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Frequently Asked Questions
Frequently Asked Questions
Do-It-Yourself Capitalist
Glossary What is SCOR? Frequently Asked Questions Frequently Asked QuestionsDo-It-Yourself Capitalist
Glossary What is SCOR?
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Venture Capital Private venture capital companies pool investments from wealthy individuals and organizations looking for small business investments. Some of the nation=s largest companies, like General Electric and Exxon Corporation, have created venture capital companies. Venture capital is a cyclical phenomenon which has been enjoying favor for the past two years largely because of changes in the tax code and because of the long bull market that stocks have enjoyed. Venture capital firms invest in two ways. They might make loans or buy bonds, or they may make equity investments by buying common or preferred stock. A combination of debt and equity may be used, but the preferred method is an equity investment. Another way of providing strong upside potential is the use of convertible securities. They are basically a debt obligation with an equity kicker. If the company is a winner, the preferred stock or debt can be converted into common stock which, because the company is successful, are worth a great deal of money. Stock with warrants supply the same up side potential, although, stock with warrants does not hedge the investment the way a convertible debt security does. Venture capital companies expect an average return of five times their original investment within five to seven years, which is why loans are not the favored means of venture capital investment. An indication of how expensive venture capital is can be gained from the fact that the interest rate on most small business loans do not exceed 20% However, although the company foregoes the opportunity to retain all the profits it might make, it does not have to pay the huge return the venture capital companies expect to make. That comes from subsequent investors. The company would have to repay any loans advanced by the venture capital firm, however. The advantage in accepting venture capital is that as equity, the company does not have to worry about interest and principal payments. The major drawback to venture capital investments is that the company=s founders may lose control of the company. That is a naive fear based on an incomplete understanding of the venture capital process. Venture capital companies are extremely busy doing what they are supposed to be doing; evaluating businesses as potential investments and monitoring the performance of the companies in which they have invested. As long as the company is performing as expected, the venture capital company will not be moved to protect its investments by installing a new management team. That is one of the reasons venture capital companies pay particular attention to the management team of any company they are considering investing in. That does not mean that the investors will not want as much equity in the company as they can get. However, the company does have some negotiating room. Just how much depends on how long the company has been around, what its track record has been, how much skin management has in the game. In most cases venture capital companies will take no more than a 50 percent stake. Many venture capital will require management representation, but they will only step in if they think their interests are threatened. At the same time, their financial expertise and business experience may be useful to the company. Stewart-Gordon Associates, Inc. P.O. Box 781992 Dallas TX 75378-1992 voice (972) 620-2489 fax (972) 406-0213 e-mail Tom Stewart-Gordon Copyright © 2000 by Stewart-Gordon Associates, Inc., Dallas, Texas,
all rights reserved.
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