Often the first step in dealing with venture capitalists is to forward them a copy of the business plan. And, because venture capitalists have to deal with so many business plans, the plan must immediately grab the reader’s attention. The executive summary will either entice venture capitalists to read the entire proposal or convince them not to invest further time.
A good plan is crucial for two reasons: first, as a management tool, and second, as a means to obtain financing. While the plan is an essential element in securing financing, it should also be an operating guide to the business-- with the goals, objectives, milestones, and strategies clearly defined and well-written. This is the best way to demonstrate the viability and growth potential of the business and to showcase the entrepreneur’s knowledge and understanding of what is needed to meet the company’s objectives. The first reading of a plan is the venture capitalist’s initial opportunity to evaluate the individuals who will manage the business and to measure the potential for return on this investment.
The plan should also address the following business issues from the perspective of the
venture capitalist:
- Is the management team capable of growing the business rapidly and successfully?
- Have they done it before?
- Is the technology fully developed?
- Is the product unique, and what value does it create so that buyers will want to purchase the product or service?
- Is the market potential large enough?
- Does the team understand how to penetrate the market?
- Do significant barriers to entry exist?
- How much money is required and how will it be utilized?
- What exit strategies are possible?
If the plan is of interest, the entrepreneur will be contacted for the first of what will generally be several meetings, and the venture capitalist may begin the due diligence process. Since venture firms are in the business of making risk investments, one can be certain a thorough analysis of the company’s business prospects, management team, industry, and financial forecasts will precede any investment.
Prepare for the Negotiation Process
Following due diligence, the successful venture will then enter into the negotiation process, where the structure and terms of financing will be determined. The entrepreneur must carefully prepare for this next step by becoming familiar with the various structures of venture capital financing and preparing a bargaining position after consulting with an attorney who has extensive venture capital experience. Attorneys will give guidance on the issues worth fighting for. Issues to consider are: vesting, salary, stock restrictions, commitment to the venture, debt conversion, dilution protection, downstream liquidity and directors. Additionally, an entrepreneur should be prepared for the possibility that a venture capitalist may want to make extensive changes to the management team. The negotiation will involve most or all of these issues in addition to price-per-share. However, price-per-share concerns should not be the overriding interest; the end result of this process must be a win/win situation in order for the relationship to progress successfully. The last step is to document and close the transaction, resulting in a term sheet, investment agreement(s) and,
finally, the closing.
Pricing and Control: The Investors’ Perspective
Pricing venture capital deals involves the estimated future values of the entity being financed and is highly subjective.
Theoretical approaches can be used to estimate the company’s future value and the corresponding percentage ownership that the investor requires—in other words, estimated future value based on the venture’s expected profitability and estimated earnings multiples. The estimated percentage ownership the investor must receive can then be calculated to derive the desired return on investment.
Venture capitalists expect an annual rate of return of 30 percent to 40 percent or more. The table below shows the percentage investment a venture capitalist would need to realize to support a 30 percent return on investment at various estimated market values. As shown, to realize a 30 percent return on an investment of $8 million, a venture capitalist would need to own 22 percent of a company with an estimated future market value of $175 million after six years. If the estimated future market value is higher --$200 million for example --a smaller percentage ownership (19 percent) will provide the required rate of return.
Why Is a Business Plan Needed?
A quality business plan is an important first step in convincing investors that the management team has the experience to build a successful enterprise. The plan also provides measurable operating and financial objectives for management and potential investors to measure the company’s progress.
Executive Summary
Business plans should be summarized into a short two- to-three page synopsis called the executive summary. The summary is used to capture the essence of the plan and generate interest so the reader further studies the full proposal. It is the most important section of the business plan and should be written last, ensuring that only vital information is included.
At many of the largest venture capital firms, fewer than 5 percent of the hundreds of plans received are reviewed beyond the executive summary. While sometimes this is because the business does not fit the type of investment favored by that firm, more often it is because the executive summary is not written convincingly or clearly enough. The summary must stand out and be noticed, and to do this it must be of the highest quality. The summary must be persuasive in conveying the company’s growth and profit potential and management’s prior relevant experience.
The effort taken in researching investor preferences and preparing a quality summary will set the plan apart and assure that it receives further consideration by venture capital firms.
Outline for Executive Summary
Company overview
Generally, the investor wants to know—in a hurry—what product the company is developing, the market/industry it serves, a brief history, milestones completed (with dates), and a statement on the company’s future plans. If the company is an ongoing business seeking expansion capital, the entrepreneur must summarize the company’s financial and market performance to date.
Management team
List the key members of the management team and technical advisors—including their age, qualifications, and work history. It is important to emphasize the team’s relevant, proven track record. Note key open positions and how you intend to fill them.
