Is Venture Capital Right for the Business?

Equity funding can take a number of forms. True equity generally is evidenced by common or preferred stock issued to the equity provider. Preferred stock is a form of stock having a higher priority than common stock. Both classes of stock are subordinate to the interests of lenders. The stock conveys an ownership interest in the business. The percentage of ownership interest is negotiated between the business owner and the equity provider while the deal is being put together. There are some investors who require a majority interest in every company in which they invest, most investors do not predetermine an ownership percentage. The stock may also provide for dividends but payment of the dividends is frequently deferred.

In addition to stock, the investor may also require seats on the Board of Directors and may take an active role in management of the company.   The investor may be a great source of advice on business and financial matters. The purpose is to help protect the investors ownership interest.

Funding can also be provided in the form of mezzanine capital. This is capital that is between the debt of senior lenders and equity capital. It is also often referred to as subordinated debt. It often takes the form of debt with a current pay requirement plus rights to an equity or ownership stake in the business. The total expected return to this type of investor is more than senior debt but less than a pure equity investment.    An important element in any investor's decision to provide funds to a company is the ability to realize a significant profit on that investment. Lenders look to the existing cash flow and any security they receive under the loan documents. Equity providers look to what is referred to as an exit strategy; an event (liquidity event) that provides a return on their stock ownership position.

This event can be a number of things (merger, reverse merger, acquisition, IPO, exempt public offering). In mezzanine capital, a combination of the current interest payments and the ultimate value of the stock position achieve the return. Pure equity providers seek rates of return in excess of 30% while mezzanine providers seek somewhat lower returns but still in excess of 20%.

A well-known exit strategy is an Initial Public Offering or IPO. This is the sale of the privately held stock to the public. The cash received from the sale of the stock is used to redeem the stock held by the investor. Often the sale of the stock held by the investor is restricted for some period. However, the public trading of the stock provides a ready exit when the restriction is lifted.

Most exits do not take the form of IPOs. Many investments are exited through buybacks of the stock position by the current owners, a strategic sale of the company or a management led buy out of the company from the current owners. Also, mergers and acquisitions have been widely used. The ability to achieve a profitable exit depends upon the growth of the company. A venture capitalist will invest in those companies that he/she perceives will grow fast. This fast growth makes it more likely that one of the exit strategies can be achieved.

The high rates of return expected by venture capitalists are a reflection of the perceived risks associated with equity investing. This risk is a result of the lower protection afforded equity owners relative to creditors of the company and the inherent risk associated with investing in newer, less established entities.