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Venture Capital Financing: Structure and Pricing
Filed under FinanceNov 1
A venture financing can be structured using one or more of several types of securities ranging from straight debt-to-debt with equity features (e.g., convertible debt or debt with warrants) to common stock. Each type of security offers certain advantages and disadvantages to both the entrepreneur and the investor. The characteristcs of your situation and current market forces will impact the type and mix of security package that is right for you.
While each of these securities has unique characteristics, they can be grouped into two categories: debt or equity. In structuring a venture financing, the primary question is whether the financing should be in the form of debt or equity.
From a company’s viewpoint, there are two potential disadvantages to debt.
From the venture capitalist’s viewpoint, there are three principal advantages to debt.
While the difference may not be great, depending on the particular circumstances of the company, a debt position involves less risk than an equity position for the venture capitalist. Accordingly, a company should not have to relinquish as much ownership when a financing is in the form of debt. However, this advantage must be weighed against the disadvantages of debt.
No matter how the venture financing is structured, it must be priced so that it is attractive to the venture capitalist. There is no clear-cut answer as to how much ownership a company will have to relinquish to make a financing attractive. Broadly speaking, the greater the potential return perceived by the venture capitalist, the less ownership he will demand. In other words, if a company has a patented product which a venture capitalist thinks is revolutionary and highly marketable, he will undoubtedly settle for less ownership than he would in the case of 4 company with a relatively less attractive product. Thus, his ultimate position will be a business judgment based on his potential return.
Before you enter negotiations with the venture capitalist, you should determine what your company is worth and how much of your company you want to sell. The following procedure can be used to get a rough idea of how much ownership you will have to give up to make the financing attractive.
Suppose XYZ Company, Inc., a start-up, needs $500,000. The company’s product appears to have excellent potential. However, because the product is new and unproven, an investment in the company would be extremely risky. Accordingly, it is reasonable to estimate that a venture capitalist would want a potential return of at least ten times his total investment in five years. Management estimates that the company should be able to “go public” at 20 times earnings in five years. Projected after-tax earnings for the fifth year is $1,250,000. Additional long-term financing of $500,000 will be needed at the beginning of the third year.
In the calculations below it is assumed that the venture capitalist who provides the initial financing ($500,000) also provides the subsequent financing ($500,000), and that he wants a return equal to ten times both. However, it should be noted that if the company made satisfactory progress during the first two years, it would be reasonable to assume that the venture capitalist would be satisfied with a lower return on the subsequent financing since it would involve less risk.
In this set of calculations it is assumed that a second investor provides the subsequent financing ($500,000). The calculations show that the venture capitalist who provides the initial financing ($500,000) would need 20% ownership as of the fifth Year to realize the return he wants. However, since the ownership to be given up for the subsequent financing will reduce his ownership position, he will want more than 20% ownership initially. For example, if it is assumed that 15% ownership will have to be given up for the subsequent financing, the venture capitalist who provides the initial financing would need 23% ownership initially to end up with 20% ownership in the fifth year.
Assume the same facts as Case I, except a second investor provides the subsequent financing for 15% ownership.
Thus, it appears that the investment ($500,000) may be attractive to an interested venture capitalist if the principals of XYZ Company, Inc. are willing to give up approximately 23% ownership.
It must be emphasized that the above procedure is highly subjective. And, you should remember that what really matters is how the venture capitalist views the relative attractiveness of a company. Typically, venture capitalists are satisfied with a minority interest. Although a venture capitalist may demand a majority interest, generally they are not interested in operating control. Some of them like to tie the amount of ownership they ultimately get to the performance of the company. For example, a venture capitalist who wants a majority interest initially may give the principals the opportunity to earn part of it back. Such an arrangement can be used to compromise on pricing when there is a significant disagreement between the principals and the venture capitalist.
To entrepreneurs unfamiliar with venture capital, it may appear that the venture capitalist is seeking an extraordinary high return on his investment. However, it is important to understand that, even under the best of circumstances, only a minority of the companies in which the venture capitalists invests will be successful. He is well aware of this, and must make a sufficient return of his successful investments to come out with an acceptable return overall.
Alan is managing partner at Greenstein, Rogoff, Olsen & Co., LLP, a leading CPA firm in the San Francisco Bay Area. Alan has more than 23 years of experience in public accounting, and works with some of the most successful venture capitalists in the world, helping to develop innovative financial strategies for business enterprises. Alan earned a B.S. in Accounting from Brigham Young University, and an MBA (Taxation) from California State University at Hayward.
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