All Financing Sources Are Not Equal
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Most entrepreneurs would love to be in the position of having multiple sources eager to invest. However, when you dig beneath the surface you find that the choices are not easy.
The decision about financing sources involves fundamental choices in deal structure, valuation, cost and even business strategy. These choices are a function of the different business and legal requirements/realities imposed by the financing source. Unfortunately there is not much written material available on the subject, but here are some of my observations:
The structure and functioning of the professional venture capital industry follows a typical pattern. Professional venture capital money managers form a venture capital limited partnership fund in which they are the general partners and through which money is raised from wealthy individuals, private and public pension funds, educational endowments, insurance companies and sometimes operating companies.
The fund typically has a ten-year life, at the end of which the partnership dissolves and distributes its assets to the partners. A typical lifecycle of a venture capital fund is as follows: Initial investments are made during the years one to four of the fund. Years two to six primarily involve follow-on investments in portfolio companies. Harvesting or "cashing out" of the investments typically occurs from years four through ten. Somewhere in the middle of the fund's life after the bulk of the initial investment is made and perhaps some harvesting of the early "winners" has occurred, the general partners may start to raise an additional fund, recycling some of the investment success money and adding new limited partner investors. What does this life cycle mean to the entrepreneur? First, you should focus on funds which are in the initial investment phase as opposed to funds which are in their eight or ninth year.
The entrepreneur also needs to know how the venture capitalists are compensated. General partners receive a management fee of from 1% to 2.5% of the assets in the fund. This fee is used to run the operations of the general partners, e.g. pay rent, annual salaries to the general partners, etc. Obviously the larger the fund the bigger the cash management fee. Larger funds are usually not interested in investing small amounts of money, say under $1m, because the general partners are legally required to monitor the investment and it takes as much effort to monitor a large investment as it does a small investment. Although the management fee is nice, the real payoff to the general partners comes through participation in the fund's profits. Typically the profits of the fund are distributed 99% to the limited partners and 1% to the general partners until the limited partners receive all of their investment back, at which time a "flip" occurs and the split is 80% limited partners and 20% general partners. This structure drives the venture capitalists to invest in potential high growth and big return situations because it is only through "homeruns" that the general partners' 20% carried interest is worth much. Moral for the entrepreneur: don't bother pursuing venture capital unless you have a potential "homerun" venture. I leave it to you to think through some of the other implications of the institutional attributes of venture capital funds.
Private Placements Through Brokerage Firms.
Two clients are talking with a Wall Street brokerage
firm to do a private placement to wealthy individual clients of the brokerage
firm. They can expect to pay
commissions or fees of 10+% with some equity "kickers".
Why? Brokers receive a small
commission by getting their clients to buy and sell securities.
The more times this happens the larger the dollar volume of commissions
to the broker. If the broker puts
his client in an illiquid private placement it reduces the amount which the
client can use to buy public securities on which the broker makes his normal
brokerage commission. The higher
commission for the private placement is to compensate the broker for giving up
the opportunity to earn his regular commissions.
In addition, these private placement deals may have an implicit quicker
"exit" requirement than the more patient venture capital funds having
a ten year life.
The strategic partner investor may give higher
valuations than other investors because it is more knowledgeable about the
business. Sometimes it is not a
valuation issue but the synergies which the strategic partner sees with its own
business which makes it willing to do the deal when others won't from only a
financial analysis perspective. A
strategic partner which is not financially driven may not be there for future
rounds if its technology transfer goals are not being met, if the technology
falls out of favor with the partner or if there are other managerial issues
which get in the way.
Experienced private investors, often former
entrepreneurs, can be worth a lot more than the money they invest by adding
value through hands on advice, contacts, etc.
On the other hand do they have the depth of pocketbook to fund multiple
rounds of financing if needed?
As this quick overflight of investor types shows, not
all money is the same and not all funding sources are equal.
The entrepreneur must carefully consider the implications which may
follow from the institutional and other requirements of various financing
sources. There are few written
materials which cover these points. Pratt's Guide to Venture Capital and the Venture Capital
Journal are good sources for information about professional venture capital.
The entrepreneur will have to do some digging to find information about
the other financing sources- ask other entrepreneurs, your lawyer, accountant,
banker and other advisers. Once you
have amassed as much information as possible, don't hesitate to discuss these
issues directly with the financing sources you are considering.
DISCLAIMER: This column is designed to give the reader
an overview of a topic and is not intended to constitute legal advice as to any
particular fact situation. In addition, laws and their interpretations change
over time and the contents of this column may not reflect these changes. The
reader is advised to consult competent legal counsel as to his or her particular
Copyright 1994-2005, Joseph G. Hadzima Jr., All Rights Reserved.