3-Part Series on Venture Capital

The Main Street Herald is proud to have as guest-author Mr. George Parker, venture capitalist.  His series will cover an important topic in small business today – the viability of venture capital for small businesses.  Enjoy!

Should You Consider Venture Capital For Your Small Business? (Part 1)

By George A. Parker

Each year, venture capital investors help launch or expand thousands of businesses in the U.S.   These investors pour billions of dollars into fast growing companies, helping to fuel economic activity, create new products and services, and provide new jobs in communities across our country. Given the huge dollars invested and the helpful impact, is venture capital an option that your small business should consider?

Often we read news accounts spouting the virtues of venture capital as a way for small businesses to launch or to expand. All too often, these sources imply that venture capital is viable and widely available for most small businesses. Is venture capital really a reasonable option for the entrepreneur looking to launch a new bike shop, the contractor looking to bring in new equipment or the local coffee shop owner planning to add a new location? Is venture capital attractive enough for most small businesses when this option is available? To answers these questions, it helps to understand what venture capital is and what venture capitalists look for in their investments.

In a nutshell, venture capital is risk capital provided by investors to launch or expand young companies with the expectation of high investment returns achieved via an exit event. It is a good source of funding for some startups and small companies that have limited operating histories and do not have good access to capital.

Venture investors vary from highly specialized institutions to private individuals (known as angel investors), but most seek high investment returns in exchange for assuming the high risks associated with investing in new or young businesses. They vary in size from firms that invest just a few million dollars to much larger institutions that invest billions in companies globally. Some are single investors or small investors groups, while others are affiliates of large companies making investments on behalf clients or outside investors.

Most venture capital transactions are structured to achieve annual returns of at least 20% and in many instances involve a sale of company stock to investors in exchange for their investment. In addition to high returns, many investors look for a say in how the businesses are managed and some seek board representation.

Venture investors use a variety of transaction structures, ranging from straight debt to transactions involving various forms of company stock. Each transaction results in certain advantages and disadvantages to the business owner.  Here are a few of the transaction types:

  • Senior debt: typically used for high-risk situations or for temporary financing in cases where the company has obtained a commitment for financing at a future date.
  • Subordinated debt: usually not payable until all senior notes are repaid, is typically convertible to or accompanied by warrants to purchase common stock. Many senior lenders consider subordinated debt as equity and this may have the advantage of increasing the amount of funds that can be borrowed.
  • Preferred stock: grants investors superior/preferential rights to and is usually convertible into common stock. Preferred stock generally improves the company’s debt to equity ratio and borrowing capacity.
  • Common stock; these transactions are usually the most expensive and typically require a controlling or substantial percent of ownership be given to the venture capitalist.

Disadvantages

Venture capital has plenty of disadvantages. Here are a few:

  • An excessive amount of debt strains a company’s credit standing and reduces its ability to meet long-term financing requirements. Senior debt usually has a greater negative impact on borrowing capacity than subordinated debt.
  • With loan investments, venture capitalists almost always have the option of calling a loan if the company is in default of the loan agreement.
  • Many investors seek significant management control either by board representation or by restricting certain activities, use of funds or privileges of the business managers.
  • Venture investors have investment horizons that require definite exits. Many of the investments take the form of company stock which must be sold to exit and to achieve the desired investment return. Investors usually require the right to force a sale of their stock positions within a given time period regardless of management’s preferences.
  • No matter how the investment is structured, it must be attractively priced for the venture capitalist. Generally speaking, the greater the investor’s risk perception and required return, the more ownership he or she will demand.

Clearly, venture capital is not for every business. In fact, it only fits a fraction of the small businesses that launch or seek growth capital each year.  Before you spend a lot of time searching for venture capital, consider the points above and discover what venture capitalists look for in almost every investment by reading “Should You Consider Venture Capital for Your Small Business? Part 2”.

George Parker is a twenty-five year industry leader, co-founder and Executive Vice President of Leasing Technologies International, Inc. LTI provides superior financing solutions to venture capital-backed start-ups and emerging growth companies. Visit http://www.ltileasing.com/ to learn how LTI’s innovative equipment financing can help your startup move ahead.

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