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Definition or Explanation:A 401(k) is a tax-deferred savings account that an employer establishes for its employees. This savings vehicle can be used for almost any kind of investment. The 401(k) stays intact even if the employee leaves the firm. If the employee leaves to start a new business, his or her 401(k) can be used to invest in, or even to finance, the new venture.

Appropriate For: Any company at any stage of development. Since entrepreneurs fund the company with their own retirement savings, they need only convince themselves that the deal is worth the risk.

Supply: This option is for entrepreneurs who have been cut loose from corporate America with their 401(k) plans intact. Beyond the requirement of simply having a 401(k) account, the supply is further influenced by how much of their tax-deferred retirement savings entrepreneurs are willing to put at risk.

This article has been excerpted from Financing Your Small Business, available from SmallBizBooks.com.
Does your business qualify for institutional venture capital? Run through this diagnostic test developed through an interview with John Martinson. He's the managing partner of the Edison Venture Fund, a Lawrenceville, New Jersey venture capital firm with $420 million under its management.

1. Are you a technology company? Technology is the stuff of gods for venture capitalists. With proprietary technology, a company can dominate a market and protect its profit margins. Institutional venture outfits do invest in low- or no-tech deals, just not as often. This means that competition among nontechnology companies is keener than among technology companies.

2. Can you be a market leader? Martinson says institutional venture capital firms are hesitant to throw money at a company that is going up against a market leader with a me-too product or service. It's too difficult and too unlikely to succeed simply by stealing market share from the leader. There are exceptions, however. In particular, this is where technology can play a role by shattering the existing paradigm of how a product or service is offered, as well as by providing entree for an upstart.

3. Will it be cheap to make this company? Of course, what's expensive to one is cheap to another. But in most venture capitalists' terms, cheap is a company that can be put together and establish significant profitability on $10 million to $15 million. According to Martinson, this preference stems from the fact that most institutional venture capitalists do not want to rely on other sources of capital to make the venture work. Rather, they want to be able to help the company reach a profitable plateau with the funds they are able to commit to the deal.

4. Is there a clear distribution channel? Entrepreneurs often come up with great products and services but no clear or easy way to sell them, Martinson says. It's important to ask whether the distribution channel can be accessed fairly inexpensively. For instance, the existence of mass-market retailers appears to offer inexpensive and wide distribution for many consumer products and even some technology products. However, hidden costs often make these channels prohibitive, such as the need to supply thousands of stores with inventory, the right to return unsold product, "slotting" fees or mandatory cooperative advertising costs. Companies that have joint-venture marketing opportunities--that is, the chance to move product through someone else's distribution network or take advantage of someone else's direct and proven access to the market--are typically more attractive to venture capitalists than those that must invent their distribution or pay high fees to use someone else's resources, Martinson says.

5. Can this product be distributed without significant support? Complex products or services usually require customer-support organizations that are expensive and sometimes difficult to establish and maintain. For instance, given rising concern over security, a relatively low-tech home alarm system sold through mass-market distribution channels might appeal to an investor. But can customers install the system themselves, or must a third party be involved? If so, says Martinson, "it's a much harder business to orchestrate and much less appealing because of the involved costs and their impact on the margins." But the need for customer support need not kill a deal. Sometimes a third party wants to get involved because it smells opportunity. For instance, SAP, one of the world's largest applications software companies, relies heavily on Big Five accounting firms to install and support its products. For SAP, funds that might otherwise go to a massive customer-support organization go instead to the bottom line.

6. Can the product or service generate gross margins of more than 50 percent? Gross margins are defined as sales less cost of sales. If that number is less than 50 percent, it's a turnoff for most institutional venture investors. Why? Because it's difficult to pay all the selling, general and administrative expenses and generate a healthy profit at this level. It's much more likely that a company will deliver the required high-operating or net margins if its gross margin is above 50 percent to begin with.

7. Can the company go public or be acquired? If neither of these events occur, there's little chance of a real payday for the venture capitalists. The requirement also represents a double-edged sword. First, are the company's founders willing to go this route? People who want to run family businesses don't go public or get acquired. Second, does the company have the ability to go public? A desire to do so is just that, but actually getting such a deal done requires a great business, guts, some luck and a lot of money upfront.

8. Can the company achieve $25 million in sales, and are there prospects for $50 million to $100 million in sales?With $25 million in sales, a company can generate the level of profits that makes the business worth enough so that a venture capitalist can become involved. Let's say, for instance, that a $25 million business brings $5 million to the bottom line and that the VC invests $10 million and owns 50 percent. Let's assume that the company goes public at 20 times its earnings, suggesting a value of $100 million. The VC who owns 50 percent of the company--hence 50 percent of the value, or $50 million--records a return of five times the original investment. That is generally considered a successful investment for most venture capitalists.

If you answered "no" to any of the preceding questions, with possible exceptions for numbers 1 and 6, institutional venture capital is probably not an option for your company. Edison Venture Fund's Martinson is particularly firm on question 8. "If there is no possibility you will hit the $25 million benchmark within five years, pursuing institutional venture capital is simply a waste of time," he says.

