Venture Capital

The venture capitalist has increasingly become a source of financing for small businesses. A definition of venture capital investing is difficult in that venture capital ists have a broad range of interests and activities. Most venture capitalists, however, would fall somewhere along the following spectrum of investment interests:

1. Providing capital for any high risk financial venture
2. Providing "seed capital" for a start up situation
3. Investing in a firm that is unable to raise capital from conventional sources
4. Investing in large publicly traded corporations where the risk is significant

As to which definition is most descriptive depends in part on the eye of the beholder. For instance, some venture capitalists believe that providing seed money is too risky. others, however, believe that such start up capital is the primary intent of their investments. Thus, generalities become difficult, but three underlying attributes normally prevail with venture capital investing. First, the investor is usually "locked in" to the firm for some duration of time, without an opportunity to sell stock quickly in response to a change in the firm's position, either favorable or unfavorable. Second, the venture capitalist normally represents the first equity financing from an "independent" party, as opposed to a friend or relative, However, additional financing from the venture capitalist may be required at a later date. Finally, venture capital investors have divergent interests. An investment having no appeal to one venture capital group might be of extreme interest to another venture group. For this reason, the management of a firm seeking funds should be aware of the compatihility of interests of the firm and the venture capitalist being approached.

if a financing package comprised of debt financing is presented to a venture capitalist, two major issues are involved. First, the venture capitalist may insist upon covenants in order to protect himself if the financial condition of the firm either deteriorates or does not materialize as anticipated. These covenants, similar to the protective restrictions of a bank loan, are particularly common in start up situations, with effective control of the organization being more easily lost through default on these long term covenants than through the loss of majority ownership of the equity shares.

Second, the venture capitalist considers the tradeoff between the interest rate and the conversion privilege, The use of debt by venture capital investors generally involves a convertibility feature or bonds with warrants attached. By attaching either warrants or a conversion privilege, a significant reduction in interest charges usually results. For a small growth business a reduction in interest payments is not only desirable but essential, since most small businesses may have difficulty in meeting the interest requirements associated with straight debt.,

Assuming that the business owners either have depleted all available equity funds or want to take advantage of what they hope will be favorable financial leverage, the management will no doubt search for debt financing. Potential sources of such financing for a small firm include (1) commercial banks,
(2) life insurance companies,
(3) venture capital groups,
and (4) government agencies. The commercial bank is the leading source of borrowed funds available to the small business. The loans available through the bank are primarily of two types, shortterm and mortgage loans. However, the short term instruments, although "formally" being defined as short term, provide considerable long term financing for the small ,business entity. Although statistics indicate that the bank is principally a provider of short term capital, such figures can, be misleading. For instance, a loan with a maturity of 90 or 180 days, although being "classified" as short term, provides long term financing through regular renewals as the indebtedness approaches the due date. Turning the debt over frequently is a technique by which the owners of a small firm convert short term financing to an equivalent long term status. This approach carries with it one distinct disadvantage in that the firm's financing is at the discretion of the banker each time the debt matures, which may cause some anxiety for the small business owner. The second and more formal source of long term financing is the mortgage loan. These obligations relate to a specific purchase of real estate that is used as collateral in securing the financing arrangement.

In relying on the bank as a source of funds, the small business owner should develop a relationship with the banker prior to the actual need for funds. ideally, the interaction should be on both a professional and a personal basis. As part of the relationship, the business owner should be completely open with the banker. Only in this way can the banker be of maximum effectiveness in providing services. Also, in maintaining an association with the banker, the business owner should continue to examine the benefits being received. He or she should be aware of the services being provided by competitive banks, as well as the costs related to these services. However, the affiliation with a banker is not purely a function of the interest rate being charged but involves a number of factors. The mere fact that a bank is charging a slightly higher interest rate does not necessarily justify changing banks. A longterm relationship is important, especially if monetary conditions are tight or if the firm temporarily encounters adversity. Finally, an inquiry should be made as to the banker's special expertise and the bank's capabilities in terms of loan size. The firm's owner should seek out a bank having particular expertise in the firm's type of operation. That is, not only is the accessibility of capital important, but a source of counseling may be of substantial benefit. In selecting a bank, the size of the bank should also be considered. If large sums of money will be required, a small bank may not have the capability to service such loans. On the other hand, if the credit requirements are not so extensive, it may be quite beneficial to use a small bank where the owner of the small firm has access to the key bank officers.

Insurance companies The executive of the small firm may find that an insurance company is a viable source of financing. As a financial intermediary, an insurance company has large sums of money available for investments. Only a small portion of such funds is available for the small firm, but to the extent that such funds may be used, the extension of credit generally comes in the form of a mortgage loan. Hence, a life insurance company may be a potential long term source of financing for a small firm planning the construction of a real estate investment, such as a plant or an office. In examining the request for a loan, the insurance company looks closely at the type of building being constructed, with a preference for a facility having potential multiple uses. As to the size of loans, most insurance companies are interested in making loans in large amounts; however, loans for as little as $10,000 have been granted. In general, mortgage loans extend over a 10 to 20 year period, with the amount of the mortgage being limited to approximately 70 percent of the appraised value of the property.

In addition to the mortgage loan, the insurance company may issue credit on an unsecured long term basis to the borrower having an excellent credit rating. Such loans, if granted, generally extend for periods of ten years with an interest rate exceeding that of the bank by 1 to 2 percent.

Small Business Investment Corporations, one form of a venture capital organization, extend long term loans, usually in excess of $75,000 for periods exceeding five years. Historically the loans have been in high technology industries involving medium sized operations. In addition, the firm normally must have a track record in terms of proven profit capabilities and growth potential. An in depth explanation of SBICs is given later in the chapter.