| Introduction | | | | give up to make the financing attractive. |
| A venture financing can be structured using one or | | | | 1. Estimate the risk associated with the venture |
| more of several types of securities ranging from | | | | financing. If the investment is very risky, the venture |
| straight debt-to-debt with equity features (e.g., | | | | capitalist may be looking for a return as high as 15 |
| convertible debt or debt with warrants) to common | | | | times his investment over five years. Conversely, if a |
| stock. Each type of security offers certain | | | | relatively low degree of risk is involved, the venture |
| advantages and disadvantages to both the | | | | capitalist may be satisfied with doubling or tripling his |
| entrepreneur and the investor. The characteristcs of | | | | investment over five years. |
| your situation and current market forces will impact | | | | 2. Make a reasonable estimate of the price/earnings |
| the type and mix of security package that is right | | | | ratio applicable to comparable publicly held companies. |
| for you. | | | | The market value of the company can then be |
| Types of Securities | | | | projected by multiplying forecasted annual earnings |
| - Senior debt: Which is usually for long-term financing | | | | by the estimated price/earnings ratio for comparable |
| for high-risk companies or special situations such as | | | | companies. |
| bridge financing. Bridge financing is designed as | | | | 3. Divide the estimate of the total dollar return the |
| temporary financing in cases where the company has | | | | venture capitalist wants by the projected market |
| obtained a commitment for financing at a future | | | | value of the company. This yields the percentage |
| date, which funds will be used to retire the debt. It is | | | | ownership the venture capitalist will need, as oil the |
| used in construction, acquisitions, anticipation of a | | | | future date, to realize his desired return. It is |
| public sale of securities, etc. | | | | important to note that any equity financing required |
| - Subordinated debt: Which is subordinated to | | | | during the interim period must be considered in |
| financing from other financial institutions, and is usually | | | | making these calculations. |
| convertible to common stock or accompanied by | | | | |
| warrants to purchase common stock. Senior lenders | | | | Case Study |
| consider subordinated debt as equity. This increases | | | | Suppose XYZ Company, Inc., a start-up, needs |
| the amount of funds that can be borrowed, thus | | | | $500,000. The company's product appears to have |
| allowing greater leverage. | | | | excellent potential. However, because the product is |
| - Preferred stock: Which is usually convertible to | | | | new and unproven, an investment in the company |
| common stock. The venture's cash flow is helped | | | | would be extremely risky. Accordingly, it is reasonable |
| because no fixed loan or interest payments need to | | | | to estimate that a venture capitalist would want a |
| be made unless the preferred stock is redeemable or | | | | potential return of at least ten times his total |
| dividends are mandatory. Preferred stock improves | | | | investment in five years. Management estimates that |
| the company's debt to equity ratio. The disadvantage | | | | the company should be able to "go |
| is that dividends are not tax deductible. | | | | public" at 20 times earnings in five years. |
| - Common stock: Which is usually the most | | | | Projected after-tax earnings for the fifth year is |
| expensive in terms of the percent of ownership | | | | $1,250,000. Additional long-term financing of $500,000 |
| given to the venture capitalist. However, sale of | | | | will be needed at the beginning of the third year. |
| common stock may be the only feasible alternative if | | | | Scenario I |
| cash flow and collateral limits the amount of debt the | | | | In the calculations below it is assumed that the |
| company can carry. | | | | venture capitalist who provides the initial financing |
| While each of these securities has unique | | | | ($500,000) also provides the subsequent financing |
| characteristics, they can be grouped into two | | | | ($500,000), and that he wants a return equal to ten |
| categories: debt or equity. In structuring a venture | | | | times both. However, it should be noted that if the |
| financing, the primary question is whether the | | | | company made satisfactory progress during the first |
| financing should be in the form of debt or equity. | | | | two years, it would be reasonable to assume that |
| | | | the venture capitalist would be satisfied with a lower |
| Disadvantages of Debt to a Company | | | | return on the subsequent financing since it would |
| From a company's viewpoint, there are two potential | | | | involve less risk. Estimate of Total Dollar Return |
| disadvantages to debt. | | | | Required Total Investment $ 1,000,000 Estimate of |
| 1. An excessive amount of debt can strain a | | | | Return Required X 10 |
| company's credit standing, thereby reducing its | | | | $10,000,000 |
| flexibility in meeting future long-term financing | | | | V. Projected Market Value in Fifth Year VI. VII. |
| requirements on a favorable basis. It can also | | | | Projected Earnings $1,250,000 VIII. Estimate of P/E |
| negatively affect a company's ability to obtain | | | | Ratio x 20 |
| short-term credit. Of course, the form of debt the | | | | $25,000,000 |
| venture financing takes makes a difference. For | | | | Percentage Ownership Needed in Fifth Year Estimate |
| example, subordinated debt will have less impact on | | | | of Total Dollar Return quired $10,000,000 Projected |
| borrowing capacity than senior debt. | | | | Market Value of Company in Fifth Year 25,000,000 |
| 2. The venture capitalist has the option of calling his | | | | 40% Scenario II |
| loan if the company is in default of the loan | | | | In this set of calculations it is assumed that a second |
