Venture Capital and Private Equity

Posted by PITHOCRATES - May 28th, 2012

Economics 101

An Idea is only an Idea unless there’s Capital to Develop it and a Business Plan

People put money in the bank to save it.  And to earn interest.  To make their savings grow.  So they can afford a down payment on a house one day.  Or start up a business.  To start a college fund.  Or a variety of other things.  They put their money into a bank because they have confidence that the bank will repay that money whenever they want to withdraw it.   And confident that the bank will earn a profit.  By prudently loaning out their deposits in business loans, mortgages, equity loans, etc.  So the bank can pay interest on their savings.  And make it grow.  While not risking the solvency of the bank by making risky loans that people won’t be able to repay.  With responsible saving and responsible lending both parties achieve what they want.  And the economy grows.

A high savings rate means banks can make more loans.  And businesses can borrow more to expand their businesses.  This is a very critical element in capitalism.  Getting capital to the people who need it.  Who can do incredible things with it.  Create new jobs.  Develop a new technology.  Find a better way to use our limited resources.  Bringing consumer prices down and increasing our standard of living.  Because when prices go down we can buy more things.  So we don’t have to sacrifice and go without.  We have a higher standards of living thanks to capitalism.  And the efficient use of capital.

As technology advanced individuals had more and more brilliant ideas.  But an idea is only an idea unless there’s capital to develop it.  And a business plan.  Something a lot of brilliant entrepreneurs are not good at.  They may think of a great new use of technology that will change the world.  Their mind can be that creative.  But they don’t know how to put a business plan together.  Or convince a banker that this idea is gold.  That this innovation is so new that no one had ever thought of it before.  That it’s cutting edge.  Paradigm shifting.  And it may be that and more.  But a banker won’t care.  Because bankers are conservative with other people’s money.  They don’t want to loan their deposits on something risky and risk losing it.  They want to bet on sure things.  Loan money to people that are 99% certain to repay it.  Not take chances with new technology that they haven’t a clue about.

Venture Capitalists make sure their Seed Capital is Used Wisely so it can Bloom into its Full Potential

Enter the venture capitalists.  Who are the polar opposite of bankers.  They are willing to take big risks.  Especially in technology.  Because new technologies have changed the world.  And made a lot of people very wealthy.  Especially those willing to gamble and invest in an unknown.  Those who provide the seed money for these ventures in the beginning.  That’s their incentive.  And why they are willing to risk such large sums of money on an unknown.  Something a banker never would do.  Who say ‘no’ to these struggling entrepreneurs.  And tell them to come back when they are more established and less risky. 

This is responsible banking.  And this is why people put their money into the bank.  Because bankers are conservative.  But there is a price for this.  Lost innovation.  If no one was willing to risk large sums of money on unknowns with brilliant ideas the world wouldn’t be the same place it is today.  This is what the venture capitalists give us.  Innovation.  And a world full of new technology.  And creature comforts we couldn’t have imagined a decade earlier.  Because they will risk a lot of money on an unknown with a good idea.

Most venture capitalists have been there before.  They were once that entrepreneur with an idea that turned it into great success.  That’s part of the reason they do this.  To recapture the thrill.  While mentoring an entrepreneur into the ways of business.  Like someone once did for them.  But it’s also the money.  They expect to make a serious return on their risky investment.  So much so that they often take over some control of the business.  They do what has to be done.  Make some hard decisions.  And make sure they use their investment capital wisely.  Sometimes pushing aside the entrepreneur if necessary.  To make sure that seed capital can bloom into its full potential.  Perhaps all the way to an initial public offering of stock.  And when it does everyone gets rich.  The entrepreneur with the good idea.  And the venture capitalist.  Who now has more seed capital available for other start-ups with promise.

The Goal of the Private Equity Firm is to Get In, Fix the Problems and Get Out

Venture capital belongs to the larger world of private equity.  Where private equity investment firms operate sort of like a bank.  But with a few minor differences.  Instead of depositors they have investors.  Instead of safe investments they have risky investments.  Instead of low returns on investment they have high returns on investment.  And instead of a passive review of a firm’s financial statements by a bank’s loan officer they actively intervene with business management.  Because private equity does more than just loan money.  They fix problems.  Especially in underperforming businesses.

A mature business that has seen better days is the ideal candidate for private equity.  The business is struggling.  They’re losing money.  And they’ve run out of ideas.  Management is either blind to their problems or unable (or unwilling) to take the necessary corrective action.  They can’t sell because business is too bad.  They don’t want to go out of business because they’ve invested their life savings to try and keep the business afloat.  Only to see continued losses.  Their only hope to recover their losses is to fix the business.  To make it profitable again.  And selling their business to a private equity firm solves a couple of their problems fast.  First of all, they get their prior investments back.  But more importantly they get hope. 

The private equity firm uses some of their investment capital to secure a large loan.  The infamous leveraged buyout which has a lot of negative connotations.  But to a business owner about to go under and lose everything the leveraged buyout is a blessing.  And it’s so simple.  A private equity firm buys a business by taking on massive amounts of debt.  They put that debt on the business’ books.  Debt that future profits of the business will service.  Once the equity firm does its magic to restore the business to profitability.  Starting with a new management team.  Which is necessary.  As the current one was leading the firm to bankruptcy.  They may interview people.  Identify problems.  Find untapped potential to promote.  They may close factories and lay off people.  They may expand production to increase revenue.  Whatever restructuring is necessary to return the firm to profitability they will do.  Their goal is to get in, fix the problems and get out.  Selling the now profitable business for a greater sum than the sum of debt and equity they used to buy it.

But with great risk comes the chance for great failure.  When it works it works well.  Producing a huge return on investment.  But sometimes they can’t save the business.  And the firm can’t avoid bankruptcy.  The business then will be liquidated to repay the banks who loaned the money.  While the equity the firm invested is lost.  Which is why they need to make big profits.  Because they suffer some big losses.  But they typically save more businesses than they fail to save.  And the businesses they do save would have gone out of business otherwise.  So in the grand scheme of things the world is a better place with private equity.

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