AngelInvestorsForum.com

Alan L. Olsen


duction

A venture financing can be structured using one or more of several types of securities ranging from straight debt-to-debt with equity features (e.g., convertible debt or debt with warrants) to common stock. Each type of security offers certain advantages and disadvantages to both the entrepreneur and the investor. The characteristcs of your situation and current market forces will impact the type and mix of security package that is right for you.

Types of Securities Senior debt: Which is usually for long-term financing for high-risk companies or special situations such as bridge financing. Bridge financing is designed as temporary financing in cases where the company has obtained a commitment for financing at a future date, which funds will be used to retire the debt. It is used in construction, acquisitions, anticipation of a public sale of securities, etc. Subordinated debt: Which is subordinated to financing from other financial institutions, and is usually convertible to common stock or accompanied by warrants to purchase common stock. Senior lenders consider subordinated debt as equity. This increases the amount of funds that can be borrowed, thus allowing greater leverage. Preferred stock: Which is usually convertible to common stock. The venture’s cash flow is helped because no fixed loan or interest payments need to be made unless the preferred stock is redeemable or dividends are mandatory. Preferred stock improves the company’s debt to equity ratio. The disadvantage is that dividends are not tax deductible. Common stock: Which is usually the most expensive in terms of the percent of ownership given to the venture capitalist. However, sale of common stock may be the only feasible alternative if cash flow and collateral limits the amount of debt the company can carry.

While each of these securities has unique characteristics, they can be grouped into two categories: debt or equity. In structuring a venture financing, the primary question is whether the financing should be in the form of debt or equity.



Disadvantages of Debt to a Company

From a company’s viewpoint, there are two potential disadvantages to debt.

An excessive amount of debt can strain a company’s credit standing, thereby reducing its flexibility in meeting future long-term financing requirements on a favorable basis. It can also negatively affect a company’s ability to obtain short-term credit. Of course, the form of debt the venture financing takes makes a difference. For example, subordinated debt will have less impact on borrowing capacity than senior debt. The venture capitalist has the option of calling his loan if the company is in default of the loan agreement. This remedy, which is not available to him under other financing agreements, puts him in a better position to influence the company’s affairs when it is in default. Advantages of Debt to a Venture Capitalist

From the venture capitalist’s viewpoint, there are three principal advantages to debt.

There is a greater likelihood that the venture capitalist will get his principal back and, at least, a small return. Many of the companies in the average venture capitalist’s portfolio are referred to as "the living dead." Needless to say, their performance has turned out to be disappointing. In some cases, these companies are able to repay principal with interest but have limited appeal to potential acquirers or the public. As a result, a venture capitalist with an investment in such a company’s common stock may be unable to recover his investment within a reasonable period, if at all. As previously discussed, under certain circumstances the venture capitalist is in a better position to influence the company’s affairs. The venture capitalist has a senior claim. However, it should be emphasized that the meaningfulness of a senior claim depends on the marketability of a company’s assets and the amount of equity it has to cushion its creditors’ position. For example, in the case of a start-Lip situation with little or no equity, a senior claim means little or nothing. Percentage Ownership Needed

While the difference may not be great, depending on the particular circumstances of the company, a debt position involves less risk than an equity position for the venture capitalist. Accordingly, a company should not have to relinquish as much ownership when a financing is in the form of debt. However, this advantage must be weighed against the disadvantages of debt.

No matter how the venture financing is structured, it must be priced so that it is attractive to the venture capitalist. There is no clear-cut answer as to how much ownership a company will have to relinquish to make a financing attractive. Broadly speaking, the greater the potential return perceived by the venture capitalist, the less ownership he will demand. In other words, if a company has a patented product which a venture capitalist thinks is revolutionary and highly marketable, he will undoubtedly settle for less ownership than he would in the case of 4 company with a relatively less attractive product. Thus, his ultimate position will be a business judgment based on his potential return.

Before you enter negotiations with the venture capitalist, you should determine what your company is worth and how much of your company you want to sell. The following procedure can be used to get a rough idea of how much ownership you will have to give up to make the financing attractive.

