Monday, 14 January 2013

There is Plenty of Investment Capital Out There, Except For...

I have spoken before about the variety and depth of venture capital (VC) and private equity (PE) funds (see: Specialized Funds for Unique Needs).  To reiterate, there are over 40,000 private equity funds in North America ranging from individuals to multi-billion dollar funds; from special purpose acquisition companies (SPACs), to Leveraged Buy-Out (LBO), Growth Capital, Mezzanine and Distressed funds.
Venture capital investors typically take a substantial minority equity position and look for investments that can return 5x to 10x (i.e. if they invest $1 million, they target a realization of $5M to $10M in a sale or IPO exit).  VCs don’t typically look to achieve their goals by acquiring additional companies but rather by betting on, and working with, the expected winner in the space.  Private equity on the other hand, quite often seeks 100% ownership and will then continue to look for add-on or tuck-in acquisitions to grow and increase the market position of its investments.
In Canada there are quite a few start-up or incubation venture capital funds which will invest from several hundred thousand to $1M in promising ideas but, as-of-yet unprofitable companies. Some notable ones include: Extreme Startups, FounderFuel, GrowLab, Hyperdrive, and Version One Ventures.  There are also quite a few VCs and PEs that focus on profitable companies with investments of $5M and up such as Bedford Capital, Clairvest, Huron Capital, OnCap, Torquest and more.  But, where is the capital for companies that are profitable generating EBITDA from $0 to $1M?  This is the black hole of institutional investment.  If you have two or more years at profits of less than $1M, it becomes very hard to attract investment capital. 
What motivates the incubation funds is the possibility of a home run; the $5M folks are looking for typical private equity returns of 25% to 30% and find this area one where they can put some carry, or yield, into the structure to pay the bills, and they can grow to a ready exit either through IPO or sale.  The less than $1M profit, modest growth segment just doesn’t tick the boxes as well as the other segments.  Anyone that starts in this segment tends to move on to bigger deals.  One reason for this is (and I have heard this one a thousand times so I hate to say it) it takes as much work to close a small deal as it does to close a big deal (but the bigger deals just earn way more money); but also because it is a transition phase between the conceptual incubation funding, that relies on vision, and the proven entities where the valuation looks to cashflow.  Once cashflow is generated it tends to define the company.
Many good companies will have windows of equity financing opportunities.  They may be presented when the company is pre-revenue and has technology or customer commitments that put it ahead of the crowd; or it may be presented when the company is in accelerating revenue growth mode and, at that moment, the stars align with respect to market position and owner and investor value perception.  When the growth rate starts to decelerate and the owner’s value expectations continue to increase, that is when the window begins to close.  Entrepreneurs may act or pass on these opportunities, that is their choice, but just know that when you pass on an equity financing opportunity it may be gone forever.

Derek van der Plaat, CFA has worked in private market M&A for more than 20 years and is a Managing Director with Veracap Corporate Finance in Toronto.

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