Choosing your business and weighing your capital needs

As a venture capitalist, I meet a lot of entrepreneurs who introduce their company and opportunity to me with hopes of raising capital. All tell me of their strong growth plans, catalyzed by a single round of financing that will propel them from a standing start in year zero to profitability by year 2. However, this is no small feat, and precious few actually achieve it, even with the best team, a unique product and a willing market.

In brief, growth consumes capital, so be prepared to mix the good news of growth with the challenge of securing capital to feed that growth.

Your choice of the kind of business you’re going to start will inform the degree to which capital can become a bottleneck to growth. Here are some thoughts on how you might weigh this all-important decision.

• Choosing a business model: We (venture capitalists) look for businesses that “scale.” That is, each dollar of investment yields three or more dollars of revenue. Scale can be viewed through three lenses:

a) Gross margin: generally, we see gross margin (sales less cost of goods sold) as an important litmus test for attractiveness of a business. If you have healthy gross margins (typically north of 40 percent), then you have a business that competes on attributes other than price alone. Given the limited cash thrown off by product sales, commodity businesses are expensive to scale and do not tend to lend themselves to small-scale entrepreneurship.

b) Selling model: How a product gets to market often informs how scalable it might be. If every sale requires an expensive sales rep to make it happen, then you require a high selling price (hundreds of thousands to millions per unit) to justify the cost of the full-time salesperson. If the price point for a given product is low (tends of thousands or less per unit), then you must have a low-cost method of selling and distributing (telemarketing, Web, independent brokers, value-added resellers, etc.).

c) Make once, sell many times: If your business model is one that creates a unique product or service for each and every customer, then your business probably lacks scale. Better models are those in which some aspect of production/manufacturing achieves economies of scale. Examples range from application software (MS Word), to branded consumer products (iPod) to Web services (Google). Each application is designed once and produced the same way for each customer, creating leverage and an opportunity to maximize the cost of that design over hundreds, thousands or millions of units.

• Capital requirements: Related to businesses that generate strong gross margins is the capacity for your chosen business focus to create cash flow from product/service sales that can partly or fully fund your way forward. Venture capital is a high-impact, though expensive, source of capital and, unfortunately, reaches only a precious few. Your ability to tap other sources of capital (or perhaps “no capital”) may mean the difference between survival and failure.

If you’re committed to securing venture capital, then you need to know which types of ventures get funded by venture investors:

a) Technology: Generally, at an early stage, any technology business (that meets the tests of scale, as above) is a good starting point. With gross margins that go as high as 90 percent-plus, tech businesses tend nonetheless to be capital-consumptive. Fortunately, there are a lot of venture capital investors with a lot of capital available to help fund you if you have this problem.

b) B2B products: Selling products and services to other businesses is far more appealing to investors — as a general rule — than selling to consumers. Businesses tend, generally, to have ready cash available to buy products and/or services that solve problems.

Businesses are fewer in number than are individual consumers, making the selling model inherently less expensive and therefore more attractive to investors.

c) Consumer products: While consumer businesses tend to have lower gross margins (40-60 percent), they can, for some investors, be an attractive area for investment, depending on the product, model and (most importantly) management. Consumer businesses tend to require much more capital (to build end-demand) than do businesses that sell to other businesses. To make the world aware that you have a better mousetrap, you have to find an inexpensive means of creating awareness given the diversity and scale of individual consumers that may represent your target market.

If you can find a cheap growth model (i.e. viral marketing, in which word-of-mouth creates awareness), then the appeal of a consumer business is the sheer size of the buyer base. By contrast to B2B, in which meaningful revenue can come from hundreds or thousands of customers, consumer businesses often require millions of customers to make the economics work from an investors’ perspective.

The final consideration is your lifestyle. Venture capital does not readily mix with a lifestyle business. Having said this, capital requirements of your business may not be a big deal if you believe that you can build yourself a nice lifestyle business without having to go begging for investors.

Michael Gurau is president of CEI Community Ventures Fund, an early-stage venture capital fund targeting opportunities in New Hampshire, Maine and Vermont. His column is meant to provide New Hampshire Business Review readers with insight into the myriad issues facing small, growing businesses. Topics for this column will span all aspects that growth-oriented companies face, including financing, staffing, building a board of directors and making strategic decisions. If readers have specific questions or topics that they would like to see covered in future columns, send your request to mhg@ceicommunityventures.com.