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Business Combinations and Other Sources of Venture Capital

Filed under Getting Financing. Fact checked on May 24, 2012.

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Learn how to secure more financing through mergers, joint ventures, consolidations and many other combinations of business entities.

While most small businesses limit their financing to borrowing money (debt financing) or selling shares of ownership in your business (equity financing), those aren't your only options.

Mergers, joint ventures, consolidations, acquisitions, strategic alliances, associations—these are all a few of a savvy small business owner's favorite things.

The Benefits of Business Combinations

If you can remember way back to the 1990s, you might recall the business climate encouraged the use of joint ventures (a mutually beneficial cooperation two or more individuals or businesses engage in to share profits) and alliances (a sharing of resources between two or more individuals or business for a joint project).

It's a shame many entrepreneurs have forgotten about these and other business combinations. They can offer a multitude of advantages to recession-era businesses, including:

  • reduced costs and better results through shared responsibilities, expertise, asset and expenses
  • ownership dilution
  • tailored contracts that consider both parties' needs

But before you dive to deep into a joint venture, you might want to dabble in the business-combination waters with strategic alliances.

How to Strike Up a Strategic Alliance

For small businesses, strategic alliances often consist of simple bartering with customers, suppliers and even competitors. 

Let's say you own a manufacturing business. You may be thinking, "That's so much overhead and equipment and labor and..." And you're absolutely right. But if you make strategic alliances within your industry, you can split some of the cost with your closest business associates. Approaching your supplier about using its trademark on your labels can result in a better price for component parts.

Alliances for research and development efforts are also quite common as a means of minimizing these long-term costs. In certain high-tech industries, the cooperation of other businesses is essential, not only from the standpoint of financing, but also for marketing, licensing and distribution.

Of course, splitting costs isn't the only reason to form a business combination. What a fellow entrepreneur can't contribute in money can easily be made up for in value. 

What a Value-Added Partner can Bring to Your Business

"Value add" and "value-added partner" are two of those buzzwords that leave a lot of people scratching their heads, wondering what exactly the terms mean. Unlike other business catchphrases which are so complex they're hard to decipher, these are so simple you think it can't be that basic.

Value add is all about finding products or services (or in our case, partners) that make whatever your business offers more enticing and useful for your customers. Joining a business association with a well-recognized industry name, for example, can generate immediate credibility and also assist in advertising and marketing for your company. As you already know, your networking ability plays a major role in locating and investigating strategic partnering opportunities.

Work Smart

Keep in mind that although partnering arrangements are often with other businesses, you may also find that trade associations, nonprofit groups, local community organizations, etc., may offer great opportunities for financing some advertising and distribution expenses. Moreover, you may be able to work out arrangements with these groups that target a very specific, and important, consumer audience.

Venture Capital Firms

Venture capital ("VC") firms supply funding from private sources for investing in select companies that have a high, rapid growth potential and a need for large amounts of capital. VC firms speculate on certain high-risk businesses producing a very high rate of return in a very short time. The firms typically invest for periods of three to seven years and expect at least a 20 percent to 40 percent annual return on their investment.

Warning

When dealing with venture capital firms, keep in mind that they are under great pressure to identify and exploit fast growth opportunities before more conventional financing alternatives become available to the target companies. Venture capital firms have a reputation for negotiating tough financing terms and setting high demands on target companies. Three bottom-line suggestions:

  • make sure to read the fine print

  • watch for delay maneuvers (they may be waiting for your financial position to weaken further)

  • guard your trade secrets and other proprietary information zealously

Venture capital financing may not be available, nor a good choice of financing, for many small businesses. Usually, venture capital firms favor existing businesses that have a minimal operating history of several years; financing of startups is limited to situations where the high risk is tempered by special circumstances, such as a company with extremely experienced management and a very marketable product or service. The target companies often have revenues in excess of two million dollars and a preexisting capital investment of at least one million.

