Venture Capital and Entrepreneurial Management

Most new entrepreneurial ventures require outside investors in order to successfully bring their innovations to the marketplace and create a sustainable, viable organization. There are several sources of funding available for start-up firms, but one of the most popular is venture capital firms. These firms invest in the entrepreneurial organization for substantial equity in the company and with an eye toward a quick and high return on investment. To help minimize the risk inherent in such investments, venture capital firms analyze the entrepreneurial organization's potential for success. Through a good business plan, the entrepreneur can show not only the viability of the innovative product or service but also the viability of the management team that will help guide that product or process to the marketplace. Venture capital firms look for organizations whose management processes and structures are scalable and will allow them to meet the changing demands of the market while still supporting continued creativity and innovation.

Keywords Business Plan; Management; Organizational Structure; Return on Investment; Risk; Scalability; Venture Capital

Entrepreneurship > Venture Capital & Entrepreneurial Management

Overview

Turning a new venture into a viable business requires more than an innovative idea; it also requires money to provide the infrastructure necessary to successfully realize the idea and bring it to the marketplace. However, most entrepreneurs exhaust their own funds before their fledgling businesses reach this point. To succeed, therefore, they need to acquire outside funding. Although there are a number of different sources of funding available to the entrepreneur once the business is up and running, start-up organizations frequently do not qualify for debt capital. Young companies in this situation have three major sources of investors: family or friends, angel investors (wealthy investors who expect a higher return on investment and who can typically invest more capital than the entrepreneur's acquaintances), and venture capital firms that may invest more money but expect an even higher return on investment. Increasing numbers of entrepreneurs turn to venture capital as a way to keep the organization running while bringing the new concept to market. Some well known companies whose initial success was enabled by venture capital include Amazon.com, Federal Express, Genentech, Intel, Netscape, and Yahoo!.

Venture capital is funding provided to expand business within entrepreneurial firms that exhibit great growth potential. Wealthy investors commit money as limited partners to a pool of funds that is professionally managed in exchange for equity in the new company and with the expectation of a quick and high rate of return on their investment. The funds are professionally managed by general partners in exchange for a fee and a percentage of the return on the investments.

The investment of capital in new ventures is by definition a risky proposition and comes at a cost not only to the venture capital firm but to the entrepreneurial venture as well. Typically, venture capital firms seek a high return on investment (often 50 to 60 percent) and significant equity to compensate for the risk of investing in a start-up company. In return for equity in the company, venture capital firms frequently provide not only money to the start-up firm but also other help, which may include introductions to other businesses and individuals that may be of use to the entrepreneurial company in the future (e.g., banks and financial institutions, potential suppliers) and advice on how to grow the organization from an innovative start-up to a viable, successful venture. Such advice can be invaluable to the start-up firm because the venture capital firms typically have had experience with the pitfalls and processes of starting a new company and know what leads to success — or a lack thereof — in the marketplace.

In order to attract the interest of a venture capital firm, the entrepreneur needs to have a well-crafted business plan. This plan should set out the start-up organization's operational and financial objectives as well as detailed supporting plans and budgets to show how these objectives will be achieved. However, the business plan is not just about the innovative idea that the entrepreneur wishes to market. Venture capital firms prefer to invest in organizations that have complete, well-balanced founding teams. Therefore, the business plan should help the venture capital firm better understand the potential of the entrepreneurial company both from the point-of-view of its product or service and also from the point-of-view of whether or not it has the managerial and administrative resources in place to be successful. It is important that the management of an entrepreneurial organization takes the time and effort necessary to write a good business plan. Venture capital firms typically will also investigate both the potential of the organization to yield a quick and high return on investment as well as whether or not it is structured in a way that can sustain it during the transition from being a mere good idea to being a successful organization.

