Venture Capital - How Venture Capitalists Structure Their Investments

It is first important to understand how venture capitalists achieve their targeted rates of return of 30% per year. Not every company will make this return on equity but there are ways around it.

Much depends on the exit value of your company. A 30% rate of return reflects a price-earnings ration of 3. If the investor can exit at a higher price-earnings ratio they will earn more than their 30% desired return.

Another way to reach this target is by offering options. An option is the right to purchase shares of your company in the future at a pre-determined price today. If you grow at 20% annually and your earnings were 100 in the first year, your earnings would be 120 in the second year and 145 in the third. By using options the investor can then immediately purchase additional shares at 100 and sell them for 145 which can be added to their 20% annual return to reach the desired 30%.

A 30% return is an average figure and relates to the degree of perceived risk. If you have an early stage company you will need to provide a high rate of return. If you have a more mature business that has traction and you need financing for expansion or working capital, 30% may not be the required target due to the lower risk level.

Younger companies may also be forced to give up a disproportionately high percentage of shares to compensate for the high degree of risk. However, venture capitalists will frequently sell a certain amount back to you based on you meeting clearly defined performance objectives.

Another investment structure is subordinated debt. This usually caries a high yield and is usually not accompanied by equity. Subordinated debt is ideal for companies with solid cash flow and who need addition capital to grow thereby raising the value of their shares before raising any equity capital.

A 30% annual return may sound high to you. The reason why venture capitalists require such a high return is that anyone can purchase shares in the public markets in major companies and get a 15 to 18% return on their equity. Venture capitalists do not have this flexibility because, as a private company, your shares are not very liquid. Investors are locked in for a period of years and face the risk of your company failing. They therefore need a higher rate of return to compensate for this risk.

Of every 10 investments, no one can predict at the outset which will be successful and which ones will not. On average 1 to 2 will be very successful, 1 to 2 will go bankrupt and the rest will be what are known as the “walking wounded.” They will continue to operate but investors will never recover their investments in these companies. Venture capitalists therefore need to average out the good investments against the bad to ensure their 30% annual return.

An example is a department store that is unsure which items will sell the best over the next season. For that reason store managers will put a high markup at the beginning and at some point have to mark some of the products down. They just do not know which products they will have to mark down at the beginning of the season.

Venture Capital - Venture Capitalist Governance Requirements

Once a venture capitalist becomes an investor they will want board representation. They will either nominate their own staff members or an outside representative of mutual consent. The last thing a venture capitalist wants to do, however, is run your company. They have enough problems trying to run their own firm and do not want to get involved in the operations of your business.

Board members want to stay informed, monitor your progress and feel comfortable with the progress that is being made.

A board of directors is like your own private management consultancy group. Some entrepreneurs are very good at getting the most out of their directors and some are not. Understand that directors are the cheapest consultants working for corporations.

Board members are elected to represent shareholders. Since the venture capitalists will become significant shareholders, they will usually request at least one seat on your board.

The board of directors is responsible for broad policies and strategies for your company. Directors will want to know what your budgets will be, who you are hiring and help you develop your ongoing business plan.

Remember that the board of directors is in a position legally to approve or disapprove your actions.

The frequency of meetings is usually a direct result of how effective you are at using your board and how well your group works together. The board can provide strategy and policy recommendations but can also help in specific ways such as introducing you to key players in the industry.

Some of the items that directors care about are law suits, environmental problems, and when you are about to sign a major new contract. Directors are highly allergic to unexpected bad news and unexpected good news. Make sure to keep your board and bankers informed at all times.

Generally, governance is a great help to you more than it is a hindrance. It will keep you focused on your business and help you grow. This is of particular importance if you have aims of one day going public.

Venture Capital - How An Intermediary Can Help Close The Deal

An intermediary can help save you a lot of time which you can then use to concentrate on running your business. An intermediary will help prepare you for going into the market, set up times and appointments and guide you through the presentations, get you to the point where you have a legally binding term sheet, and then close the deal by making sure that al the needed documentation is completed.

This is not always a smooth procedure and requires someone to manage the process to ensure that your legal bills do not get out of hand.

Most Important Lessons About Raising Venture Capital

Remember that in most cases, the deal you end up with is not the deal you thought you would get when you started. You have to be flexible and able to turn on a dime in order to make the deal progress.

Deal with people of quality. Associate yourself with experienced people who have gone through several cycles and have a proven track record in a wide variety of industries.

Do not be greedy. In the market the bears can make money, the bulls can make money but pigs go to slaughter. If you are too greedy, you cannot make a deal. Markets will change. Windows open and windows close. To some extent investing is a fashion business. Certain types of deals are in fashion and then they are out. When money is being made available you are better off to take it when it is being offered.

Always be very open and candid in your discussions. Do not hide. Do not play games. Be totally open. And whatever you do, do not bluff. An investor will find out quickly when you are bluffing and you will lose the deal.

Financing is just one of the tools you need to build a good company. It is like the blood in your body. Financing is not the heart and soul – your business is.

Good entrepreneurs build great companies because they are good at motivating their employees, excellent at working with suppliers, have an obvious ability to satisfy customers and they also treat the venture capitalist as a supplier, albeit a supplier of money and not a physical product. If you think of investors with a “me against them” attitude or with any degree of hostility you should not enter into the deal. You will need their support when times get tough. A good working relationship with investors will help ensure your long term success.

Evan Carmichael

Evan Carmichael
YoungEntrepreneur.com Blog Manager

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