Trends Report

 In 2004, some of the best known companies in our space received funding. Fastclick raised $75 million, Netblue another $20 million. With the online ad market so hot, it makes sense to expect that trend to continue. Last week it did with AzoogleAds who announced the sale of a minority stake in their firm for an undisclosed amount. Chances are too that they won’t be the last and that this trend towards funding will continue throughout the year. Given that, this Trends looks at the world of funding, specifically this article attempts to explain the reasons for the prevalence in funding, the different types of funding available, and what companies do with that money.

When people think of funding, generally what they think of is venture capital, a term bandied about during the dot come heyday where large amounts of money went towards speculative investments with no proof of concept or revenue model. Venture capital still exists, but the deals thus far have not been to fund unproven businesses. The deals in our industry have focused on established businesses with demonstrated successes – companies with a proven record that earn a positive net income. These deals have been private equity as opposed to venture capital.

An investment firm might do both private equity and venture capital deals, but the deals have marked differences with respect to how the money gets used. Venture capital helps a business test its concept and/or provide working capital. Venture capital allows companies to market their product, pay for development, etc. Those placing venture deals expect equity for their investment, but the money they use to finance the purchase comes entirely from the venture company’s funds. Private equity deals also involve the purchase of equity from existing stakeholders; however, in contrast to venture capital, this money does not have to be, and is usually not, used to fund existing operations. Private equity money often goes directly to the principle shareholders whose equity was purchased. Private equity becomes an insurance policy, allowing the shareholders a means to cash out on some of their efforts, and they do so in an easier fashion than going public for example.

Another difference between venture capital and private equity deals with the source of the funds. If a company has a positive cash flow, the private equity firm might opt to purchase their shares with a combination of their own money and debt, such as borrowed money from a bank. For example, if a venture firm invests $50 million dollars and these shares appreciate to $100 million at the liquidity event, they have earned a respectable 200% return. If however, rather than investing all $50 million from their funds, they invest $25 million of their money and $25 million of borrowed money, their total investment has not changed, and at the time of liquidity the value has not changed either. Over the years from initial investment to liquidity, the private equity group has paid off the debt with cash flow from the business leaving them a 400% return as opposed to a 200% return. They earned the difference between $100 million and $25 million as opposed to $100 million and $50 million. The original shareholders, for example the founders of the company, tend not to object to the use of debt because they still receive cash for their shares during the initial investment.

Having discussed the general difference between venture capital and private equity placement, the next topic when it comes to the world of funding is, “Why now?” There is a popular theory that revolves around the fees the funding institutions make, that is often cited to explain the seeming uptake in interest in funding. Venture capital and private equity companies create funds that are classes of investments, i.e. they are a unique asset class just as mutual funds are. Companies like Battery Ventures, Sequoia, and Garage Technology Ventures raise money from lending partners which are typically large endowments and other financial institutions. These fund companies place investments on behalf of the lending partners with the expectation that the value of the fund will increase at higher yields over time than other investment vehicles such as buying shares in publicly traded companies. These placement companies seek a liquidity event after a certain number of years so that they can show the return to the lending partners. Given that each successful liquidity event provides substantially greater percentage returns than a standard investment, the fund companies can afford to make more and often riskier gambles so long as the aggregate returns equal around 25% per year invested.

In exchange for their investing efforts, the fund raisers who place venture capital and private equity placements receive a management fee. The typical management fee has the investment company receiving a flat 2% of the fund amount for the first five or six years. After this period, any money not deployed, think spent, goes back to the lending partners. Assume that the investment company receives a fee for the first five years for a fund that is $500 million dollars. They will earn $10 million dollars in fees for the first five years along with some percentage thereafter in decreasing intervals which tends to equal 3/4 of the initial management fee percentage for years six, seven, eight and 1/2 of that percentage for years nine and ten. If the company only deploys half of the $500 million, they stand to lose out on a substantial amount of money, namely 1.5% of $250 million for three years and 1% of $250 million for the past two years.

During the boom years, these investment funds raised substantial money, and, if their contracts were for six years, that would mean the period for deployment would be near and a rush of capital would need to be spent. According to those in the business, that is only part of the reason there is an apparent up-tick in funding. These funds have become an increasingly popular asset class which has led to more and more money chasing fewer and fewer opportunities; some of the biggest funds have actually sprung up in the past 18 months. More private companies are willing to part with their shares because they know that they are receiving higher valuations than in other times. If the share owners want to earn $25 million, they can do so now by selling a smaller stake or sell the same stake they had initially planned and earn even more money. Equally important, the banks are lending more now than in other times, this allows for more leveraged buyouts, i.e. using debt to finance the equity purchase. Willingness on the banks parts only increases the interest private equity firms have in taking stake in profitable companies.

Like everything else, the investing market is cyclical. There is no one reason for the interest, and after a point, the interest will lessen. Similarly, there is no easy answer for whether to accept the interest of these outside firms. In most cases, the principle stakeholders do well, but it might have unforeseen consequences on the rest of the company. Accepting investments will have operational impacts as well. Ultimately, they are a popular way to cash out on work done and a growing asset class impacted like everything by market conditions. As is the case with any trend, expect this year to treat several people very well, but no reasonable person would bet their future on the placement of private equity in their company.