Traditionally, entrepreneurs have been characterized not only as innovators but also as poor managers. The stereotypical entrepreneur is seen as creative, egocentric, and individualistic, interested more in the creation of the new idea than in the day-to-day running of a business. Another assumption frequently made is that entrepreneurs lose their edge when they become successful. Rather than viewing the entrepreneurial organization as one that can continue to create and develop new innovations that can be brought to the marketplace, this stereotype assumes that the entrepreneur will change when his or her business becomes successful, settling down to become the head of an organization whose goal is to maintain and survive rather than to innovate.

As with most stereotypes, there are some individuals who can be characterized in this way. However, an increasing number of entrepreneurs do not fit this mold. Rather than changing the culture of the organization from entrepreneurial to maintaining, an increasing number of entrepreneurial organizations today strive for sustainable innovation. Under this paradigm, entrepreneurs continue to develop products or processes that are new or significant improvements over previous products or processes and successfully introduce them in the marketplace. To be successful in continuing innovation, entrepreneurs rely not on luck but on continued observation and analysis of market and industry trends that allow for the strategic planning necessary to make additional innovations. Such innovations allow the organization to remain on the leading edge in the industry and to be a successful business venture. In order to support sustainable innovation, however, the entrepreneurial management team must not only consider the creative and innovative side of the organization, but the management and administrative side of the organization as well.

Under this paradigm, the management team of entrepreneurial firms needs two kinds of skills. First, sustainable innovation requires strategic skills. These include the ability to synthesize market data and identify and extrapolate trends to anticipate new products and markets. These data can be used in the development of a sound business plan that will be of interest to potential venture capital firms. In addition to being able to identify innovative ideas that have the potential to be very successful in the marketplace, entrepreneurial firms need to be able to show that they have the organizational skills necessary to implement these plans. Venture capital firms look for both these characteristics when reviewing entrepreneurial business plans.

It is the intent of venture capital firms to invest in entrepreneurial organizations in order to see a high, quick return on their investment. Although venture capital firms are by nature in the business of taking risks, they apply the principles of good risk management in order to increase the probability that both the entrepreneur and their investors will be successful.

Risk is the quantifiable probability that a financial investment's actual return will be lower than expected. Higher risks mean both a greater probability of loss and a possibility of a greater return on investment. Venture capital firms assess the risk of investing in an entrepreneurial organization by determining the potential loss and probability of loss of the organization's objectives. This risk assessment is the first step in risk management. Venture capital firms then seek to manage that risk through the process of analyzing the objectives of the organization, planning ways to reduce the impact if the predicted normal course of events does not occur, and implementing reporting procedures so that problems are discovered earlier in the process rather than later.

One of the factors that venture capital firms look at when evaluating the potential for success of an entrepreneurial team is the abilities of the management team. A strong management team can help minimize the risk of the new venture by being able to efficiently and effectively accomplish work through the coordination and supervision of others. A strong management team will support the creative work of the innovators in the organization and make sure that they have the infrastructure necessary to succeed. If, on the other hand, the management team does not have these characteristics, the organization is much less likely to be successful.

In particular, venture capital firms look at the ability of the entrepreneurial organization's processes and structures to rapidly respond to needs for increased output driven by requirements of the marketplace. This characteristic is called organizational scalability. This is the ability of the organization's processes and structures to rapidly respond to needs for increased output driven by requirements of the marketplace. Scalability is increased by the inclusion of flexible processes and distributed, hierarchical structures. Scalability is necessary in today's economy due to the pressures of rapid changes in markets and technologies as well as the plethora of potential competitors in the early stage of the business. Because of the risk associated with start-up ventures and with the introduction of innovations to the marketplace, venture capital firms attempt to determine how responsive the entrepreneurial firm will be to changing demands on the business. If the entrepreneurial organization cannot rapidly expand to accommodate the changing needs of the marketplace, once the need for the product or service has been established, it will fail.

It has been theorized that entrepreneurial ventures go through an early stage of growth in which the original entrepreneur or team dominates the processes of the organization. During this phase, emphasis is placed on creating both the new product and its market. The organization at this stage is likened to a living organism that adapts as necessary to meet the demands of its environment rather than as a machine that cannot tolerate change. This organic model emphasizes creativity, has flat organizational structures, lateral communication modes, information control and authority structures, and low emphasis on management activities.

