When
people think of funding, generally what they think of is
venture capital, a term bandied about during the dot come
heyday where large amounts of money went towards speculative
investments with no proof of concept or revenue model.
Venture capital still exists, but the deals thus far have
not been to fund unproven businesses. The deals in our
industry have focused on established businesses with
demonstrated successes – companies with a proven record that
earn a positive net income. These deals have been
private equity as opposed to venture capital.
An investment firm might do
both private equity and venture capital deals, but the deals
have marked differences with respect to how the money gets
used. Venture capital helps a business test its concept
and/or provide working capital. Venture capital allows
companies to market their product, pay for development, etc.
Those placing venture deals expect equity for their
investment, but the money they use to finance the purchase
comes entirely from the venture company’s funds. Private
equity deals also involve the purchase of equity from
existing stakeholders; however, in contrast to venture
capital, this money does not have to be, and is usually not,
used to fund existing operations. Private equity
money often goes directly to the principle shareholders
whose equity was purchased. Private equity becomes an
insurance policy, allowing the shareholders a means to cash
out on some of their efforts, and they do so in an easier
fashion than going public for example.
Another difference between
venture capital and private equity deals with the source of
the funds. If a company has a positive cash flow, the
private equity firm might opt to purchase their shares with
a combination of their own money and debt, such as borrowed
money from a bank. For example, if a venture firm invests
$50 million dollars and these shares appreciate to $100
million at the liquidity event, they have earned a
respectable 200% return. If however, rather than investing
all $50 million from their funds, they invest $25 million of
their money and $25 million of borrowed money, their total
investment has not changed, and at the time of liquidity the
value has not changed either. Over the years from initial
investment to liquidity, the private equity group has paid
off the debt with cash flow from the business leaving them a
400% return as opposed to a 200% return. They earned the
difference between $100 million and $25 million as opposed
to $100 million and $50 million. The original shareholders,
for example the founders of the company, tend not to object
to the use of debt because they still receive cash for their
shares during the initial investment.
Having discussed the general
difference between venture capital and private equity
placement, the next topic when it comes to the world of
funding is, “Why now?” There is a popular theory that
revolves around the fees the funding institutions make, that is often
cited to explain the seeming uptake in interest in funding.
Venture capital and private equity companies create funds
that are classes of investments, i.e. they are a unique
asset class just as mutual funds are. Companies like Battery
Ventures, Sequoia, and Garage Technology Ventures raise
money from lending partners which are typically large
endowments and other financial institutions. These fund
companies place investments on behalf of the lending
partners with the expectation that the value of the fund
will increase at higher yields over time than other
investment vehicles such as buying shares in publicly traded
companies. These placement companies seek a liquidity event
after a certain number of years so that they can show the
return to the lending partners. Given that each successful
liquidity event provides substantially greater percentage
returns than a standard investment, the fund companies can
afford to make more and often riskier gambles so long as the
aggregate returns equal around 25% per year invested.
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In exchange for their
investing efforts, the fund raisers who place venture
capital and private equity placements receive a management
fee. The typical management fee has the investment company
receiving a flat 2% of the fund amount for the first five or
six years. After this period, any money not deployed, think
spent, goes back to the lending partners. Assume that the
investment company receives a fee for the first five years
for a fund that is $500 million dollars. They will earn $10
million dollars in fees for the first five years along with
some percentage thereafter in decreasing intervals which
tends to equal 3/4 of the initial management fee percentage
for years six, seven, eight and 1/2 of that percentage for
years nine and ten. If the company only deploys half of the
$500 million, they stand to lose out on a substantial amount
of money, namely 1.5% of $250 million for three years and 1%
of $250 million for the past two years.
During the boom years, these
investment funds raised substantial money, and, if their
contracts were for six years, that would mean the period for
deployment would be near and a rush of capital would need to
be spent. According to those in the business, that is only
part of the reason there is an apparent up-tick in funding.
These funds have become an increasingly popular asset class
which has led to more and more money chasing fewer and fewer
opportunities; some of the biggest funds have actually
sprung up in the past 18 months. More private companies are
willing to part with their shares because they know that
they are receiving higher valuations than in other times. If
the share owners want to earn $25 million, they can do so
now by selling a smaller stake or sell the same stake they
had initially planned and earn even more money. Equally
important, the banks are lending more now than in other
times, this allows for more leveraged buyouts, i.e. using
debt to finance the equity purchase. Willingness on the
banks parts only increases the interest private equity firms
have in taking stake in profitable companies.
Like everything else, the
investing market is cyclical. There is no one reason for the
interest, and after a point, the interest will lessen.
Similarly, there is no easy answer for whether to accept the
interest of these outside firms. In most cases, the
principle stakeholders do well, but it might have unforeseen
consequences on the rest of the company. Accepting
investments will have operational impacts as well.
Ultimately, they are a popular way to cash out on work done
and a growing asset class impacted like everything by market
conditions. As is the case with any trend, expect this year
to treat several people very well, but no reasonable person
would bet their future on the placement of private equity in
their company.
Jay Weintraub