VCs research target companies and markets more vigorously than conventional lenders, although the ultimate investment decision is often influenced by the market speculations of the particular venture capitalists. Due to the amount of money that venture capital firms spend in examining and researching businesses before they invest, they will usually want to invest at least a quarter of a million dollars to justify their costs.

Warning

Be wary of "shopping" innovative ideas to multiple venture capitalists or private investors. Use caution in revealing any information you consider proprietary. Even if you already have intellectual property protection (e.g., a patent, trademark or copyright), you don't want to be forced to police your rights. Do your best to limit the details of your particular innovation and seek confidentiality arrangements for additional protection of any preexisting legal rights you may have.

Venture Capital Firms and Small Business Investment Companies

Before you consider venture capital as the end-all-be-all to your financing needs, consider this your warning: The price of financing through venture capital firms is high.

What VC Firms Demand

Although the investing company will not typically get involved in the ongoing management of the company, the VC firm will usually insist upon retaining at least one seat on the target company's board of directors. For better or worse, the firm will have a voice in the major decisions affecting the direction of your business.

The VC firm's ownership interest is usually a straight equity interest or an ownership option in your company. If it's the latter, the firm maintains the ownership option through either:

  • a convertible debt (where the VC firm has the option to convert the loan instrument into stock of the borrower) or
  • a debt where the VC firm has the right to buy shares of common stock at a fixed price within a specified time period—also called a debt with "warrants."

Your firm may expect you to shoot for the stars; that is, their arrangement may eventually call for an initial public offering.

Yet despite the high costs of financing through venture capital companies, they do offer tremendous potential for obtaining a very large amount of equity financing and they usually provide qualified business advice in addition to capital.

Finding a VC Firm

Venture capital firms are located nationwide, and a directory is available for $125 through the:

National Association of Venture Capital
1655 N. Fort Meyer Dr.
Arlington, VA 22209
703.524.2549

It's always a good idea to check with your local bankers, insurance companies and business associations as you explore venture capital options.

Tapping Into the Government's VC Program

Yes, you read that right. The federal government sponsors its own public venture capital organization through the Small Business Investment Corporation (SBIC) program.

An SBIC is a privately owned and operated small business investment company that partners with the federal government to provide venture capital to small business. Using a combination of private funds and funds borrowed from the federal government, the SBICs provide equity capital, long-term loans (up to 20 years, with a possible 10-year extension) and management assistance to eligible small businesses. Because the program emphasizes a long-term partnership, loans and securities for less than five years are unusual. The loans and debt securities are regulated by the Small Business Administration.

Comparing and Contrasting SBICs and VC Firms

Like a VC firm, an SBIC primarily focuses on financing fast-growing, existing businesses (rather than startups) in need of a substantial amount of financing to rapidly expand.

An SBIC must be federally licensed; however, almost anyone or any entity can be an SBIC owner with:

  • the minimum initial private capital of $5 million and
  • an SBA-approved full-time manager

Every SBIC is subject to annual financial reporting requirements and onsite compliance examinations by the SBA, but then again, most VC firms will require consistent reporting about the state of your business. Regulations control investment approvals and operating procedures. Most SBICs are owned by small groups of local investors, although commercial banks are often also owners.

SBICs operate like venture capital firms, although they may be more flexible in the terms of their investment arrangement. The SBIC may want to make an equity investment or may be interested simply in long-term lending on a fully secured basis

An SBIC is not permitted to control any small business on a permanent basis. The 2009 Stimulus bill set the maximum funding level the SBA can provide SBICs at up to three times private capital raised or $150 million, whichever is less.

Act Now

Stop by one of the SBA offices located throughout the country and the agency staff will help locate your nearest SBIC. To reach your local SBA office, go to the SBIC programs and services site.

As far back as the early 1970s, the SBA created a second category of government-operated small business investment companies, the Specialized Small Business Investment Company (SSBIC). They generally operate in the same manner as SBICs, but they can obtain additional government financial assistance by investing in, or loaning to, small businesses owned by people who are socially or economically disadvantaged.


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