Venture Capital and Manufacturing

Manufacturers who want to enter new markets or develop new product lines, whether they are start-up companies or established businesses, should consider venture capital. Venture capital is early-stage, risk financing offered by equity funds, small business investment companies (SBICs), and private individuals. Traditional venture capital funds look for strong management, unique technology, rapidly accelerating growth, and the potential for great profitability (generally 30 percent or more). Because manufacturing companies frequently possess these characteristics, they offer attractive investment opportunities for venture capitalists. Venture capital funding can occur at several stages of a company’s life:
• Seed capital is contributed at the start-up stage, when the company may be nothing more than a well-conceived business plan. • Early-stage funding is more popular with venture capitalists. At this stage, the company has achieved some revenue, is poised for further growth, and the ultimate opportunity to make money may be more clearly demonstrated. • Later-stage funding is used to fuel rapid growth, possibly in conjunction with debt. Often, an initial public offering is only two or three years away.

The bulk of the funds invested by venture capital funds and SBICs belong to institutional investors and pension fundsonly a portion of their own funds are at risk. For this reason, venture capitalists take great care in making investment decisions. Investments depend on the type of venture capital fund and the industries in which it specializes. How Venture Capital Works Venture capital refers to equity in a variety of forms, depending on the situation and the preference of the investors. Often, capital is invested in convertible preferred stock, convertible notes, or common stock. Because equity is invested in a relatively risky business enterprise, the return to investors must be commensurate with the perceived risks. Most venture capital funds seek manufacturing companies capable of generating a return on investment of 50 percent or more. Certain SBICs target a return of 25 to 30 percent, while individual investors, or “angels,” may accept a lower return. The return is calculated based on the value of the enterprise at or near the time the investors plan to cash out. This is often called the “exit strategy” and is of paramount importance to the investors. Typically, the preferred exit strategy is an initial public offering (IPO) in which the company sells a minority interest (say 20 percent) into the public markets. The venture capital investor may sell some or all of its shares, but the real significance of the IPO is that it creates the “exit,” i.e., the increased liquidity of the investment resulting from the ability to sell shares on the open market. Other exit strategies include selling the company to a larger industry player or to management. If profitability is extremely high, investors may continue to hold their interests in the hope of realizing higher capital gains later. How Much Equity Should Be Sold? How does a company determine how much equity to give up to the venture fund? Typically, the venture fund will make a determination of the current value of the enterprise based on its expected value at the projected time of exit. An approximation of value can be made by using the price/earnings ratio for comparable public companies and applying net present value principles. For example, suppose a venture capital fund is interested in investing in an early-stage manufacturing company and contemplates an IPO exit strategy in five years. The company projects a net after-tax profit of $5,000,000 after five years in operation. If the price/earnings ratio for this particular sector of the manufacturing industry is ten-to-one, the company would be worth $50 million as a publicly traded company. The present value of the company, based on the investor’s required rate of return of 50 percent, would be $6.7 million. The computation is illustrated in the box on this 79 page.© 2009 Principa. All Rights Reserved.

Venture Capital and Manufacturing (Cont’d)
Suppose the company needs to raise an additional $3 million in capital. Under this approach, the owners would have to give up 45 percent of the company ($3 million/$6.7 million) to attract venture capital financing. Note that changing any of the variables in the equation produces a very different result. For example, if the required return were 30 percent, the value of the company would be $7.7 million and only 39 percent of the company would have to be exchanged for the funding. Choose Your Partner Wisely Fund managers should be viewed as partners, and never as adversaries. For the most part, these partners will help guide the company to growth and profitability. Most venture capital funds don’t participate in day-to-day management, but they typically require board representation in proportion to their equity interest in the company. As a director, the venture capitalist helps to ensure that the company performs in accordance with its business plan. However, should the company fall substantially short of its goals, the owners/management might lose additional board seats, additional equity and, ultimately, control of the company. Benefits While the pricing and control aspects of venture capital may seem onerous, there are significant advantages to working with venture capital sources for equity financing. Venture capitalists generally are: • very knowledgeable about the industry, • relatively quick to provide financing, • able to provide significant management assistance in the early stages, • able to provide staged financing, relieving management of the burden, • investment professionals who can help guide the company’s future, and • able to smooth the way to Wall Street. Before approaching a venture capital provider, management should have a well-defined and documented business plan that meets the investment goals of the fund. The business plan may provide the only opportunity to impress investors, since many venture capitalists require a business plan prior to arranging a personal interview. Most funds will readily disclose their investment criteria and the industry segments in which they are most interested. Finding the right fit can sometimes be difficult and frustrating-the use of advisors can be a significant shortcut in the process. Present value of the company = Projected after-tax profit in year N = Price/earnings ratio for public companies = P/E = Investors? required rate of return = Number of years projected = N Formula PV = (ATP) X (P/E) ___________ (1 + R) X N PV = $5,000,000 X 10 = ______________ 1.50 X 5 7.50 Present Value Calculation PV = ? ATP = $5,000,000 10 R = = 5 50 percent

$50,000,000 __________

=

$6,666,667

© 2009 Principa. All Rights Reserved.

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