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[1]
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[2].
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.
+CC 17.3: If you were a venture capitalist, what are some of
the factors you would consider in deciding whether to invest in a private
business?
[1] By 1999, for instance, the target rate of return for private equity investors was in excess of 30%.
[2] 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.