Private firms that need more equity capital than can be provided by their owners can approach venture capitalists and private equity investors. Venture capital can prove useful at different stages of a private firmÕs existence. Seed-money venture capital, for instance, is provided to start-up firms that want to test a concept or develop a new product, while start-up venture capital allows firms that have established products and concepts to develop and market them. Additional rounds of venture capital allow private firms that have more established products and markets to expand. There are five steps associated with how venture capital gets to be provided to firms, and how venture capitalists ultimately profit from these investments:
1. Provoke equity investorÕs interest: There are hundreds of small firms interested in raising finance from private equity investors, and relatively few venture captialists and private equity investors. Given this imbalance, the first step that a private firm wanting to raise private equity has to take is to get private equity investors interested in investing in it. There are a number of factors that help the private firm, at this stage. One is the type of business that the private firm is in, and how attractive this business is to private equity investors. In the late 1980s and early 1990s, for instance, firms in bio-technology were the favored targets for private equity investors. By the late 1990s, the focus had shifted to internet and technology stocks.
The second factor is the track record of the top manager or managers of the firm. Top managers, who have a track record of converting private businesses into publicly traded firms, have an easier time raising private equity capital. For instance, Jim Clark, who founded Netscape Communications and Silicon Graphics, both successful publicly traded firms, was able to raise private equity for Healtheon, the venture he founded after leaving Netscape, because of his past track record.
2. Valuation and Return Assessment: Once private equity investors become interested in investing in a firm, the value of the private firm has to be assessed by looking at both its current and expected prospects. While venture capitalists sometimes use discounted cash flow models to value firms, they are much more likely to value private businesses using what is called the venture capital method. Here, the earnings of the private firm are forecast in a future year, when the company can be expected to go public. These earnings, in conjunction with a price-earnings multiple, estimated by looking at publicly traded firms in the same business, is used to assess the value of the firm at the time of the initial public offering; this is called the exit or terminal value.
For instance, assume that InfoSoft is expected to have an initial public offering in 3 years, and that the net income in three years for the firm is expected to be $ 4 million. If the price-earnings ratio of publicly traded software firms is 25, this would yield an estimated exit value of $ 100 million. This value is discounted back to the present at what venture capitalists call a target rate of return, which measures what venture capitalists believe is a justifiable return, given the risk that they are exposed to. This target rate of return is usually set at a much higher level than the traditional cost of equity for the firm.
Discounted Terminal Value = Estimated exit value /(1+ Target return)n
Using the InfoSoft example again, if the venture capitalist requires a target return on 30% on his or her investment, the discounted terminal value for InfoSoft would be
Discounted Terminal value for InfoSoft = $ 100 million/1.303 = $ 45.52 million
3. Structuring the Deal: In structuring the deal to bring private equity into the firm, the private equity investor and the firm have to negotiate two factors. First, the private equity investor has to determine what proportion of the value of the firm he or she will demand, in return for the private equity investment. The owners of the firm, on the other hand, have to determine how much of the firm they are willing to give up in return for the same capital. In these assessments, the amount of new capital being brought into the firm has to be measured against the estimated firm value. In the InfoSoft example, assuming that the venture capitalist is considering investing $ 12 million, he or she would want to own at least 26.36% of the firm.
Ownership proportion = Capital provided/ Estimated Value
= $ 12/ $ 45.52 = 26.36%
Second, the private equity investor will impose constraints on the managers of the firm in which the investment is being made. This is to ensure that the private equity investors are protected and that they have a say in how the firm is run.
4. Post-deal Management: Once the private equity investment has been made in a firm, the private equity investor will often take an active role in the management of the firm. Private equity investors and venture capitalists bring not only a wealth of management experience to the process, but also contacts that can be used to raise more capital and get fresh business for the firm.
5. Exit: Private equity investors and venture capitalists invest in private businesses because they are interested in earning a high return on these investments. How will these returns be manifested? There are three ways in which a private equity investor can profit from an investment in a business. The first and usually the most lucrative alternative is an initial public offering made by the private firm. While venture capitalists do not usually liquidate their investments at the time of the initial public offering, they can sell at least a portion of their holdings once they are traded. The second alternative is to sell the private business to another firm; the acquiring firm might have strategic or financial reasons for the acquisition. The third alternative is to withdraw cash flows from the firm and liquidate the firm over time. This strategy would not be appropriate for a high growth firm, but it may make sense if investments made by the firm no longer earn excess returns.
Figure 17.8 traces a hypothetical firm from the idea stage to going public, with estimates of value at each stage and measures of who owns the firm.
 By 1999, for instance, the target rate of return for private equity investors was in excess of 30%.
 Black and Gilson (1998) argue that one of the reasons why venture capital is much more active in the U.S. than in Japan or Germany is because the option to go public is much more easily exercised in the U.S.