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Getting
funded is an occupational hazard for entrepreneurs
with a great idea. Overly preoccupied with the
moment-to-moment thinking of how to get it, they
often gloss over the really important task of
assessing the pluses and minuses associated with
the individual sources of financing, be that in
the form of equity, debt, leasing or grants.
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Especially when caught in a cash crunch, they ignore
the fact that the built-in expectations of the providers
of capital today may constrain the decisions they'll
be able to make down the road.
This
could be a big mistake.
That's
because the very process of getting the money sends
many entrepreneurs on a march toward failure unless
they can ensure that the capital providers' expectations
of the venture's performance in terms of growth and
profitability will allow them to correctly make the
decisions that will lead to success. For example, traditional
venture capitalists (VCs) may be impatient for revenue
growth when investing in nascent ventures, while leveraged
buyout (LBO) players investing in mature enterprises
tend to be patient for growth but impatient for profit
and cash flow.
Most
entrepreneurs would agree with George Bernard Shaw who
once wrote that "lack of money is the root of all evil."
Indeed, lack of funding is the number one reason given
for the failure of so many promising ventures. Even
those engaged in mature businesses soon realize that
not much, if anything, happens without money to keep
things going.
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While
no amount of money will make a bad venture successful,
for many businesses, especially the ones that
are seriously underperforming or financially distressed
or are in the early stages before profits become
predictable, traditional sources of capital, e.g.,
banks and credit unions, are simply unavailable.
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Much
like Sir Winston Churchill who once described
Russia as "a riddle wrapped in a mystery inside
an enigma," many entrepreneurs are often at
a loss in the notoriously secretive world of
private equity finance.
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For
these ventures, private equity - or more broadly, entrepreneurial
finance - may offer the best hope to raise the money needed
to succeed.
However,
much like Sir Winston Churchill who once described Russia
as "a riddle wrapped in a mystery inside an enigma,"
many entrepreneurs are often at a loss in the notoriously
secretive world of private equity finance. Nevertheless,
what's at stake here is the more than $1 trillion that
has been poured since 1980 into the clubby private equity
"industry" - traditionally the preserve of rich families
and private endowments - to take equity or ownership
positions in both new and mature businesses worldwide.
With
the emergence of major LBO firms like Apax, Apollo Management,
Bain Capital, Blackstone, Kohlberg, Kravis & Roberts
(KKR), Permira, Texas Pacific Group and the Carlyle
Group (not to mention the private equity arms of investment
banks like Goldman Sachs and J. P. Morgan), huge amounts
of money are now sloshing around through these equity-based
private investment vehicles.
The
growing pool of private equity funds
Although
the volume of private equity (including VC and LBO)
funds - amounting to $302 billion invested in 2004 alone
- is minuscule relative to the more than $118 trillion
of "other people's money" currently available in the
form of global financial stock - including bank deposits,
government and private debt securities, and equities
- it plays a disproportionate role in catalyzing wealth
creation by entrepreneurial individuals as well as nations.
In other words, if money makes the world go around,
private equity is the "smart money" that makes it go
the extra mile to create and capture more economic value.
Case in point: Small buyout funds (up to $250 million)
reported returns of 14.7% in the year to June 2004,
while funds of greater than $1 billion sported returns
of 26.3% for their investors, according to Thomson Venture
Economics. This is in sharp contrast to the lower single-digit
or even negative returns from investments in the major
US-based public equity indexes, e.g., Dow Jones, S&P
500, or NASDAQ throughout much of the post-bubble period
since 2000.
Of
course, some private equity firms are more successful
than others, much in line with the 80/20 principle,
which suggests that 20% of the players are likely responsible
for 80% of the results. KKR, for example, invested $18.4
billion since its creation in 1976 until the end of
2003. These investments are estimated to have increased
in value to $49.7 billion (roughly equal to the annual
gross domestic product of a country like Bangladesh!),
of which $39.3 billion has already been banked. In the
past 18 months alone, KKR has returned $9 billion in
cash to investors, beating even Carlyle's impressive
cash return of $6.6 billion.
