Venture Capital

   AMERICAS STOCK VENTURE CAPITAL INFORMATION

Venture Capital Funds

The principal sources of venture capital funds for a business firm are equity capital, preference capital, debenture capital and term loans. Equity capital represents ownership capital because equity shareholders collectively own the company. They enjoy the rewards, as well as bear the risks of ownership. However, their liability, unlike the liability of the owner in a proprietary firm and the partners in a partnership concern, is limited to their capital contributions. As equity capital funds represent permanent capital, there is no liability for repayment. It enhances the creditworthiness of the company. In general, the larger the equity base, the higher the ability of the company to obtain credit.
Preference capital represents a hybrid form of financing. It partakes of some characteristics of equity and some attributes of debentures. It resembles equity in the way that preference divided is payable only out of distributable profits and is not an obligatory payment. Preference capital is similar to debentures in that the dividend rate on preference dividend is usually fixed and preference stockholders do not normally enjoy the right to vote. When using preference capital funds, there is no legal obligation to pay preference dividend. A company does not face bankruptcy or legal action if it skips preference dividend, and there is no redemption liability in the case of perpetual preference shares.
Akin to promissory notes, debentures are instruments for raising long-term debt capital. Debenture holders are the creditors of the company. The obligation of the company towards its debenture holders is similar to that of a borrower who promises to pay interest and capital at specified times. The specific cost of debt capital, represented by debentures, is much lower than the cost of preference or equity capital. This is because the interest on debentures is tax-deductible, and the effective cost of debentures is much less. Debenture financing does not result in dilution of control since debenture holders are not entitled to vote.
Term loans, also referred to as term finance, represent a source of debt finance that is generally repayable in more than one year but less than 10 years. They are employed to finance acquisition of fixed assets and working capital margin.

Venture Capital Investments

When investing in venture capital, always keep one thing in perspective. All investments have equal risk, and the average cost of capital for the firm can be used for evaluating investment proposals. Investment proposals differ in risk. An investment proposal to manufacture a new product, for example, is likely to be more risky than one involving replacement of an existing plant. In view of such differences, variations in risk need to be considered in venture capital investment appraisal.
In many cases, the revenues expected from a project are conservatively estimated to ensure that the viability of the proposed project is not easily threatened by unfavorable circumstances. The capital budgeting systems often have built-in devices for conservative estimation.
A margin of safety in venture capital investing is generally included in estimating cost figures. This varies between 10 and 30 per cent of what is deemed as normal cost. The size of the margin depends on how management feels about the likely variation in cost. The cut- off point on an investment varies according to the judgment of management on how risky the project might be. In one company, replacement investments are okayed if the expected post-tax return exceeds 15 per cent but new investments are undertaken only if the expected post-tax return is greater than 20 per cent. Another company employs a short payback period of three years for new investments. Its finance controller stated this rule as follows:
“Our policy is to accept a new project only if it has a payback period of three years. We have never, as far as I know, deviated from this. The use of a short payback period automatically weeds out risky projects.” Some companies calculate what may be called the overall certainty index, based on a few crucial factors affecting the success of the project.

Target Capital Structure

Firms can choose whatever mix of debt and equity they desire to finance their assets, subject to the willingness of investors to provide such funds. And, as we shall see, there exist many different mixes of debt and equity, or capital structures - in some firms, such as Chrysler Corporation, debt accounts for more than 70 percent of the financing, while other firms, such as Microsoft, have little or no debt.
In the next few sections, we discuss factors that affect a firm's capital structure, and we conclude a firm should attempt to determine what its optimal, or best, mix of financing should be. But, you will find that determining the exact optimal capital structure is not a science, so after analyzing a number of factors, a firm establishes a target capital structure it believes is optimal, which is then used as a guide for raising funds in the future. This target might change over time as conditions vary, but at any given moment the firm's management has a specific capital structure in mind, and individual financing decisions should be consistent with this target. If the actual proportion of debt is below the target level, new funds will probably be raised by issuing debt, whereas if the proportion of debt is above the target, stock will probably be sold to bring the firm back in line with the target debt/assets ratio.
Capital structure policy involves a trade-off between risk and return. Using more debt raises the riskiness of the firm's earnings stream, but a higher propor- tion of debt generally leads to a higher expected rate of return; and, we know that the higher risk associated with greater debt tends to lower the stock's price. At the same time, however, the higher expected rate of return makes the stock more attractive to investors, which, in turn, ultimately increases the stock's price. Therefore, the optimal capital structure is the one that strikes a balance between risk and return to achieve our ultimate goal of maximizing the price of the stock.
Four primary factors influence capital structure decisions:
1. The first is the firm's business risk, or the riskiness that would be inherent in the firm's operations if it used no debt. The greater the firm's business risk, the lower the amount of debt that is optimal.
2. The second key factor is the firm's tax position. A major reason for using debt is that interest is tax deductible, which lowers the effective cost of debt. However, if much of a firm's income is already sheltered from taxes by accelerated depreciation or tax loss carryforwards, its tax rate will be low, and debt will not be as advantageous as it would be to a firm with a higher effective tax rate.
3. The third important consideration is financial flexibility, or the ability to raise capital on reasonable terms under adverse conditions. Corporate treasurers know that a steady supply of capital is necessary for stable operations, which, in turn, are vital for long-run success. They also know that when money is tight in the economy, or when a firm is experiencing operating difficulties, a strong balance sheet is needed to obtain funds from suppliers of capital. Thus, it might be advantageous to issue equity to strengthen the firm's capital base and financial stability.
4. The fourth debt-determining factor has to do with managerial attitude (conservatism or aggressiveness) with regard to borrowing. Some managers are more aggressive than others, hence some firms are more inclined to use debt in an effort to boost profits. This factor does not affect the optimal, or value- maximizing, capital structure, but it does influence the target capital structure a firm actually establishes.
These four points largely determine the target capital structure, but, as we shall see, operating conditions can cause the actual capital structure to vary from the target at any given time. For example, as discussed in the Managerial Perspective at the beginning of the chapter, the debt/assets ratio of Unisys clearly has been . much higher than its target, and the company has taken some significant correc- tive actions in recent years to improve its financial position.