Many small businesses need equity capital when they start up. Others grow so quickly that they require significant amounts of equity beyond any bank financing they may have already obtained. When private companies need considerable amounts of equity they will look for partners or venture capital. Venture capital and private debt can be a blessing or a curse depending on the quality of the venture capitalists and who is in control of the company.
The availability of venture capital usually ebbs and flows depending on the strength of the overall economy and the amount of available deals. According to the industry database, VentureDeal, deal flow for 2009 was down 40% from previous years. However, since the long-term outlook for the economy is positive, we are likely to see a rise in both venture capital and private debt deals in the near future.
There are several ways that small business owners can finance a start-up company or a significant expansion of operations. When the amount of necessary capital is a significant percentage of current company value, owners will usually use some type of venture capital or private debt. Venture capital funding places a considerable number of guidelines and restrictions on how the firm is to be run. The VC firm usually has at least one seat on the Board of Directors, and has the ability to take managerial control of the company should it fail to meet certain performance targets. In some case, the shares owned by the VC firm will get a preferential investment return, or in the event of liquidation or restructuring, a superior interest in company assets in advance of other shareholders.
Similarly, private debt will usually have higher returns than preferred equity returns and have the ability to convert shares into stock should the company’s value increase as predicted. Private debt may also lend in a greater percentage of company value than traditional bank financing. They have the ability to do normal debt financing as well as preferred equity which is a hybrid between debt and equity. Although usually more expensive then bank financing, this type of debt becomes much more popular in periods where banks and other financial institutions are reluctant to lend.
Like VC equity, these lenders usually have some way to access control of the company should it fail to meet the desired objectives. With both and debt capital infusions, venture capitalist will usually require some sort of public exit or other method to take profits within a relatively short period of time (3-5 years).
Although venture capital and private debt may be the only access to external funding, it does come with significant risks. Many entrepreneurs have lost control and even been squeezed out of their own businesses, because the company did not perform as forecasted and the VC investors took over. This type of financing is usually required when a company is planning a significant expansion that cannot be completed without massive funding. Very often VC investors get involved in companies that have the potential to become a public entity and provide investors returns at levels that can only be achieved through an Initial Public Offering (IPO).
In addition to understanding the market opportunities for obtaining traditional financing, small business owners should understand the benefits and risks of venture capital and other investor partnership arrangements. With any small business, achieving expansion goals is usually a function of the quality and quantity of capital resources and financing. The ability to attract quality venture capitalists and other appropriate investors is a function of a company’s reputation for managerial prowess and its experience in meeting its obligations and performance goals.