FUNDING A RAPIDLY GROWING VENTURE (PART THREE)
Capital Structure
It may seem that the entrepreneur is totally at the mercy of the venture capitalist. That, unfortunately, is true if the entrepreneur enters the negotiation from a weak position, desperately needing the money to keep his business alive. A better approach is to go to the negotiation from a position of strength. True, venture capitalists have hundreds of deals presented to them on a regular basis, but most of those deals are not big hits; in other words, the return on investment is not worth their effort. They are always looking for that one business that will achieve high growth and thus return enough on their investment to make up for all the average -or mediocre-performing investments in their portfolio. If the entrepreneur enters the negotiation with a business that has a solid record of growth and performance, he or she is in good position to call many of the shots.
Any investment deal has four components:
- The amount of money to be invested
- The timing and use of the investment moneys
- The return on investment to investors
- The level of risk involved.
The way these components are defined will affect the new venture for a long time, not only in constructing its growth strategy but also in formulating an exit strategy for the investors. Venture capitalists often want both equity and debt – equity because it gives them an ownership interest in the business, and debt because they will be paid back more quickly. Consequently, they tend to want redeemable preferred stock or debentures so that if the company does well, they can convert to common stock, and if the company does poorly or fails, they will be the first to be repaid their investment. If the entrepreneur has entered the negotiation from a position of strength, he or she is more likely to be able to convince them to take common stock, which makes things much easier.
In another scenario, the venture capitalists may want a combination of debentures (debts) and warrants, which allow them to purchase common stock at a nominal rate later on. If this strategy is implemented correctly, they may be able to get their entire investment back when the debt position is repaid and still enjoy the appreciation in the value of the business as stockholders.
There are several other provisions that venture capitalists often request to protect their investment. One is anti-dilution provision, which ensures that the selling of the stock at a later date will not decrease the economic value of the venture capitalist’s investment. In other words, the price of stock sold at a later date should be equal to or greater than the price at which the venture capitalist could buy the common stock on a conversion from a warrant or debenture.
In addition, to guard against having paid too much for an interest in the company, the VC may request for a forfeiture provision. This means that if the company does not achieve its projected performance goals, the founders may be required give up some of their stock to the VC as a penalty. The forfeited stock increases the VC’s equity in the company and may even be given to new management that the VC brings on board to steer the company in a new direction.
Entrepreneurs should never accept these terms unless they are confident of their abilities and commitment to the venture. One way to mitigate this situation is for the entrepreneur to request stock bonuses as a reward for meeting or exceeding performance projections. Venture capital is certainly an important source of funding for the entrepreneur with a high-growth venture. It is, however, only one source, and with the advice of experts, the entrepreneur should consider all possible avenues. The best choice is one that gives the new venture the chance to reach its potential and the investors or financial backers an excellent return on investment.
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