Estimate the risk associated with the venture financing. If the investment is very risky, the venture capitalist may be looking for a return as high as 15 times his investment over five years. Conversely, if a relatively low degree of risk is involved, the venture capitalist may be satisfied with doubling or tripling his investment over five years. Make a reasonable estimate of the price/earnings ratio applicable to comparable publicly held companies. The market value of the company can then be projected by multiplying forecasted annual earnings by the estimated price/earnings ratio for comparable companies. Divide the estimate of the total dollar return the venture capitalist wants by the projected market value of the company. This yields the percentage ownership the venture capitalist will need, as oil the future date, to realize his desired return. It is important to note that any equity financing required during the interim period must be considered in making these calculations.

Case Study

Suppose XYZ Company, Inc., a start-up, needs $500,000. The company’s product appears to have excellent potential. However, because the product is new and unproven, an investment in the company would be extremely risky. Accordingly, it is reasonable to estimate that a venture capitalist would want a potential return of at least ten times his total investment in five years. Management estimates that the company should be able to "go public" at 20 times earnings in five years. Projected after-tax earnings for the fifth year is $1,250,000. Additional long-term financing of $500,000 will be needed at the beginning of the third year.

Scenario I

In the calculations below it is assumed that the venture capitalist who provides the initial financing ($500,000) also provides the subsequent financing ($500,000), and that he wants a return equal to ten times both. However, it should be noted that if the company made satisfactory progress during the first two years, it would be reasonable to assume that the venture capitalist would be satisfied with a lower return on the subsequent financing since it would involve less risk.

Estimate of Total Dollar Return Required Total Investment $ 1,000,000 Estimate of Return Required X 10

$10,000,000

V. Projected Market Value in Fifth Year VI. VII. Projected Earnings $1,250,000 VIII. Estimate of P/E Ratio x 20

$25,000,000

Percentage Ownership Needed in Fifth Year Estimate of Total Dollar Return quired $10,000,000 Projected Market Value of Company in Fifth Year 25,000,000

40% Scenario II

In this set of calculations it is assumed that a second investor provides the subsequent financing ($500,000). The calculations show that the venture capitalist who provides the initial financing ($500,000) would need 20% ownership as of the fifth Year to realize the return he wants. However, since the ownership to be given up for the subsequent financing will reduce his ownership position, he will want more than 20% ownership initially. For example, if it is assumed that 15% ownership will have to be given up for the subsequent financing, the venture capitalist who provides the initial financing would need 23% ownership initially to end up with 20% ownership in the fifth year.

Assume the same facts as Case I, except a second investor provides the subsequent financing for 15% ownership.

Estimate of Total Dollar Return Required Total Investment $ 500,000 Estimate of Return Required X 10

$5,000,000

Projected Market Value in Fifth Year Projected Earnings $1,250,000 Estimate of P/E Ratio x 20

$25,000,000

Percentage Ownership Needed in Fifth Year Estimate of Total Dollar Return required $5,000,000 Projected Market Value of Company in Fifth Year 25,000,000

20%

Thus, it appears that the investment ($500,000) may be attractive to an interested venture capitalist if the principals of XYZ Company, Inc. are willing to give up approximately 23% ownership.

Conclusion

It must be emphasized that the above procedure is highly subjective. And, you should remember that what really matters is how the venture capitalist views the relative attractiveness of a company. Typically, venture capitalists are satisfied with a minority interest. Although a venture capitalist may demand a majority interest, generally they are not interested in operating control. Some of them like to tie the amount of ownership they ultimately get to the performance of the company. For example, a venture capitalist who wants a majority interest initially may give the principals the opportunity to earn part of it back. Such an arrangement can be used to compromise on pricing when there is a significant disagreement between the principals and the venture capitalist.

To entrepreneurs unfamiliar with venture capital, it may appear that the venture capitalist is seeking an extraordinary high return on his investment. However, it is important to understand that, even under the best of circumstances, only a minority of the companies in which the venture capitalists invests will be successful. He is well aware of this, and must make a sufficient return of his successful investments to come out with an acceptable return overall.

Why?


I majored in Computer Science/IT. I work for a consulting firm and most people talk about investment, capital, private equity, share holder, venture capital, and the like. I have no idea whatsoever what those terms are, since they never did teach those in college. When my co-workers talk about these kind of stuff, I am always out of words. I want to learn all about these business terms? Is there a Book that you can recommend or any learning alternatives that would help me be able to hop in on one of the “business topic conversations” that they always have. Thanks!

admogul


Looking for a standard format and example if possible for a 2 page business plan popular when seeking venture capital.

