There are more than a thousand venture capital companies in the United States.
Historically, venture capital companies look for companies with high levels of potential and take a minority, not a majority, position. They take their investment in the form of common stock or preferred stock convertible into common. Preferred stock would be paid in case of liquidation before common.
If you are an electrical contractor or a wholesaler of electrical products or a restaurant, you are not a candidate for venture capital. If you have a breakthrough cure for cardiovascular disease, if you have a state of the art internet concept, if you have an aerospace widget that makes aerospace more efficient, you are a candidate for venture capital.
Private equity companies take a majority equity share in the business, therefore, creating a liquid event for the owner, as well as being responsible for all additional capital in the future. In the typical private equity transaction, the private equity fund would multiply EBITDA (Earnings, Before, Interest, Taxes, Depreciation, Amortization) by five. To put a preliminary value on the business, they would add cash from the bank, subtract interest bearing debt, add equity in real estate and make an adjustment for adequate working capital, which can either be positive, neutral or negative.
As an example, if the company has a $1 million dollar EBITDA, they must have a value of $5 million dollars. Accordingly, the owner would receive $5 million dollars and an opportunity to coinvest with a private equity fund. In a $5 million dollar purchase, the private equity firm might use $2 million dollars in equity and $3 million dollars in debt and accordingly the owner could keep a 25% ownership in the company by reinvesting $500,000.
Private equity money is only suitable for companies operating in a
Private equity availability starts at $1 million dollars in EBITDA
and goes to a limitless amount of EBITDA. Even companies,
theoretically, could be a candidate for private equity with as much
as a billion dollars in EBITDA.
If you are not profitable, you are not a candidate for private equity. If you are in industries like the construction industry, you are probably not a candidate for private equity.
For most entrepreneur businesses, one of the most effective ways to raise money is by finding partners. Partners could be passive or active, majority or minority, or they could make an investment or not make an investment.
A company is valued in a similar method to the way in which a company is valued for private equity and then the partner participates in that fashion. The formula for partnership investments is the numerator of the fraction equals the amount of money that the partner has to put up and the denominator of the
fraction equals the current value of the business, plus the money to be put up.
E.g. A business is worth $10 million, the partner is to put up $2 million, then the numerator of the fraction is $2 million, the denominator is $10 million plus $2 million, the partner is to get 2/12th, 1/6th or 16.6% of the company.
There are considerable benefits of partners, because they bring not only money, but generally bring some level of expertise, even if it is expertise in a different industry. In general, individuals with money tend to be successful, all things being equal.
A strategic alliance is a form of a partnership, but generally means an alliance with a larger company. A company can bring to the table, not only money, but technical expertise, distribution, marketing advice and other forms of unique benefits that only a large company can bring to a small company. With strategic alliances the alliance partner tends to take a minority, not a majority stake.
However, the strategic alliance partner will be seeking first right of refusal, should the business be sold in the future. The alliance partner does this because they do not want to find themselves in bed with a company or individual that they would not find to be desirable. They also wish to option the future as they help nurture the smaller alliance to grow and prosper.
Asset Based Lending
Asset based lending means a lender providing money, taking security largely out of inventory and receivables and to a lesser extent, real estate and equipment. In general, asset based lenders will lend 80% of receivables that are current and 40%-50% of finished goods inventory. That formula cost varies dramatically depending on the industry. As an example, in the cigarette industry, it is customary to lend 90% against receivables and 70% against inventory. Whereas, where one has raw materials in inventory, it will either be difficult to obtain any loans or the loan will be minimal for that type of inventory.
The Small Business Administration will make more than 30,000 loans in the coming year. They tend to guarantee banks 75% to 85% of their risk, allowing banks who participate in SBA programs to have higher cash on cash return.
The SBA looks at three basic C’s (Collateral, Cash flow and Character). One should not assume that the SBA makes ridiculous loans when there is no hope of being repaid. It is more accurate to say that they make marginal loans which could not stand up to scrutiny on a bank by themselves. The SBA has many programs, but in general can loan up to $1, 750,000, although the average loans tend to be approximately 40% of that amount.