Products and services
Provide a short description of the product or service and highlight why it is unique (i.e., what makes it better than its potential competitors). Discuss any barriers to entry that prevent further competition (e.g., patents). Mention the product’s direct or indirect competition. If possible, briefly mention future product development plans such as upgrades or product line extensions in order to show the investor that the venture is not a one-product/service enterprise.
Market analysis
Define the target market to be served using recent market data and analysts’ estimates of current and projected size and growth rates. Also note what percentage of the market the company plans to capture. Mention the names of your largest, current, well-known customers who have either purchased your product or given you letters of intent. It is important to discuss who will buy the product and why. Briefly note the distribution/ selling strategies used in the industry and explain which one(s) you plan to use to penetrate the market.
Funds requested and uses
State the amount of money required and be specific in the description of the uses of the funds sought. Avoid such general terms as “working capital.”
Summary of five-year financial projections
This section should summarize key financial projections through breakeven. Only projected revenues, net income, assets and liabilities should be listed. It is also useful to note additional expected rounds of financing needed.
Business plan dos and don'ts
Body of the plan
Company overview
In this section one should fully describe the reason for founding the company and the general nature of the business. The investor must be convinced of the uniqueness of the business and gain a clear idea of the market in which the company will compete. The entrepreneur’s vision for the company’s future production and operations strategy should also be described. An investor needs to be assured that the company is built around more than a product idea. The entrepreneur needs to demonstrate that a profitable business can be built based on the strategies detailed in the plan.
Products and services
The business plan must convey to the reader that the company and product truly fill an unmet need in the marketplace. The characteristics that set the product/service and company apart from the competition need to be defined. It is also important to describe each of the end-user segments that will be targeted. A full profile of the end-users and the key potential applications of the product will demonstrate to an investor that the entrepreneur has done his/her marketing homework. A description of the status of patents, copyrights and trade secrets is very important. It is equally imperative to describe barriers to entry. Keep in mind that patents are only as good as they are defensible.
The plan should list all the major product accomplishments achieved to date as well as remaining milestones. Knowing that the entrepreneur has tackled several hurdles and is aware of upcoming challenges and how to surmount them will provide investors with a greater comfort level. Specific mention should be made of the results of alpha (internal) and beta (external with potential customers) product testing. If alpha or beta tests are upcoming, mention how these tests will be conducted.
Single product companies can be a concern for investors. It is always beneficial to include ideas and plans for future products/services. If the plan demonstrates the viability of several products, an investor will see an opportunity to grow a successful business.
Market analysis
The analysis of market potential separates the inventors from entrepreneurs. Many good products are never successfully commercialized because their inventors don’t stop to understand the market or assemble the management team necessary to capitalize on the opportunity.
This section of the business plan will be scrutinized carefully. Market analysis should, therefore, be as specific as possible, focusing on believable, verifiable data. Market Research should contain a thorough analysis of the company’s industry and potential customers. Industry Data should include growth rates, size of the market, recent technical advances, government regulations and future trends. Customer Research should include the number of potential customers, the purchase rate per customer, and a profile of the decision-maker. This research drives the sales forecast and pricing strategy, which relates to all other strategies in marketing, sales and distribution. Finally, comment on the percentage of the target market the company plans to capture.
Management and ownership
Venture capitalists invest in people—people who have run or who are likely to run successful operations. Potential investors will look closely at the members of the company’s management team. The team should have experience and talents in the key disciplines: technological development, marketing, sales, manufacturing, and finance. This section of the plan should therefore introduce the members of your management team and what they bring to the business. Detailed resumes should be included in an appendix.
The management team in most start-up companies includes only a few founders with varied backgrounds and an idea. If there are gaps in the team it is important to mention them and comment on how the positions will be filled. Glossing over a key unfilled position will raise red flags. Often, because venture capital investors have access to networks of management talent, they can provide a list of proven candidates appropriate for these crucial positions.
Include a list of the board of directors or advisors: key outside industry or technology experts who lend guidance and credibility. This is another area where empty positions may be filled from suggestions of a well-networked investor.
Marketing plan
The primary purpose of the marketing section of a business plan is to convince the venture capitalist that the market can be developed and penetrated. The sales projections made in the marketing section will drive the rest of the business plan by estimating the rate of growth of operations and the financing required. The plan should include an outline of plans for:
- Pricing;
- Distribution channels; and
- Promotion.
Pricing
The strategy used to price a product or service provides an investor with insight for evaluating the strategic plan. Explain the key components of the pricing decision—i.e., image, competitive issues, gross margins, and the discount structure for each distribution channel. Pricing strategy should also involve consideration of future product releases and future products.