Getting
to know the many faces of other people's money
Given
that success today hinges not only on providing a quality
and timely product or service but also on knowing how
to finance the enterprise, it pays to recognize that
not all sources of entrepreneurial finance are created
equal and nor do they have the same expectations of
returns. One can think of at least six different - admittedly
somewhat caricatured - "faces" or facets of private
equity, namely venture (i.e., buildup) vs. vulture (i.e.,
cleanup) capital, virtuous (autocatalytic or self-sustaining)
vs. vicious (self-destructive or toxic) capital, and
virtual (liquid) vs. viscous (illiquid) capital.
Venture
Capital
Traditional
venture capitalists (VCs), for example, invest in new,
unproven enterprises that conventional financial institutions
ignore. In addition to the well-known venture capital
firms (e.g., Benchmark Capital, Chase Capital, Kleiner
& Perkins, Sequoia Capital, Softbank and the like),
this group includes successful serial entrepreneurs
and wealthy individuals (often dubbed "angel investors")
who often wish to get in on the ground floor of a new
or expanding enterprise. Instead of lending money, they
exchange capital for an equity or ownership stake in
the companies they finance.
VCs
are active investors and are integrally involved in
the creation of young companies. In addition, most venture
capital investment takes place in syndicates involving
two or more venture capital firms. This process referred
to as co-investing enables venture capitalists to pool
expertise, diversify their investment portfolios and
share risk. VCs actively cultivate networks comprised
of financial institutions, universities, large corporations,
entrepreneurial companies and other organizations. These
networks and the information flow at their disposal
enable them to reduce many of the risks associated with
new enterprise formation and thus to overcome many of
the barriers that hold back innovation. In other words,
the traditional VCs are in the buildup mode and a lot
of the new VC money is also contingent on startups'
meeting certain goals, such as revenue targets.
In
the past when selling a company, VCs had tried to get
their investment back in full, and then everyone else
had divided up what remained. Today, however, many VCs
are insisting that they get several times their investment
back before anyone else - including the founder(s) -
gets any money. Here are some daunting statistics stacked
against entrepreneurs when soliciting VC funds in the
U.S. (needless to say, the hurdles are likely to be
even higher for entrepreneurs in developing countries):
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Traditional
VCs generally finance only six out of every 1,000
business plans they receive each year |
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Fewer
than 20%, and more like one in ten, of funded startups
go public through initial public offerings (IPOs)
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About
60% of high-tech companies that get VC funding go
bankrupt, and another 30% end up in mergers or liquidations
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VCs
generally own about 60% of the equity in software-based
startups by the time they go public |
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Founder-CEOs
generally own less than 4% of their ventures after
the IPO, an amount usually worth about $6.5 million
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Critics
may argue that many VCs have become so greedy that they
often act more like vulture capitalists. There is, however,
another type of vulture capitalists, who, despite their
obvious image problem, carry out an important role of
scavenging or cleaning up by consolidating highly fragmented
industries to improve performance or turning around
financially distressed or dying businesses. The traditional
LBO firms have been playing this role over the past
two decades in the US and more recently in Europe, and
many are now venturing into Asia.
Vulture
Capital: The alchemy of financial leverage
The
beauty - albeit it's in the eye of the beholder - of
the LBO-style vulture capitalism is that it often combines
the financial discipline of operating management accruing
from the high debt level (also known as "leverage")
in the capital structure of a business with the unlimited
upside potential of capital gains or appreciation of
the equity investment's value. By shrinking the equity
investment required, it allows managers of modest means
to become owners. The key to high equity gains is the
recognition that top-line or revenue growth is not necessary
for value creation. The leveraged financing allows reforms
in management - sometimes radical, sometimes no more
than mundane operational "blocking and tackling" - to
be converted into capital gains.
To
see how this works in its simplest form, imagine an
all-equity company that is bought for $10 million. Before
the acquisition, the business generates $1 million in
cash flows, just enough to give shareholders a 10% return.