Not every successful new venture meets these criteria, however. Other new firms are quite successful following a hierarchical model that is characterized by a narrow organizational structure, vertical communication modes, formal control and authority structure, and emphasis on management activities. In these organizations, great emphasis is placed on improving internal communication and on the development of formal but flexible processes that allow the organization to respond to market demands.

Whichever model the organization follows, however, it must be scalable. Venture capital firms can contribute to the degree to which an organization is scalable in several ways. First, venture capital firms are more likely to invest in new ventures that are founded by experienced entrepreneurs than those that are not. Experienced entrepreneurs typically have already learned the importance of scalability and bring that knowledge with them to the creation of the new venture. In addition, venture capital firms tend to encourage the new venture in the creation of flexible processes and distributed hierarchical structures through their roles on the board of directors and interest in the company. The demands of the venture capital firm and other major stakeholders can encourage the fledgling organization to develop the flexibility it needs to respond quickly and appropriately to changing market demands and the management structure it needs to adequately control and coordinate activities while supporting the continuing creativity and innovation of the employees. This ability of the organization to grow and change to meet the needs of its environment by responding with appropriate management will help make it a success in the marketplace and more attractive to venture capital firms.

Applications

There are a number of models of management, each of which is appropriate in different situations. Successful management requires the ability to understand the nature of the organization and its processes in order to choose the most appropriate style. The philosophy of management in most organizations can be characterized as falling on a continuum from a high tolerance for risk-taking to the desire to achieve and maintain stability within the organization. Each of these philosophies is fed by different pressures and results in a different approach to management. Entrepreneurial organizations differ from more traditional organizations in a number of important ways. As a result of these differences, entrepreneurial organizations tend to need different policies and procedures, including increased strategic orientation, commitment to opportunity, commitment of resources, control of resources, and management structure. Entrepreneurial firms differ from many other organizations and need to implement an appropriate management style in order to help ensure their success.

Entrepreneurial firms are by definition risk takers that offer innovative goods and services to the marketplace. To be able to do this effectively, entrepreneurial firms are driven by what they perceive as opportunity. In fact, the very nature of sustainable innovation means that entrepreneurial firms are constantly looking for new opportunities to exploit. As a result, they need to be more responsive to rapid changes in such factors influencing the organization as technology, consumer economics, social values, and political values. Traditional organizations, on the other hand, are driven by the resources that they currently control rather than new opportunities. For example, traditional organizations are more driven by criteria of performance that will enable them to continue to succeed in areas in which they already succeed rather than encouraging them to take risks on new ventures. Rather than being driven by perceived opportunities, therefore, traditional organizations tend to formalize their strategies using planning systems and cycles.

Another difference between management in entrepreneurial organizations and traditional organizations lies in their commitment to opportunity. Entrepreneurial firms tend to have an action orientation with short duration windows. The difference between being the leader in one's field and just one of the pack is often based on which firm gets an innovation to the market first. Because of this, entrepreneurial organizations try to manage their risks rather than eliminate them, since it is the very nature of the risk that brings with it potential rewards. Traditional firms, on the other hand, tend to evolve more slowly; striving to reduce rather than manage risks.

Entrepreneurial firms also differ from traditional firms in how they commit and use their resources. When a firm is just starting out, the risks are greater than when a firm is established. Therefore, it is often a better strategy for entrepreneurial organizations to avoid making long-term commitments of capital for resources that may not be used extensively if the new business venture fails. As a result, entrepreneurial firms often take a multistaged approach to the commitment of resources in order to minimize their risk at each stage. This is due to the lack of predictable resource needs (e.g., if the new widget is not an immediate success in the marketplace, the organization may only need two engineers rather than twenty) and the concomitant lack of long-term control as well as pressures for more efficient resource use. Traditional firms, on the other hand, tend to commit their resources with a single stage approach, committing them completely once they have made the decision. The forces toward this approach include the existence in such organizations of capital allocation systems and formal planning systems. These are compounded with a high turnover in management that is seen in many traditional organizations as well as incentive compensation systems that encourage workers to be high producers.

