United States: Seeking Venture Capital In The Tech Depression

As many entrepreneurs are unhappily discovering, the stream of venture capital has narrowed in the past several months, and companies and individuals that supply venture capital have employed increasingly stringent examinations of potential investments, given the current economic climate of our markets.

Given the increasing strictness of venture capital investment, now, more than ever, a fundamental question for every new entrepreneur is whether venture capital, or just plain old debt, is the best way to finance a young company in this environment.

Generally, companies receive venture capital through cash infusions in exchange for an equity interest in the company, in the form of either common stock or securities that convert into common stock. Usually this occurs through a private placement of securities using certain exemptions available under the federal and state securities laws. As a result, a company seeking outside financing should evaluate the advantages and disadvantages of external equity in the form of venture capital vis a vis traditional debt.

Sometimes, new companies have no alternative to equity financing other than coupling their businesses to profitability, in the hopes of growing by reinvesting profits or borrowing from bank. This may be more difficult in a climate where such borrowing is not likely to be available until after the company has demonstrated satisfactory performance. Unfortunately, bootstrapping and bank financing are not viable alternatives for many entrepreneurs because initial capital requirements prior to profitability are beyond the founder’s financial capability. In other instances, bootstrapping and bank financing are not viable alternatives for many entrepreneurs because the cost of missing the optimal market entry opportunity may be too great. Therefore, especially in a climate like we are seeing in today’s market place, the process of evaluating the financial trade-offs of equity versus debt is very useful to a young company.

Equity financing such as venture capital infusions can offer numerous advantages to an entrepreneur.First, equity can come in the form of permanent capital that does not require immediate repayment. Hence, it provides the two most valuable commodities a venture start-up is seeking: time and money.

Second, equity can improve a firm’s credit worthiness because it adds to net worth by increasing assets, without incurring offsetting liabilities. In this way, equity can facilitate payment terms from vendors and ease concerns about a company’s strength. Equity can also provide a sufficient asset base to enable lease financing or bank borrowing to increase a company’s operating leverage.

Third, equity financing can enhance a young company’s credibility with vendors, customers and financial institutions where the equity investor receives a return on his investment only if the business succeeds. Equity can benefit the company’s status by implying that an external validation of the company’s business has occurred (usually by a sophisticated outsider), who has chosen to invest. In short, it presents a stamp of approval, particularly if the infusion is from a prestigious professional venture capital firm; in turn, this encourages others to invest.

Fourth, equity infusions in the form of common or preferred stock which do not pay dividends, usually imposes no fixed charges that might restrict strategic or operating decisions because the stock often has no scheduled interest or dividend payments.

Fifth, equity investors, unlike many banks, typically will not demand an imposition of personal liability on the owners and managers or take a security interest in corporate assets.

First, the most obvious and significant disadvantage of financing the new company with equity infusion is that it immediately dilutes ownership. Obviously, this allows the investor an unlimited upside benefit if the business is highly successful. This unlimited benefit potential is what fundamentally motivates venture capitalists.

Second, external equity obviously becomes more expensive than debt when the business begins to succeed. Where a banking institution providing debt financing would usually only obtain an interest payment in return for its loan, the venture capitalist may end up owning stock worth a much greater amount, assuming no further equity financing is required, and the company succeeds.

Third, equity capital tends to be more permanent, which in some instances means a difficult reversal of the transaction for either the company or investors. Thus, external equity investors in some way become an indirect economic ally for as long as they hold the ownership interest regardless of the relationship between owner, managers and the owner investor.

Fourth, equity has an ownership nature, in that obtaining external equity can require owner managers to give up real or effective control or at least some operating flexibility. These third and fourth disadvantages can become problems if the company’s relationship with its investors should suddenly sour, imposing a useful and potentially unpleasant discipline on both company and investor and in turn reinforcing the value of building a mutually profitable, personal relationship.

A fifth and often overlooked disadvantage of equity is the difficulty of obtaining it, and the time and transaction costs, particularly in legal fees, to implement both successful and unsuccessful efforts to seek outside capital, particularly through stock offerings.

Nonetheless, venture capital, although increasingly more difficult to obtain, can also bring with it many non-financial benefits. Often times, with money will come more sophisticated guidance and technical help, sometimes whether the entrepreneur wants it or not. Venture capital firms will frequently volunteer assistance beyond mere equity financing.

In some ways this can be very good because non-monetary assistance to young companies has become increasingly important in helping them reach their full potential. Increasing competition and short product life cycles in many emerging markets means that young companies must make fewer mistakes in a shorter period of time. Therefore, venture capitalists can be of invaluable assistance in helping entrepreneurs avoid some of the common but crippling mistakes made by young companies.

In many instances, leading venture capitalists now typically have multidisciplined external contact networks or sometimes professional staff that can provide portfolio companies with technical and marketing guidance, strategy assistance, financing, recruiting advice, and contacts to keep potential customers, vendors, and financial institutions involved with the company. When appropriate, a venture capitalist can even assist a new company in forming an alliance with a larger established corporate partner through technology exchanges, customer agreements and minority equity investments. In this way, venture capital also offers a young company the opportunity to obtain a true economic partner, rather than a mere transaction oriented investor who is interested only in a quick return on his or her investment.

Whatever financing method is ultimately chosen by the entrepreneur, a young company is always well advised to carefully consider the benefits and detriments of venture capital versus debt financing in structuring a new company. Ultimately, venture companies are only as good as the people behind them, and the careful structuring decisions they have made.

The information contained in this article is not intended as legal advice and should not be construed or relied upon as such. Each set of circumstances may be different. If you have a legal problem, or require advice, you should seek the counsel of an attorney.