14 percent; plus the lender generally retains an ownership interest after the debt is repaid.

Typically, according to Burgess, the lender will receive warrants to purchase stock in the company, for virtually nothing, that they can exercise from the time the loan is repaid until up to 10 years from the initial funding. For example, in the case of my client looking to cash out his partner, if he had to sell stock to raise $2 million to bridge the gap between what he could borrow and the price he had to pay for his partner’s interest, he would have to give up about 20 percent of the company. If he instead borrowed mezzanine debt, he might give up only 5 percent of the stock.

Mezzanine debt is typically paid back over a five- to seven-year period. If it is paid back more quickly, the number of options or warrants is typically reduced and, if it takes longer to pay it back, the number of shares the lender can purchase are increased.

With traditional banks tightening the reins on lending, more and more companies have considered mezzanine financing for the first time in recent years. Not surprisingly, a lot of capital has poured into the mezzanine market since 2001, attracting some of the major players on a national basis who had never before focused on this market, such as Goldman Sachs and The Carlyle Group.

One fund that has been active in Atlanta is CapitalSouth Partners out of Charlotte, NC. Joe Alala, president of Capital South, says he visits Atlanta monthly and views it as one of the most attractive markets in the south. CapitalSouth invested $1 million to help the management team from Alpharetta-based Staircase and Millwork acquire the company from its prior owner. Alala’s fund also invested $5 million to help fund the buyout of Atlanta-based Canterbury Engineering, a supplier of engineered plastic parts.

Capital South is looking to invest about $100 million in chunks of $3 million to $8 million. Locally, a new mezzanine fund, Chatham Capital, has recently been formed in Atlanta.The reason the rates on mezzanine debt are so high is that the risk associated with subordinated debt are much greater than for traditional senior bank debt, which is often secured by the assets of the company.

According to Burgess, for investments in companies with annual cash flow less than $5 million, a mezzanine investor is looking for a total return of about 20 percent to 25 percent a year. because most companies can’t handle an interest burden that onerous, the lenders achieve their returns by attaching options or warrants to the loan.

While most business owners recoil at the notion of paying this level of return, the cost of mezzanine debt is still less than what venture capitalists or private equity investors seek — typically in the 30 percent to 40 percent range. Equity investors who strictly buy stock may not charge a current yield on the funds they invest, which reduces the burden on cash flow; however, they get their returns by taking a larger chunk of the company and demanding greater rights to control the business.

​With the reduced availability of private equity and bank financing in recent years, mezzanine lenders have evolved from fringe players in the capital markets to mainstream sources of capital. Of course, whenever that happens, as Burgess notes, a lot more money gets poured into the sector and it becomes much more competitive. Moreover, both private equity and bank financing are starting to flow a bit more freely these days, all of which bodes well for the business owner seeking to grow or transition the ownership of their business.

Learn more about Jacobs Capital

Dealing with a Venture Capital Firm

Now that the venture capital market is coming back to life, entrepreneurs have a shot once again at raising some early-stage and growth capital from professional investors. If you are contemplating traveling down this road, however, a little planning can save a lot of time. I will share some tips on who to approach, how to approach them and what materials to have prepared in advance.

The first step is research. Which firms are a good match for your type of business and the stage of financing you are looking for? According to Melissa Lassiter, an investment manager with Parish Capital in Research Triangle Park, NC, early stage capital is increasingly available only through the small venture funds. Many of these are spin-offs of larger funds, where a successful individual or two from an established VC fund goes out to start a fund of their own.

Today, the larger, better-known funds are focusing primarily on sizable “growth capital” rounds for established, profitable businesses. So before you call the top funds in town seeking to raise $1 million to get a new business going, do a little research to identify the smaller guys with whom you have a legitimate shot at securing some capital. For a list of venture capital funds and their target markets, check out www.vfinance.com, www.entrepreneur.com OR www.nvca.org. Yahoo also has an extensive list.

In selecting the funds to approach, be sure to visit each firm’s web site to see if your business is a fit for their strategy. Pay particular attention to who their portfolio companies are, as this will give you better insight into their true appetite than the general parameters they list on their home- page. VC funds that have invested in the same or a related industry sector are often the most receptive, and if not, at least they are less likely to waste your time if there is not a fit.
Kathy Harris, with Atlanta’s largest venture capital fund Noro-Moseley, says the best way to approach a venture firm is through someone who has done a deal with them in the past. This might be a management team member or board member from one of their portfolio companies or even an attorney who has previously done business with the fund.

If you have a good meeting with a fund that decides not to invest in your business, ask them who they think would be a good fit, and ask if they will make an introduction. According to Bill Henagan, chairman of Atlanta Technology Angels, relying on an agent to promote an early stage deal is “the kiss of death” because early-stage investors don’t like to see a meaningful chunk of their investment going to pay fees. It also shows a lack of resourcefulness on the part of the entrepreneur; it is not difficult to identify whom to call in the close-knit venture capital community.

But before you pick up the phone and start dialing for dollars, you need to be sure you have the type of business that professional investors will look at and that you have the information they will be asking for written down on paper.