G


but which takes photos that can be shown on personal computers. This is an example of:
A. economies of scale.
B. product innovation.
C. process innovation.
D. venture capital.

Naz Daud


Raising business finance isn’t always easy, and especially so when you’ve not got enough assets to secure against your ambitious plans. In some cases, you’re going to have to part with equity. Venture capital funding can help you grow your business, and plays a vital role in fuelling growth and innovation in the world economy.

Venture capital has helped to fuel the growth of some of the world’s biggest public companies at one stage in their life-cycle. Venture capitalists are willing to run the risk of making poor returns, or losing all of their money, for a chance to hit a home run. That’s why their capital tends to follow big ideas, and is hard to get when you’re looking to do something that isn’t too innovative with huge growth potential.

The Dynamics of Venture Capital Funds

When entrepreneurs are looking to raise money from venture capitalists, they often have a poor understanding of how the market works. Venture capital firms do not raise their funds from shareholders; they usually raise their funds from private institutions. They will then charge a management fee, and take a percentage of equity for themselves. They also have a tendency to work together – often they will have other firms invest in a deal along with them. This can be to limit their exposure, and bring in expertise. Some VC firms will take an active role in managing their investments, while others prefer to watch carefully on the sidelines.

Don’t Be Too Scared Of Equity Dilution

Many a business has failed because the management have been too afraid of diluting equity. While it’s important to ensure you treat your equity with the respect it deserves, you shouldn’t be afraid to let go of some if it’s going to mean you own a smaller share of a bigger business. Using venture capital you can explore a high risk, high reward, rapid growth strategy. In many cases VC firms will be happy to fund your business to run at a loss initially, because they can see the bigger picture. This is a luxury that you will not be able to take advantage of when you have bank managers looking at your ever dwindling balance sheet.

Raising equity also gives you an opportunity to profit from your businesses success, or idea, before you manage to take dividends or experience a liquidity event. Although it will probably only be offered in later rounds, a VC firm might be prepared to buy equity from you directly as well as buying it from the company.

Choosing The Right Venture Capital Firm For You

Working with a company that’s worked in your space before can be of tremendous benefit. They will have domain knowledge to share, and will often have the right contacts in their phone book for closing partnerships and recruiting expertise. The relationship that you have with your VC could make or break your success, so make sure you pick the right one and the best fit for your business.

hc_dx


I am not interested in contacting online venture capital firms coz they demand for project plans and end up doing nothing. I am from a small asian country and it is quite dufficult convenincing investors to come here. My business interestes are in productions such as mobile phones and computer assemblies. Placing adverts on newspaper, web directories etc.? Thanks for your interest!!!

Low Jeremy


Venture capitalism is a system wherein a person or a company often referred to as venture capitalists invest money in a company or business exchange for a stake in the business or a share in the earnings, present and future, of the company.

Venture capitalists are frequently the ones that provide funding for companies that are in need of seed money to start up their business. Often, they support businesses that have a high potential for growth and those that they feel will return their investments multiple-folds. Companies that have innovative ideas and products are primary targets of venture capitalists. They are also partial to industries that are into innovations like Information Technology, Biotechnology and the medical fields.

Other venture capitalists focus on providing capitals for already established companies who are seeking to expand their operations while some rescue companies that are in trouble and those that badly need restructuring. There are also venture capitalists that go into buyouts and company takeovers but of course, these are just a few.

Often, venture capitalists do not just provide money but also the know-how. They help fledgling companies start by offering their managerial, executive and marketing expertise. They can also provide the contacts in the industry as well as other business requirements.

Venture capitalism starts with the business plan submissions, which the company seeking seed money can pass or the venture capitalist company can submit. The business plan should more or less include a description of the size of the target market, the people that will work behind the team, the technology and the product that the company will be offering, and the financial projections.

It is also important to include a summary of the business concept at the beginning. Remember that these venture capitalists do not have the time to read through the rest of the proposal. Your summary will determine if they will be interested or not in your business.

After submitting your business plan, wait for three weeks and then follow up with the venture capitalist. If you are lucky to make the cut, you will be scheduled a face to face meeting with the venture capitalist, where you can present your case in the flesh. This might help them make their decision.

