Raising money may be one of the least appealing aspects of building a business. For most entrepreneurs, it involves a combination of begging, borrowing, and making countless PowerPoint presentations. And, of course, every investment comes with a price. Novel sources of funds have cropped up recently, sometimes bringing with them unusual conditions for making an investment. Deals are also being put together in new ways, and different industries are in fashion. Here are the trends that every entrepreneur should know.
The means by which most entrepreneurs finance their companies have changed markedly in recent years. In 2000, fully half of all small businesses were relying on credit cards for working capital, according to a survey by the National Small Business Association. This year, only 11 percent of businesses were financed that way, according to a similar survey. What happened? The housing boom. Higher home values combined with low interest rates gave homeowning entrepreneurs easy access to inexpensive lines of credit.
As home prices plateau (and in some areas drop), however, it's likely that business owners will rediscover the power of plastic. But if you have financed a business this way in the past, beware: Credit cards come with new pitfalls. Interest rates obviously are higher. Card issuers have also been quietly adopting new billing tactics such as two-cycle billing, which tacks on interest between the purchase date and the billing statement. And President Bush last year signed a bankruptcy reform law that was lobbied for by credit card issuers. The law makes it more difficult to retire credit card debt in the event of a bankruptcy.
Some good news. Venture capitalists are showing renewed interest in start-ups. Yes, mature companies received 80 percent of all venture capital investments in 2005, according to the National Venture Capital Association. But VC firms also invested $786 million in seed-stage companies, which often have only a founder with a concept. That's up from $295 million in 2002. Mark Heesen, president of the NVCA, which published the research, attributes the gain to the fact that many VCs have been raising new funds. Firms traditionally earmark a portion of new funds for seed-stage deals, he explains.
For years angel investors have invested alongside VCs and private equity firms in syndication deals. Lately, however, angel groups and larger investors have begun to use the same term sheet, says James Geshwiler, managing director of CommonAngels, a group in Boston. This closer working relationship between angels and institutional investors has driven more angel money into deals worth between $2 million and $5 million. Deals of this size accounted for 45 percent of all reported angel investments in 2005, up from 35 percent in 2004, according to the Center for Venture Research.
Some venture capitalists are concerned about hedge funds tromping on their turf.
Joining the angels and conventional VCs are state-sponsored venture capital funds. Forty-three states reported budget surpluses in the 2006 fiscal year, and many of them are taking the opportunity to plump up state-run funds. So far, 42 states have set aside at least $5.8 billion for their VC funds. States such as Maryland and New Mexico will sometimes invest directly in companies, but most states prefer to invest through regular VC funds, says Sue Strommer, head of the National Association of Seed and Venture Funds.
Eclipse Aviation, an Albuquerque company that makes small jets and counts Bill Gates among its investors, was one of the first companies to receive venture capital from the state of New Mexico. Vern Raburn, the founder of Eclipse, says the experience was not significantly different from dealing with a traditional VC. New Mexico never acts as a lead investor in a financing round, which means that another firm must commit more money to the deal, complete the due diligence, and set the valuation. But the fact that New Mexico was investing in his company "gave the other investors a lot of comfort," Raburn says. (For more on how states are helping entrepreneurs, see our report "Rating the Governors")
If you're looking for this amount of money, you're squarely in the market for venture capital. The average investment this year stands at $6.6 million. One popular area: Clean technologies--water purification, ethanol, and efficient manufacturing--which grabbed $843 million, or 13 percent, of all venture money raised in the second quarter of 2006. That's a 129 percent increase from the same period last year, according to the Cleantech Venture Network, a research firm based in Ann Arbor, Michigan. Of 61 deals involving clean companies in that time frame, 41 of them exceeded $5 million. Companies that run consumer Internet technology such as social networking websites have also been hot, although the investment community has begun to fear another bubble.
In the past, companies moving toward a public offering of stock would often finance growth by selling a chunk of the company to a private equity firm or a VC. Now there's a new source of capital: hedge funds.
Having doubled their assets in the past five years, hedge fund managers are looking for places to park the more than $1 trillion they have under management. Some funds have begun providing debt financing to later-stage, pre-IPO private companies. Hedge funds are stealing deals--which they often close quickly--away from VCs in part because they're not asking for ownership. The market for this kind of financing is strong because entrepreneurial growth companies are typically taking up to a year longer to go public, thanks to new regulations and higher costs for completing an offering. Investment banks such as Credit Suisse Group (NYSE:CS) and UBS (NYSE:UBS) have driven hedge funds into this area by introducing them to entrepreneurs.
Some venture capitalists are concerned about hedge funds tromping on their turf, but so far hedge fund managers haven't been looking to build long-term relationships with entrepreneurs, says Heesen. "A hedge fund manager is not going to be there at the board meeting, helping to direct the company over the next five years," he says.
For companies like Pay By Touch, the lack of involvement can be appealing. In October 2005, the San Francisco-based company, which makes a fingerprint sensor that can authorize retail purchases, raised $75 million in debt from three hedge funds. Because Pay By Touch had a seasoned management team, founder John Rogers says, it didn't need (or want) input from VCs. "We were also more comfortable raising debt that is less dilutive," says Rogers.
Two caveats: Loading up on debt can be risky, of course. Plus, the Treasury Department is starting to scrutinize the investing practices of hedge funds, which could lead to new regulations.
Max Chafkin can be reached at email@example.com and Bobbie Gossage can be reached at firstname.lastname@example.org.