In addition to differences in how they commit their resources, entrepreneurial and traditional organizations also differ in how they control their resources. Entrepreneurial organizations tend to use many of their resources only occasionally or even rent them if it will free up more money for development and marketing in the short-term. This tendency is due to a number of factors. For example, in many entrepreneurial ventures, the useful life of a resource is significantly longer than the need. So, for example, entrepreneurial organizations may rent extra computers that are needed for a development-heavy start-up phase or even hire temporary contract personnel to help in the initial development phase. This helps avoid the problem of investing too heavily in resources that are not needed for the long-term and also takes into account the risky nature of the entrepreneurial venture. Traditional firms, on the other hand, tend toward outright ownership or employment of whatever resources are needed for the effective functioning of the firm. This decision makes more sense for the established firm since they are better able to predict their longer-term needs due to the relatively less risky nature of their businesses.

Finally, entrepreneurial organizations differ from more traditional organizations on how their management is structured. In general, entrepreneurial organizations tend to be flat and utilize multiple informal networks, whereas traditional organizations tend to be more hierarchical in nature due to their organizational culture and need for clear lines of authority and reward structures.

There are several factors that contribute to the entrepreneurial organization's tendency to be managed in this way, including the need to coordinate key non-controlled resources and the desire of the employees for greater independence than can be found in most traditional organizations. Organizations that are purely entrepreneurial are willing to tolerate a high degree of risk. Such companies are often organized as team-based structures (also called lateral, cluster, or circle structures) that are highly departmentalized and have a flat span of control and little formalization. This structure requires little of the typical management supervision seen in more traditional organizations. In some ways, this is a good approach to entrepreneurial management because it supports the synergy that can contribute to sustained innovation. On the other hand, the very flexible nature of team-based structures can also lead to role ambiguity, increased conflict, and more stress for the team members. Further, if the teams are based on the contributions of single key personnel, the loss of one of these individuals can have severe negative impact on the success of the organization as a whole. All of these factors must be taken into account when determining how best to manage the new organization.

Terms & Concepts

Business Plan: A document prepared by the organization's management that summarizes the operational and financial objectives of the organization as well as detailed plans and budgets to show how these objectives will be achieved.

Equity: Ownership interest in a corporation. Equity typically takes the form of common or preferred stock.

Hierarchical Model: A model of organizational management that is characterized by a narrow organizational structure, vertical communication modes, formal control and authority structure, and emphasis on management activities.

Management: The process of efficiently and effectively accomplishing work through the coordination and supervision of others.

Organic Model: A model of organizational management based on the analogy of the organization as a living organism that is highly adaptable to the requirements of its environment. Organic models of the organization emphasize creativity, have flat organizational structures, lateral communication modes, information control and authority structures, and low emphasis on management activities.

Organizational Structure: The design of an organization including its division of labor, delegation of authority, and span of control.

Return on Investment (ROI): A measure of the organization's profitability or how effectively it uses its capital to produce profit. In general terms, return on investment is the income that is produced by a financial investment within a given time period (usually a year). There are a number of formulas that can be used in calculating ROI. One frequently used formula for determining ROI is (profits - costs) / (costs) x 100. The higher the ROI, the more profitable the organization.

Risk: The quantifiable probability that a financial investment's actual return will be lower than expected. Higher risks mean both a greater probability of loss and a possibility of greater return on investment.

Risk Assessment: The process of determining the potential loss and probability of loss of the organization's objectives. Risk assessment is one step in risk management.

Risk Management: The process of analyzing the objectives of the organization, planning ways to reduce the impact if the predicted normal course of events does not occur, and implementing reporting procedures so that problems are discovered earlier in the process rather than later.

Scalability: The ability of the organization's processes and structures to rapidly respond to needs for increased output driven by requirements of the marketplace.

Venture Capital: Funds made available to entrepreneurial firms with great growth potential to expand or grow the business. Venture capital firms typically invest in a firm in exchange for equity in the company and with the expectation of a quick and high rate of return on their investment.

