Considering Venture CapitalBy
When looking at the broader financing options available, many small businesses are asking whether venture capital is right for them.
Venture capital (VC) funding is expanding outside of Silicon Valley to new industries and geographies, and many entrepreneurs are wondering if they should pursue this option. According to Justin Field, senior vice president of government affairs at the National Venture Capital Association, approximately 2.2 million Americans now work at a VC-backed company, but the amount of VC funding available is still relatively small (cnb.cx/3jAjkAP).
A new or emerging small business has several options for financing, including the following: crowdfunding (through a platform like Kickstarter), business credit cards, angel investors (wealthy individuals investing their own money in the business), VC, bootstrapping (using personal or family money, or initial revenue streams), personal financing (home mortgage, 401(k) assets), equity financing, or, very rarely, traditional bank loans or a U.S. Small Business Administration loan.
WHAT’S RIGHT FOR YOUR COMPANY
These different funding options allow for a wider range of possible exit strategies when founders decide to move on from the business. Some of these options include continued family ownership, merger or acquisition with another company in the industry, management or employee buyout, liquidation, sale to another partner or investor, or an initial public offering (IPO).
Most individuals are more familiar with traditional private equity, which typically occurs in mature, established companies that are failing to achieve profitability or operational efficiency. Private equity firms have longer holding periods, seven or more years, for investments compared to VC funds and often purchase 100% of the equity in a business, exerting total control. VC firms more often invest less than 50% of the equity, and in smaller dollar amounts than private equity, to spread risk over higher numbers of early investments. The investment holding period is shorter, targeting three to five years, followed by an exit to achieve return.
GETTING IN THE DOOR
VC firms receive hundreds of pitches and offers from start-ups, and your business needs to stand out. A referral from another banker, a lawyer, an accountant, or other industry professional with an existing relationship with a VC firm can help expedite this process.
A VC firm pursues investments in businesses with rapid, high-growth potential. Minimally, owners need to address why their business is likely to experience high growth, who the target market is, how they plan to develop or find additional revenue streams, and what their competitive advantage is. The earlier a business is in its life cycle, the higher portion of ownership the VC firm will take. Owners will likely need to give up a seat on the board of directors to a member of the VC fund, and the VC firm will exert some oversight, control, and decision-making capacity on the business. Many VC firms have experienced directors who can offer mentorship and direction to entrepreneurs as the business grows, including identifying and mitigating risks.
With a shorter holding period for investments, VC firms focus on future exit strategies. One exit option is by taking the company public, as an alternative to a private sale. There are three primary ways for a company to go public in 2020—through an IPO, a direct listing, or a special purpose acquisition company (SPAC).
THREE PUBLIC OPTIONS
IPOs garner the majority of popular media press. But of the millions of businesses in the United States, only about 7,000 are public (bit.ly/3kyo2jG). What the media doesn’t cover are the details and work behind the scenes. An IPO is more likely to be successful when backed by a VC firm with prior experience.
The IPO process is lengthy and has a high risk of leaving value on the table for the company going public. A business must choose an underwriter (an investment bank), prepare a Form S-1 with corporate information, and complete a marketing “road show.” Following this, the underwriter chooses the price of the offering and determines who will get the allocation of shares to be listed. This creates an agency problem as the underwriter works for both the listing company and the investors purchasing shares. There’s no market-based pricing approach, which is why we often see IPO share prices spike during their first day of trading.
IPOs come with a high risk of underpricing and a large cost of capital. The average company going public in 2020 (as of August) was underpriced by 31%, and with IPO fees of approximately 7% due to the underwriter, the total cost of capital to go public could be 38%, without factoring in costs for compliance with Sarbanes-Oxley reporting requirements and marketing (bit.ly/3oAsqRy).
A second and simpler option to go public is through a direct listing (Spotify used this approach in 2018). Much of the process is the same as an IPO, including preparing an S-1 and a marketing road show, but the value of the company is determined through a market-based approach, matching supply and demand. Anyone with a brokerage account (E*TRADE, Charles Schwab, and others) can participate in a direct listing IPO. The direct listing uses the same systems and processes used in daily trading of all stock markets.
If you must raise capital to continue growth while going public, however, a direct listing isn’t currently an option. The New York Stock Exchange is working with the U.S. Securities & Exchange Commission on the possibility of adding primary capital raises to the direct listing options.
The third option, an SPAC, is a company formed for the purpose of merging or acquiring another company. In its simplest form, an SPAC is a nonoperating company that’s publicly listed and holds the cash raised from the listing in trust. The SPAC has two years in which to complete an acquisition of a target operating company. After the acquisition is complete, the listed “successor company” is the publicly listed operating company.
The SPAC IPO option has grown significantly over the past decade. Only one SPAC was completed in 2009. It had a valuation of $36 million. In contrast, 78 were completed in 2020 (as of August), at an average valuation of $401 million.
An SPAC offers a flexible option for companies looking to go public and is often faster than a traditional IPO. Nearly every term in the process is negotiable, including not only the price, but also who will be on the company’s board moving forward. Selling companies have more control and access to a much lower cost of capital vs. a traditional IPO process, and the transaction can be completed in as little as two months if the company has already been preparing for sale. Due to the underpricing associated with traditional IPOs, many VC funds favor the SPAC option to avoid selling their stake at a discount and to achieve the maximum value possible.
Before pursuing VC funding, entrepreneurs should think through their vision for their anticipated business life cycle and ensure that potential VC partners share that vision. Founders need to consider the control they’re willing to give up, the value of mentorship, where their business fits within their broader market space, and exit options.