Given these kinds of hurdles, it's no wonder few companies land institutional venture capital. The supplicants beating a path to Edison Venture Fund's door seem to bear this out. "We see 2,000 plans each year," Martinson says. "We might visit 300, seriously consider and conduct due diligence on 50, and invest in eight to 12."
If your plan does qualify for venture capital, by all means start looking.
For information on more ways to raise money for your venture, check out Financing Your Small Business, available from SmallBizBooks.com.

What is Venture Capital? Who are Angel Investors?

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Angel Investors typically invest their own funds, unlike venture capitalists, who manage the pooled money of others in a professionally-managed fund.[1]

[2] Although typically reflecting the investment judgment of an individual, the actual entity that provides the funding may be a trust, business, limited liability company, investment fund, etc. Angel capital fills the gap in start-up financing between "friends and family"
(sometimes humorously given the acronym FFF, which stands for "friends, family and fools") who provide seed funding, and venture capital.

Although it is usually difficult to raise more than a few hundred thousand dollars from friends and family, most traditional venture capital funds are usually not able to consider investments under US$1–2 million. [3] Thus, angel investment is a common second round of financing for high-growth start-ups, and accounts in total for almost as much money invested annually as all venture capital funds combined, but into more than ten times as many companies (US$26 billion vs. $30.69 billion in the US in 2007, into 57,000 companies vs. 3,918 companies).[4][5] Of the US companies that received angel funding in 2007, the average capital raised was about US$450,000. However, there is no “set amount” per se for angel investors, and the range can go anywhere from a few thousand, to a few million dollars. Software accounted for the largest share of angel investments, with 27 percent of total angel investments in 2007, followed by healthcare services, and medical devices and equipment (19 percent) and biotech (12 percent). The remaining investments were approximately equally weighted across high-tech sectors. [4] Angel financing, while more readily available than venture financing,[5] is still extremely difficult to raise.[6] Angel investments bear extremely high risk and are usually subject to dilution from future investment rounds. As such, they require a very high return on investment[7].

Because a large percentage of angel investments are lost completely when early stage companies fail, professional angel investors seek investments that have the potential to return at least 10 or more times their original investment within 5 years, through a defined exit strategy, such as plans for an initial public offering or an acquisition. Current 'best practices' suggest that angels might do better setting their sights even higher, looking for companies that will have at least the potential to provide a 20x-30x return over a five- to seven-year holding period[8]. After taking into account the need to cover failed investments and the multi-year holding time for even the successful ones, however, the actual effective internal rate of return for a typical successful portfolio of angel investments is, in reality, typically as 'low' as 20-30%

9]. While the investor's need for high rates of return on any given investment can thus make angel financing an expensive source of funds, cheaper sources of capital, such as bank financing, are usually not available for most early-stage ventures, which may be too small or young to qualify for traditional loans. The term "angel" originally comes from England where it was used to describe wealthy individuals who provided money for theatrical productions. In 1978, William Wetzel,[10] then a professor at the University of New Hampshire and founder of its Center for Venture Research, completed a pioneering study on how entrepreneurs raised seed capital in the USA, and he began using the term "angel" to describe the investors that supported them. Angel investors are often retired entrepreneurs or executives, who may be interested in angel investing for reasons that go beyond pure monetary return. These include wanting to keep abreast of current developments in a particular business arena, mentoring another generation of entrepreneurs, and making use of their experience and networks on a less-than-full-time basis. Thus, in addition to funds, angel investors can often provide valuable management advice and important contacts. Because there are no public exchanges listing their securities, private companies meet angel investors in several ways, including referrals from the investors' trusted sources and other business contacts; at investor conferences and symposia; and at meetings organized by groups of angels where companies pitch directly to investor in face-to-face meetings. According to the Center for Venture Research, there were 258,000 active angel investors in the U.S. in 2007.

[11] According to literature reviewed by the US Small Business Administration, the number of individuals in the US who made an angel investment between 2001 and 2003 is between 300,000 and 600,000.[12] Beginning in the late 1980s, angels started to coalesce into informal groups with the goal of sharing deal flow and due diligence work, and pooling their funds to make larger investments. Angel groups are generally local organizations made up of 10 to 150 accredited investors interested in early-stage investing. In 1996 there were about 10 angel groups in the U.S.; as of 2008, while there are no official statistics, data from the company that provides deal management services for the majority of organized Angel investors indicates there are over 300,[13] with a roughly equal number in all other countries combined; these groups accounted for approximately 12,000 individual angel investors in 2008. The more advanced of these groups have full time, professional staffs; associated investment funds; sophisticated web-based platforms for processing funding applications; and annual operating budgets of well over US$250,000. The past few years, particularly in North America, have seen the emergence of networks of angel groups, through which companies that apply for funding to one group are then brought before other groups to raise additional capital.[14] The development of the Angel soft network, connecting a majority of existing angel groups, has led to an increase in the syndication of investments among more than one group. [15]

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