Distribution channels
A manufacturer’s business plan should clearly identify the distribution channels that will get the product to the end-user. For a service provider, the distribution channels are not as important as are the means of promotion. Distribution options for a manufacturer may include:
- Direct sales—such as mail order, direct contact through salespeople, and telemarketing;
- Original equipment manufacturers (OEM)—integration of the product into other manufacturers’ products;
- Distributors or wholesalers; or
- Retailers.
Each of these methods has its own advantages,disadvantages, and financial impact, and these should be clarified in the business plan. For example, assume the company decided to use direct sales because of the expertise required in selling the product. A direct salesforce increases control, but it requires a significant investment. A venture capitalist will look to the entrepreneur’s expertise as a salesperson, or to the plans to hire, train and compensate an expert salesforce. If more than one distribution channel is used, they should all be compatible. For example, using both direct sales and wholesalers can create channel conflict if not managed well.
Fully explain the reasons for selecting these distribution approaches and the financial benefits they will provide. The explanation should include a schedule of projected prices, with appropriate discounts and commissions as part of the projected sales estimates. These estimates of profit margin and pricing policy will provide support for the decision.
Promotion
The marketing promotion section of the business plan should include plans for product sheets, potential advertising plans, Internet strategy, trade show schedules, and any other promotional materials. The venture capitalist must be convinced that the company has the expertise to move the product to market. A well thought-out promotional approach will set the business plan apart from the competition.
It is important to explain the thought process behind the selected sources of promotion and the reasons for those not selected.
Competition
A discussion of the competition is an essential part of the business plan. Every product or service has competition. Even if the company is first-to-market, the entrepreneur must explain how the market’s need is currently being met and how the new product will compete against the existing solution. The venture capitalist will be looking to see how and why the firm will beat the competition. The business plan should analyze the competition, giving strengths and weaknesses relative to the product. Attempt to anticipate competitive response to the product. Include, if possible, a direct product comparison based on price, quality, warranties, product updates, features, distribution strategies, and other means of comparison. Document the sources used in the analysis.
Operations
The operations section of the business plan should discuss the location and size of the facility. If one location is selected over another, be sure to include justification. Factors such as the availability of labor, accessibility of materials, proximity to distribution channels, and tax considerations should be mentioned. Describe the equipment and the facilities. If more equipment is required in response to production demands, include plans for financing. If the company needs international distribution, mention whether the operations facility will provide adequate support. If work will be outsourced to subcontractors— eliminating the need to expand facilities— state that, too. The investor will be looking to see if there are inconsistencies in the business plan.
If a prototype has not been developed or there is other uncertainty concerning production, include a budget and timetable for product development. The venture capitalist will be looking to see how flexible and efficient the facility plans are. The venture capitalist will also ask such questions as:
- If sales projections predict a growth rate of 25 percent per year, does the current site allow for expansion?
- Are there suppliers who can provide the materials required?
- Is there an educated labor force in the area?
These and any other factors that might be important to the investor should be included. The sales projections will determine the size of the operation and thereby the funds required both now and in the future. Include the sources and uses of financing in the business plan, and be certain the assumptions are realistic. The timing and the amount of funds will be derived from the sales estimates.
Business plan dos and dont's
- DO be brief. Begin with a two- to three-page executive summary. Then, limit the body of the plan to seven- to ten-typewrit pages. Note that internal business plans and budgets are normally more detailed than those presented to external investors. Include everything important to the business and financing decision, but leave secondary issues and information, such as detailed financial information, for discussion at a later meeting.
- DO let the reader know, early on, what type of business the company is in. While this may seem obvious, many plans tell the reader this information on page 20, for example, and with other plans, the reader is never certain.
- DO state the company’s objectives.
- DO describe the strategy and tactics that will enable the company to reach those objectives.
- DO cite clearly how much money the company will need, over what period of time, and how the funds will be used.
- DO have a clear and logical explanation about the investor’s exit strategy.
- DON’T use highly technical descriptions of products, processes and operations. Use common terms. Keep it simple and complete.
- DO be realistic in making estimates and assessing market and other potentials.
- DO discuss the company’s business risks. Credibility can be seriously damaged if existing risks and problems are discovered by outside parties.
- DON’T make vague or unsubstantiated statements. For example, don’t just say that sales will double in the next two years or that new product lines will be added without supporting details.
- DO be specific. Substantiate statements with underlying data and market information.
- DO summarize and properly structure internal budgets and plans to facilitate review by outside parties.
- DO enclose the proposal/ business plan in an attractive but not overdone cover.
- DO provide extra copies of the plan to speed the review process.