Bibliography

Bergin, R. J. (2001).Venture design, scalability and sustained performance. Academy of Management Proceedings, A1–A5. Retrieved April 16, 2007, from EBSCO Online Database Business Source Complete. http://search.ebscohost.com/login.aspx?direct=true&db=bth&AN=6133855&site=bsi-live

Boni, A. A., & Weingart, L. (2012). Building teams in entrepreneurial companies. Journal of Commercial Biotechnology, 18, 31–37. Retrieved November 21, 2013, from EBSCO Online Database Business Source Complete. http://search.ebscohost.com/login.aspx?direct=true&db=bth&AN=84497033

Cyr, L. A., Johnson, D. E., & Welbourne, T. M. (2000). Human resources in initial public offering firms: Do venture capitalists make a difference? Entrepreneurship: Theory & Practice, 25, 77–91. Retrieved April 16, 2007, from EBSCO Online Database Business Source Complete. http://search.ebscohost.com/login.aspx?direct=true&db=bth&AN=3999032&site=bsi-live

Markman, G. D., Balkin, D. B., & Schjoedt, L. (2001). Governing the innovation process in entrepreneurial firms. Journal of High Technology Management Research, 12, 273–293. Retrieved April 12, 2007, from EBSCO Online Database Business Source Complete. http://search.ebscohost.com/login.aspx?direct=true&db=bth&AN=5424303&site=bsi-live

Maschke, K., & Knyphausen-Aufseß, D. (2012). How the entrepreneurial top management team setup influences firm performance and the ability to raise capital: A literature review. Business Research, 5, 83–123. Retrieved November 21, 2013, from EBSCO Online Database Business Source Complete. http://search.ebscohost.com/login.aspx?direct=true&db=bth&AN=76149740

Miloud, T., Aspelund, A., & Cabrol, M. (2012). Startup valuation by venture capitalists: an empirical study. Venture Capital, 14(2/3), 151–174. Retrieved November 21, 2013, from EBSCO Online Database Business Source Complete. http://search.ebscohost.com/login.aspx?direct=true&db=bth&AN=74073835

Stevenson, H. H., Roberts, M. J. & Grousbeck, H. I. (1985). New business ventures and the entrepreneur (2nd ed.). Homewood, IL: Richard D. Irwin.

Suggested Reading

Holliday, K. K. (2001). Just when it all comes together. ABA Banking Journal, 93, 36–38. Retrieved April 16, 2007, from EBSCO Online Database Business Source Complete. http://search.ebscohost.com/login.aspx?direct=true&db=bth&AN=4576555&site=bsi-live

Mitter, C., & Kraus, S. (2011). Entrepreneurial finance—Issues and evidence, revisited. International Journal of Entrepreneurship & Innovation Management, 14(2/3), 132–150. Retrieved November 21, 2013, from EBSCO Online Database Business Source Complete. http://search.ebscohost.com/login.aspx?direct=true&db=bth&AN=63709248

Wonglimpiyarat, J. (2005). Boston Route 128 Revisited. International Journal of Innovation & Technology Management, 2, 217–233. Retrieved April 16, 2007, from EBSCO Online Database Business Source Complete. http://search.ebscohost.com/login.aspx?direct=true&db=bth&AN=18526420&site=bsi-live

Wonglimpiyarat, J. (2006). The Boston Route 128 model of high-tech industry development. International Journal of Innovation Management, 10, 47–63. Retrieved April 16, 2007, from EBSCO Online Database Business Source Complete. http://search.ebscohost.com/login.aspx?direct=true&db=bth&AN=19501142&site=bsi-live

Zolin, R., Kuckertz, A., & Kautonen, T. (2011). Human resource flexibility and strong ties in entrepreneurial teams. Journal of Business Research, 64, 1097–1103. Retrieved November 21, 2013, from EBSCO Online Database Business Source Complete. http://search.ebscohost.com/login.aspx?direct=true&db=bth&AN=62556112