Catalyst - Winter 2009 - Venture Capital and Private Equity: Influencing Growth and Exit
Direct private investments cover a wide range of investment opportunities including angel investment, venture capital, mezzanine finance, and later stage private equity investment. Private investments can be anything from angel investment to buyout fund investing. Private equity's growth over the past 20 years has outpaced that of almost every other class of financial product. However, the current economic crisis will make fundraising, client acquisition and new fund launches more difficult than that seen in recent memory. In addition, the current economic crisis should have a negative impact on private equity returns due to the reduced use of leverage as part of the deal structure. Private investment vehicles are generally organized as partnerships, made up of a general partner and investors or limited partners. The funds are capitalized by capital commitments from the limited partners. Limited partners in venture funds are usually private and public pension funds, endowment funds, foundations, corporations, wealthy individuals, foreign investors and the venture capitalists themselves. The venture capital firm serves as the general partner, often being compensated with a two to two and one-half percent annual management fee.
Angel financing is capital raised for a private company from independently wealthy investors. Angel investors will typically work with the management team and provide capital and expertise to help develop companies. Of all the classes of private equity, angel investments generally have the highest risk and therefore the highest possible return. Bank or commercial finance company backing would not typically be available until the entrepreneur achieves a level of sales and production where the balance sheet reflects more significant assets. New Jersey has a very active angel investment group and it is called JumpstartNJ. JumpstartNJ is comprised of about 40 high net worth individuals, who have collectively invested approximately $16 Million, since the inception of the group five years ago.
Venture capital, a form of private equity, are investments made by institutions or high net worth individuals in primarily private companies. Venture capital investments include three types: seed, start-up and expansion-level. Seed capital is usually the initial funding secured by a new company. Seed capital is primarily used for product research and development and to determine the commercial viability of ideas. Start-up funds in contrast to seed capital are used for companies that have proven their concept and are now beginning to produce, market and sell their products. One characteristic of both seed and start-up companies is that they both use more cash than they can possibly generate. Early stage investments include both seed and start-up funds. Companies that survive the early stage become candidates for expansion stage funding. Expansion stage companies have established their product in the marketplace, but need additional capital for growing manufacturing and distribution capacity and for further research and development.
Late stage venture capital includes mezzanine financing and is usually the last round of financing prior to an initial public offering (IPO). Mezzanine financing is for a company expecting to go public within 6-12 months. Mezzanine financing is usually structured to be repaid from proceeds of public offerings. Venture capital performance for 2008 will not be stellar due to concerns about the health of the economy and the capital markets. Venture capital investing is expected to decline in the next couple of quarters. Venture capitalists have experienced tough economic times before and they have continued to invest. Venture capitalists are longer term investors and not impacted by short term changes in the market. One area that will see a dramatic increase in venture capital dollars, will certainly be the clean tech and renewable energy space. It is assumed that factors such as the price of oil , renewed interest in anything "green" and social and political trends will result in increased investment in this area. Even with the tough economic times that we are presently experiencing, these factors are significantly driving up valuations in the clean tech area.
Venture capital investment in the LifeSciences industry in Q3 2008 continues to be strong, but exhibited a decline from Q2 2008. Venture capital firms invested $2.2 Billion in 207 deals in Q3, which represented an 8% decline in dollars from Q2. For Q3 2008, the BioTech industry was the number one industry in terms of dollars invested for the quarter. $1.35 Billion was invested in 114 LifeSciences companies.
An interesting statistic to follow in the venture capital space is the mix of follow-on and first time investments. It is expected that exits for venture capital backed companies will be difficult to come by over the next couple of quarters, so venture firms will have to commit additional time and unplanned follow-on rounds of financing. These follow-on rounds will certainly channel resources away from new deal activity.
Historical performance of venture-backed companies shows that venture capital has been quite successful in backing companies with unique and innovative technologies and tremendous growth potential. Companies such as Federal Express, Apple, Microsoft and Intel were all backed at one time in their life cycle by venture capital.
Venture firms will help a company to grow, but they also seek to exit their investments in a timely fashion, usually three to seven years. An early stage investment may take seven years to mature, while a later stage investment will take a shorter period of time.
Venture capital firms, like all investors, want to see a return of principal plus a significant return on investment. Venture firms spend a great deal of time analyzing potential investment opportunities. Many more investment possibilities are rejected than accepted. Some common characteristics that venture firms look for prior to committing funds include:
- Opportunity for at least a 35% internal rate of return;
- Company is comprised of people with vision, confidence, drive and aspirations to grow the business;
- Company has a quality team leader and a management team with complementary expertise such as operations, marketing, and finance;
- Company has excellent market knowledge, a growing market and an innovative product;
- Company possesses a product or service with a competitive advantage and a unique selling point.
While the initial public offering may be the most glamorous exit for the venture capitalist, it is not the most common liquidity event. Most venture exits occur through a merger or acquisition with another company. In today's marketplace, IPO's are only appropriate for the most successful companies.
After an IPO, the venture firm will receive stock in the new company, but it is regulated and restricted in how the stock may be sold or liquidated for several years. Once the stock is freely tradable, the venture firm will distribute this stock or cash to the limited partner investors, who may then manage the public stock as a regular stock investment or may liquidate it upon receipt.
Merger and acquisition with another company represents the most common type of successful exit for the venture firm. After the merger or acquisition, the venture firm will receive cash from the acquiring company and the venture capital firm will distribute the proceeds to the limited partners.
Venture capital/private equity continues to be an attractive source of capital for companies when bank or commercial finance company lending would typically not be available. Currently, we are seeing several major trends that are defining the future of venture capital. The first trend is the absence of an IPO market that allows investors to achieve liquidity. The more attractive alternative is merger and acquisition activity, which has given many private companies good returns for their shareholders. The second trend is that venture funds are shifting away from early stage investments and doing more later-stage investments. This has the impact of reducing the risk for the venture fund and also possibly reducing the returns to the limited partners. The third trend is that the entrepreneur now faces the challenge of raising capital from angels and angel funds and not depending on venture funds for investment during the early stages. Entrepreneurs face the challenge of achieving key milestones without having access to significant amounts of capital.
Alan Wink is the director of the Technology and Private Equity groups at EisnerAmper.
EisnerAmper's Catalyst: Winter 2009
Welcome to Catalyst
Nurturing New Businesses
New Jersey's Thriving Incubator System Aids Entrepreneurs
A New Way of Thinking
Varied Funding Strategy Gives PTC Therapeutics 'Multiple Shots on Goal'
Fresh Ideas in Times of Economic Uncertainty
Life Science Financing: A Needle in a Haystack?
Investment Experts Weigh in on Myriad Funding Strategies
Venture Capital and Private Equity: Influencing Growth and Exit