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This chapter is from the book

Summary—Quick Standards of Venture Capital Investing

Using some simple standards can help you make a quick decision to go forward or say no. People use various “quick-look” criteria when making decisions about venture capital investing. Although everybody has his or her own ideas about what to look for, here is some sound advice from individuals in the business:

  1. Look for people who are hard-working and honest.

  2. Look for a growth industry with strong growth opportunities.

  3. Make sure the company has an adequate capital base.

Those three simple rules have helped us sort through hundreds of proposals and work on opportunities that make a great deal of money. If it passes this quick screening, move on to the next four criteria that the opportunity must pass.

First, is there a barrier to entry in the business? That is, each company has some kind of unique product or placement in the market that others are unable to have. It may be a proprietary situation or a patent. Each business has a competitive advantage, and you need to know how the business will defend its market.

Second, is the company leverageable? That is, the company is able to borrow money on the assets of the business so that it need not have an inordinate amount of equity capital in the business. Leverage is like buying stock on margin. You put up only part of the equity and the rest you borrow on the assets of the business. If a business is so risky that it cannot borrow money, it will have to use equity to grow. This is an expensive way to grow a business. At some point, it needs to be able to tap into the debt financing market.

Third, is the venture repeatable? That is, if you have only one location or one situation in which this business opportunity works, it is basically a one-time shot. Major venture capital firms look for things that can be done over and over again as a basis for a business. Repetition is a key trait of a good business. This concept has also led many VCs to conduct “roll ups” or “buy-and-build” strategies that we will mention later in the book.

Fourth, is the venture able to generate internal capital? The profits of a company must be great and its tax rate low if it is to generate its own capital to grow.

So, look at the cash flow being generated by the company. If it is strong, you probably have a winner. And if you are banking on a “growth” story, its ability to generate cash in the near future is essential.

These criteria are the keys to success. The harder you work at analyzing and learning as much as possible about your investment opportunity and the industry it operates in, the easier it will be to identify the keys to success in the investment.

Chapters 2–7 of this book explain in further detail the due diligence process of investigating a business. Obviously, investigating a new idea for a business is entirely different from investigating a business that is already thriving and needs growth capital. Do remember that you will have to adjust the questions you ask to the stage of development of the business in question.

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