The acquisition is financed with $9 million in debt
and $1 million in equity. The company is then able,
through improved operations, superior asset utilization,
and disciplined capital investment, to increase cash
flows from $1 million to $2 million per year, without
either increasing or decreasing the value of the assets.
By paying no dividends and using this $2 million in
cash flow strictly for debt service, this company can
pay down the $9 million of debt (say, at an interest
rate of 10%) in about 6 years. At the end of that period,
the company would still be worth $10 million, but it
would now be all equity. In other words, the original
$1 million equity investment has been transformed into
one worth $10 million, for a 47% compounded annual rate
of return! This is how financial leverage concentrates
ownership in fewer hands and substantially amplifies
the returns to the new owners.
Virtuous
Capital
The
third facet of entrepreneurial finance, virtuous capitalists
may offer only a modicum of capital (often requiring
matching funds from the founders themselves), but they
bring mountains of goodwill (in the traditional, not
financial, sense). Another distinguishing feature is
that they often - if not always - care more about promotion
of societal values and job creation than economic value
creation (i.e., monetary returns) alone. Included in
this group are friends and relatives, philanthropic
foundations, charitable organizations, nongovernmental
organizations (NGOs) funded by donor agencies, government-subsidized
investment companies (e.g., Small Business Investment
Companies, or SBICs, in the US), and government grants
(e.g., local, state and federal grants available in
the US through the Small Business Innovation Research,
or SBIR, programs). By way of promoting "finance with
a conscience," many virtuous capitalists seek to advance
the cause of balancing temporal value (i.e., making
money) with timeless values (i.e., creating a better
society).
Vicious
Capital
Vicious
capitalists include the modern-day Luddites or anti-technologists,
extreme environmentalists, and the enemies of open societies
and liberalized economies. They support subsidies and
other protectionist measures for uncompetitive businesses
or sectors in closed economic systems. Their idea of
business is the continuation of politics by other means.
As a result, these businesses/sectors cannot carry their
own weight by earning their cost of capital - for mature
businesses, the going rate being about 10%, which is
the weighted average of the interest on debt and expected
return on equity capital - end up destroying economic
value and thus become unsustainable in the long run.
Virtual
Capital
Virtual
capitalists are the globe-trotters who are always looking
for arbitrage opportunities to invest their "knowledge
capital" as much as their monies in liquid (i.e., easily
tradable) markets. Adept at parceling out venture-specific
risks, they are the equivalents of hedge funds and certain
financial derivatives traders, thus moving the private
equity world as close to the theoretical "efficiency"
of the public capital markets as possible. Examples
of virtual capitalists include the emerging new category
of financial asset-light but intellectual capital-intensive
enterprises, e.g., IP2IPO and UTEK, which work with
top-notch universities and research institutes to turn
patented or proprietary research findings into profitable
business ventures.
Viscous
capital
Viscous
capitalists are those who are willing to take the risk
of getting their capital "stuck in the mud" (perhaps
for a long time) and are not in a rush to pull out their
investments (or cannot do so without significant penalties).
For assuming the risk of illiquidity, they naturally
expect higher returns. Equipment leasing firms and vendors
who self-finance the sale to customers when traditional
financing is unavailable or unattractive to their financially
strapped customers belong in this category. However,
many of these are probably endangered species in today's
world of high-velocity finance.
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About
the author
Mr.
Gulam Samdani, PhD, is one of the thought leaders at
Virtual Change Catalysts (VC2), a non-profit
and for-benefit organization dedicated to developing
and transferring best management practices and innovations
from anywhere in the world to where they could make
the most difference today.
He
is also an industry expert in advanced materials, biotechnology
and chemicals at the New Jersey, USA office of McKinsey
& Company, an international top management consulting
firm. He welcomes constructive comments from Dinar
Standard readers and can be reached at samdani@aya.yale.edu
via e-mail.
This
article has been adapted with permission from The
Executive Times.
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