| agreement. This remedy, which is not available to him | | | | investor provides the subsequent financing |
| under other financing agreements, puts him in a | | | | ($500,000). The calculations show that the venture |
| better position to influence the company's affairs | | | | capitalist who provides the initial financing ($500,000) |
| when it is in default. | | | | would need 20% ownership as of the fifth Year to |
| Advantages of Debt to a Venture Capitalist | | | | realize the return he wants. However, since the |
| From the venture capitalist's viewpoint, there are | | | | ownership to be given up for the subsequent |
| three principal advantages to debt. | | | | financing will reduce his ownership position, he will |
| 1. There is a greater likelihood that the venture | | | | want more than 20% ownership initially. For example, |
| capitalist will get his principal back and, at least, a small | | | | if it is assumed that 15% ownership will have to be |
| return. Many of the companies in the average | | | | given up for the subsequent financing, the venture |
| venture capitalist's portfolio are referred to as | | | | capitalist who provides the initial financing would need |
| "the living dead." Needless to say, their | | | | 23% ownership initially to end up with 20% |
| performance has turned out to be disappointing. In | | | | ownership in the fifth year. |
| some cases, these companies are able to repay | | | | Assume the same facts as Case I, except a second |
| principal with interest but have limited appeal to | | | | investor provides the subsequent financing for 15% |
| potential acquirers or the public. As a result, a venture | | | | ownership. Estimate of Total Dollar Return Required |
| capitalist with an investment in such a company's | | | | Total Investment $ 500,000 Estimate of Return |
| common stock may be unable to recover his | | | | Required X 10 |
| investment within a reasonable period, if at all. | | | | $5,000,000 |
| 2. As previously discussed, under certain | | | | Projected Market Value in Fifth Year Projected |
| circumstances the venture capitalist is in a better | | | | Earnings $1,250,000 Estimate of P/E Ratio x 20 |
| position to influence the company's affairs. | | | | $25,000,000 |
| 3. The venture capitalist has a senior claim. However, | | | | Percentage Ownership Needed in Fifth Year Estimate |
| it should be emphasized that the meaningfulness of a | | | | of Total Dollar Return required $5,000,000 Projected |
| senior claim depends on the marketability of a | | | | Market Value of Company in Fifth Year 25,000,000 |
| company's assets and the amount of equity it has to | | | | 20% |
| cushion its creditors' position. For example, in the case | | | | Thus, it appears that the investment ($500,000) may |
| of a start-Lip situation with little or no equity, a senior | | | | be attractive to an interested venture capitalist if the |
| claim means little or nothing. | | | | principals of XYZ Company, Inc. are willing to give up |
| Percentage Ownership Needed | | | | approximately 23% ownership. |
| While the difference may not be great, depending on | | | | Conclusion |
| the particular circumstances of the company, a debt | | | | It must be emphasized that the above procedure is |
| position involves less risk than an equity position for | | | | highly subjective. And, you should remember that |
| the venture capitalist. Accordingly, a company should | | | | what really matters is how the venture capitalist |
| not have to relinquish as much ownership when a | | | | views the relative attractiveness of a company. |
| financing is in the form of debt. However, this | | | | Typically, venture capitalists are satisfied with a |
| advantage must be weighed against the | | | | minority interest. Although a venture capitalist may |
| disadvantages of debt. | | | | demand a majority interest, generally they are not |
| No matter how the venture financing is structured, it | | | | interested in operating control. Some of them like to |
| must be priced so that it is attractive to the venture | | | | tie the amount of ownership they ultimately get to |
| capitalist. There is no clear-cut answer as to how | | | | the performance of the company. For example, a |
| much ownership a company will have to relinquish to | | | | venture capitalist who wants a majority interest |
| make a financing attractive. Broadly speaking, the | | | | initially may give the principals the opportunity to earn |
| greater the potential return perceived by the venture | | | | part of it back. Such an arrangement can be used to |
| capitalist, the less ownership he will demand. In other | | | | compromise on pricing when there is a significant |
| words, if a company has a patented product which a | | | | disagreement between the principals and the venture |
| venture capitalist thinks is revolutionary and highly | | | | capitalist. |
| marketable, he will undoubtedly settle for less | | | | To entrepreneurs unfamiliar with venture capital, it |
| ownership than he would in the case of 4 company | | | | may appear that the venture capitalist is seeking an |
| with a relatively less attractive product. Thus, his | | | | extraordinary high return on his investment. However, |
| ultimate position will be a business judgment based on | | | | it is important to understand that, even under the |
| his potential return. | | | | best of circumstances, only a minority of the |
| Before you enter negotiations with the venture | | | | companies in which the venture capitalists invests will |
| capitalist, you should determine what your company | | | | be successful. He is well aware of this, and must |
| is worth and how much of your company you want | | | | make a sufficient return of his successful |
| to sell. The following procedure can be used to get a | | | | investments to come out with an acceptable return |
| rough idea of how much ownership you will have to | | | | overall. |