There are countless great business ideas out there and many ways to make money. A good business model, however, may not be sufficient to attract venture capital. VC firms are looking for a business concept that can become a very large company, i.e., more than $100 million in revenues, if the enterprise is successful. The market you are going after must be sufficiently large to accommodate a new entrant that will grow to that size.

I have reviewed many well-written plans in which the company would have to capture a 100 percent market share to achieve any meaningful size. Define your market and quantify how large it is before even contemplating approaching a VC fund.

Also on the checklist for VC funds is a valid “use of proceeds.” Be sure that you can explain exactly why you need someone else’s money and what you are going to do with it. I have never met a business owner that didn’t believe that they could grow much faster if they had more capital. By definition that is usually the case. However, you need to show that rapid growth and scale are required to succeed in your business and that internally generated funds are inadequate to finance that growth. In other words, there needs to be a window of opportunity that will close if you do not secure greater financial resources.

What else do professional investors look for? Paramount is evidence that the management team is up to the task. You need to have not just the potential but also to have demonstrated the capacity to build a company in the sector you are in. This experience is referred to by VCs as “domain expertise.”

Having run a similar business unit for another company or possessing a track record of building successful businesses from scratch are the best ways to demonstrate that you can accomplish what you have put on paper. Of course, the same VCs that preach the importance of “management” today all threw millions at baby-faced Internet wizards a few years ago. Because most of the VC funds got burned abandoning their number one principle, they say that they really mean it this time.

Absent a track record, you will have to deliver a proprietary advantage in the form of technology or relationships that will get your business to the stage at which you can bring in the appropriate management team to take the company to the next level. But even a great new technology is not adequate to attract venture money. There are countless inspiring technologies in search of a market.

No matter how great the idea is, you have to be able to explain your “financial model.” A financial model is an articulation of how your concept will produce profits. That means you need to know how much it will cost to produce the product or service — on a fixed and variable basis — and how much you can charge for it given the dynamics of the market you are going after.

Over the years, I have probably seen a dozen business plans from entrepreneurs who claim to be able to turn trash into energy. While that is a noble concept, unless you can demonstrate that the cost of converting the trash to energy is low enough and the amount of energy created is high enough to compete with existing energy alternatives, you don’t have a commercially viable technology. The price point for your product or service needs to be low enough to capture the market share indicated by your financial projections, yet high enough to generate an attractive return for professional investors.

The return VC firms look for depends on the size of their fund and the stage of company in which they are investing. Generally, it is in the 30 percent to 40 percent range. That means if you achieve what they believe to be a reasonable level of success, and they cash in their investment in five to seven years, they can expect a compounded annual return on that investment in the 30 percent to 40 percent range.

While this may sound high to an aspiring entrepreneur, their required return reflects the amount of risk they are taking. Out of every 10 investments, a professional venture capitalist expects to hit one or two home runs (quadrupling their money or better); a couple of doubles, a few singles and to strike out three or four times. Starting with an expected return of greater than 30 percent for every deal provides them the discipline to avoid business models that lack the potential to be an extra-base hit. In fact, the reality is that over long periods of time, venture capital funds in the aggregate have an abysmal track record. So even targeting returns of 30+ percent does not often result in achieving them.

While Harris says that Noro-Moseley seldom fails to close a deal because of a difference with the owner in price expectations, before you approach a VC fund, you should run the numbers to see what percentage of your company you can expect to give up for the amount of capital you are seeking and still provide the investor a return in their desired range.

Finally, when you are ready to send off your proposal to VC funds, be sure to send an appropriate document. Because the partners in these funds have an inbox dozens deep on any given day, they do not have time to read that 50-page treatise you wrote on the company. A one-page overview won’t do either. You should prepare a five- to 10-page executive summary that addresses all of the above issues, plus a brief analysis of the competition and why you have something to offer that other companies don’t or can’t.

As mentioned, the best entrée to a venture capital fund is an introduction from someone the VC firm respects, but the reality is that most first-time entrepreneurs do not have such connections. If that is the case, make sure you have a powerful executive summary, and mail it to the VC firms that are a fit. They are used to receiving proposals over the transom and they will eventually give it a look and get back to you.

Your chances of receiving a prompt and favorable reply, though, are greatly enhanced if you carefully select which funds to approach and send them a document that articulates answers to all the obvious questions they will ask prior to reaching for their checkbooks.

Checklist

  • Research which venture capital firms are a good match for your type of business and the stage of financing you are looking for.
  • When approaching a venture firm, leverage a contact who has done a deal with them in the past.
  • Define your market and quantify how large it is before even contemplating approaching a VC fund.
  • Be sure that you can explain exactly why you need someone else’s money and what you are going to do with it.
  • Be prepared to prove your management team is up to the task and that you possess domain expertise.
  • Absent a track record, you will have to deliver a proprietary advantage in the form of technology or relationships that will get your business to the stage at which you can bring in the appropriate management team to take the company to the next level.
  • No matter how great the idea is, you have to be able to explain your “financial model.”
  • Before you approach a VC fund, you should run the numbers to see what percentage of your company you can expect to give up for the amount of capital you are seeking and still provide the investor a return in their desired range.
  • Prepare a five- to 10-page executive summary that addresses all of the above issues, plus a brief analysis of the competition and why you have something to offer that other companies don’t or can’t.

Learn more about Jacobs Capital

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