On the average, venture capitalists receive about 200 business plans in a month. Only about five percent will be invited for a face to face meeting; so make the most out of your meeting and present a case that they can’t possibly ignore!

There are two types of people in the world. These are the rich who have money and those that don’t. When the person has money, there will be no problems going on a shopping spree in New York or hop on board a plane to see paradise in the Bahamas. The average Joe can also do that but will have to same that amount over a few months or even years.

If the rich individual doesn’t do anything to preserve the wealth, this will soon disappear. This is the reason that being a venture capital investor seems to be a good idea. A venture capital investor is an individual who would like to help fund an entrepreneur. There are two kinds namely the person who will wait to receive such a proposal while the other is out there hoping to see something interesting.

In the end, the venture capital investor will be reviewing the business plan to make sure it is sound and also meet the entrepreneur in person to clarify some issues. There are some people who might take advantage of the individual so a background check will be done even before the meeting takes place. The venture capital investor who is well aware of the trends for example in the information technology will not want to do business in a field that is unknown to that individual.

This means the person will only gamble on a high-risk investment in the preferred comfort zone. This approach is advantageous to the entrepreneur because the years of experience in that field can be useful in the partnership. What does a capital venture investor get from all of this? In exchange for the money being shelled by the individual, there are also a certain number of shares that will be given to get a seat among the board of directors.

This will ensure that the investor can play an active role in the direction of the business to be able to safeguard the money that was invested into the project. As the company grows, the money invested by the investor will be returned and the profits will be shared increasing the current wealth of the person.

Being a venture capitalist is a win-win situation for the individual and the entrepreneur. After all, two heads are better than one in making the day-to-day decisions so the company will become profitable in the long run.

elideneed33


I have 3 excellent business start-up ideas, but I have a few major problems: My credit is bad, I have no way of raising capital traditionally, I don’t understand the grant process, I have no available funds to purchase any of those grant books or venture capital memberships I have no family to help with start-up. What else is there for me?

I know that all of my ideas are viable and are needed in my area/community. I have done a lot of research, leg work, phone calls and other contact and communication.

Any ideas that would help me get my ideas out of my head and actually up and running before the end of this year? I truly want to get off government assistance but am limited to the types of employment that I can do. HELP!!!

Oh, my ideas consist of a full-range music school, youth center and a live music club. I have the verbal support of my community but no one is willing to help raise capital.

brett


Hey, I am considering doing a double major in business (finance) and accounting. I can do it in 4 years, I would just have a tight schedule with a tougher work load and not be able to take any elective classes that seem interesting. Is it worth it to risk a better GPA if I were just to mahjor in accounting? How does it benefit me if I want to go into financial services (corporate finance, i-banking, private equity, hedge fund, venture capital…) and/or corp. finance in energy or healthcare?

James Hunt


Venture capital is a fund raised by a group of wealthy investors, which is then made available to small companies and startup firms. These small businesses and potential entrepreneurs usually have excellent growth potential but lack the funds to proceed. Because there’s a chance that the business may not do well at all, venture capital is also known as risk capital.

So how does venture capital work? It’s not as difficult as it sounds. A start up business will solicit funds from a venture capital firm. If everything goes well, the venture capital firm will invest a certain amount of money into the start up, drawing on it’s capital over several years. When the fledgling firm “exits,” (meaning the business is purchased or goes public), the investment is returned to the venture capital firm’s investors, with a percentage of the profits thrown in for good measure.

How does one find a venture capital firm? One way is through a trusted financial expert such as an attorney, financial advisor, stockbroker or accountant. With luck, one of these professionals will recommend you and your business to a venture capital firm. Be sure to do your research first. The library and Internet host a wealth of information and there are many books available on the subject. You’ll need to know what steps are necessary to put in place before seeking out venture capital. For instance, a business plan and executive summary are necessary in order to convince any venture capitalist to invest in your idea.

A typical venture capital firm may invest in perhaps one out of four hundred businesses that are seeking their assistance. After losing money in the dot com boom of the nineties, many firms have become quite selective. If you wish for one of these firms to make an investment in you, you must be convincing and have great negotiation skills. Your business or product may be fabulous, but if you don’t have the ability to sell it, it’s not going to bring in any investors.