Introduction
One of the most common avenues for firms to raise money is through venture capitalists. These are individuals who are seeking out greater returns in exchange for giving them more control in the direction, planning and operations of the organization. In many cases, a number of private entities will utilize this avenue to increase working capital and continue to expand. To fully understand why this approach is utilized requires carefully examining startup financing, key terms, trends, angle investments, the evaluation of VC firms and valuation techniques. Together, these different elements will identify the role of these organizations, important trends and the impact it is having on stakeholders. (Finkel)
Start Up Financing
Venture capitalists have an impact on firms. This is taking place through the tremendous amounts of financing they provide to corporations. During some of the most critical stages of growth, these companies have the capacity to influence how a firm operates and the practices they will embrace in the process. This is taking place, with venture capitalists taking an equity stake in the organization. (Gompers) They can use their power to influence the way the company is run by impacting the board of directors, the management and the policies which are implemented. This will have a direct impact on the day to day operations of the firm. (Finkel) These and other mechanisms are designed to provide value added propositions to enhance the overall returns for venture capitalists. In this aspect, one could argue that for the increased amounts of risk taken, they will demand more control. This minimizes risk and ensures they can shape the direction of the company going forward. (Titman & Martin)
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In many cases, firms will have specific characteristics which show they can achieve strategic value and positive NPV. The most notable include: innovative products, the ability to provide significant returns, good management, emerging industries and the capacity to enhance shareholder value in the long term. Venture capital firms have a number of different avenues in determining their strategic options. These include: if the company meets the investment characteristics of the venture capital fund, aligned management structures / business philosophies, the risks, if the company / industry is growing, their previous earnings and capacity to work with shareholders. (Gladstone) Those organizations who share the same philosophy with venture capitalists will be able to attract more support. These entities will work with the management team to develop new products and bring them to the marketplace. This determines what opportunities they can take advantage of in order to achieve these objectives. (Titman & Martin) For startups, VC firms help to provide them with the critical working capital to address critical challenges they are facing.
Term Sheet
There are a number of different terms that are focused on. The most notable include:
• VC: This is an abbreviation for venture capital.
• Securities and Exchange Act of 1933: This requires any offering to be register with the Securities and Exchange Commission unless it qualifies for an exemption. (Johnson)
• Regulations A and D: These are exemptions utilized by firms to raise money without having to register. (Johnson)
These terms offer specific insights that help to illustrate the scope of the VC related activities. At the same time, it is providing clarification about key concepts. (Johnson)
Trends in the Venture Capital Industry
Inside the industry, there are a number of different trends that will have an impact on the profitability of VC firms. The most notable include: global reach and reinventing businesses. Global reach is when organizations can benefit from rapidly developing growth in emerging economies and companies. This improves the total return and it allows them to diversify their holdings. Reinventing businesses is when these organizations can influence the kinds of products / services provided, the customer’s experience and improving strategies for increasing earnings. These factors will help them to become more profitable and establish a brand image for the organization. VC firms are seeking to take advantage of these areas to realize higher levels of income and capital gains.
Angle Investment
An angle investor is someone who is wealthy and provides startup businesses with additional working capital. Prior to any initial public offering, growing firms are facing significant financial challenges. This is because the company is having trouble raising additional working capital in the form of a private placement. These are (“pre IPOs”) that are sold to accredited and a limited number of unsophisticated investors. An accredited investor is someone who earns $200 thousand annually for the last two years and has a net worth of $1 million. Unsophisticated investors are limited to 35 individuals, who fall beneath these guidelines. This allows the company to raise select amounts of additional funds (via Regulations A and D of the Securities Act of 1933). In other words, the firm can receive working capital without having to register with the Securities and Exchange Commission through the exemption. (Johnson) Venture capital firms fill this void as they are considered to be institutional investors. Under the law, they are not required to the same kinds of disclosure and can take a larger stake. This will result in them realizing greater total returns from helping to make the business economically viable. (Johnson)
Evaluation of VC Firms
To evaluate a firm requires looking at its investment philosophy. This means looking at their past investments to determine the long term impacts of the organization on startups and existing corporations. Those who share a similar philosophy increase the odds of realizing higher returns and using their experience to make the company successful. (Johnson)
Valuation Techniques
Free cash flow is focusing on the hard currency reserves a company has available on its balance sheet. This is significant, as cash is the primary tool that executives can use to expand the firm, pay dividends and engage in activities to increase shareholder value (such as: authorizing stock buybacks). Moreover, it is giving executives the flexibility to adjust with changes inside marketplace through providing them wadded amounts of liquidity when they need it. This helps to improve their credit rating among different agencies and will result in lower interest rates on any outstanding loans. Those firms with higher amounts of free cash flow are considered to be some of the strongest inside the marketplace and can quickly evolve with new challenges they are facing.
The way that this is calculated is by using one of two different formulas which are illustrated below.
• Free cash flow = EBIT (1-Tax Rate) + Depreciation & Amortization – Change in Net Working Capital – Capital Expenditure
• Free cash flow = Operating Cash Flow – Expenditures
These areas will help to objectively analyze the financial strengths of a firm and their ability to deal with a variety of challenges. When this happens, the company can adapt with the changes it is facing inside the marketplace. (Gladstone)
Conclusion
These areas are important, as they are showing the most effective ways of evaluating the financial condition of a firm. This helps venture capitalists to make more prudent decisions and it enables them to objectively decide if the company can provide the desired long term returns. At the same time, they allow them to select firms with lower amounts of volatility and withstand sudden changes in the economic cycle.
- Finkel, Robert. The Masters of Private Equity and Venture Capital. New York: McGraw Hill, 2009. Print.
- Gladstone, Dan. Venture Capital Investing. Hoboken: Wiley, 2009. Print.
- Gompers, Pat. The Venture Capital Cycle. Boston: MIT Press, 2004. Print.
- Johnson, Charles. Corporate Finance and the Securities Laws. New York: Aspen Publishers, 2006. Print
- Titman, Samuel. and Martin, Janet. Valuation: The Art and Science of Investment Decisions. Boston: Pearson Education, Inc, 2009. Print.
