Risk Model For Venture Capital Funds

March 30, 2010

How big are your risks? What is the outcome? What can I do about it?

Simply treating all risks that you may be exposed to in your business “as equal” in your business plan doesn’t really help you manage them effectively, nor will it help an investor understand them. Further, whilst you probably know intuitively that some are more likely than others to occur, an investor who doesn’t really know you, will be left thinking you haven’t really thought them through.

I had a lot of exposure to risk in my investment banking career, and have subsequently carried this discipline to business. Of course, the risk metrics used in the investment banking world has been proven to be flawed post GFC, but the framework of assessing risk is a good one.

That is – for any given risk, a bank assesses what is the probability of it happening and what is the likely impact, and what are the mitigating actions to minimize the risk and or address the outcomes if it does happen. I don’t think Lehmans were very good at assessing risk to put it lightly but the framework was there I am sure.

It is pretty straightforward when all we are talking about is numbers – and when you have huge statistical ddatabases at your fingertips:

eg $100,000 invested in a company is a $100,000 at risk.

A) What’s the worst case scenario? $100,000 loss.

B) What is the probability of this happening? Using statistics, the bank would consider that, on average, it should be expected that a loss will occur x% of the time [averages proved to be a very expensive metric to rely upon in the run up to the GFC – as it was not an average event].

C) What can we do to reduce the impact of risk?

a. not take one [and not get a return] or

b.hedge.

Hedging is generally the preferred option.

I am not suggesting that it is necessary to develop the level of sophistication that a bank might have in their assessment of risk, but we can apply similar principals that will add enormous clarity on what the risks are in your business. It is not necessary to get too hung up on the exact score you give something your gut will tell you.

In business and ideally in your business plan, your assessment of risk can follow a similar framework as follows:

  • State the risk – in wordss is fine
  • Apply a score between 1-10 to show the probability of occurrence
  • Apply a score between 1-10 to show the impact of such an occurrence
  • Take the product of the probability and impact scores
  • Rank them
  • Add in a mitigating action to minimise the impact
  • Are there any actions that can be taken to minimse the actual risk of it occurring?

Here are some examples of how risk in your business might be presented – you wouldn’t have all these entries in your assessment only one for the risk of death of the owner for example – the ones listed are only for illustration purposes:

risk-assessment

Assessment of risk is A LOT more subjective in business in general than lending money. But attempting some sort of objective assessment like the above will go along way to demonstrate you have a handle on the overall risk of being in business.

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Understanding Private Equity and Venture Capital

January 15, 2010

Some Great Definitions

This is a useful overview of some main points, as provided by VentureCapitalSA

Can private equity help my business?
If you are aiming to start up, expand, turnaround, buy into or buy out a business, private equity funding could help you. Private equity investors are seeking unlisted businesses with potential for growth who are willing to trade a share in the company for investment. Private equity funding is provided to businesses in all sectors including food, technology, retail and manufacturing.

Do I need a private equity partner?
For private businesses, finding the money required to achieve significant growth can be the biggest factor prohibiting expansion. If you are willing to trade a share of your business to an experienced private equity investor, you stand to benefit from not only the injection of money but also the experience and skills of your new partner. Private equity investors aim to increase the profitability of their investment companies by providing a stable base for strategic decision making, not by taking day to day control. Think of it this way: you may have a smaller percentage ownership, however in a few years, that percentage should be worth more than the whole of your business was before. However, if you are not willing to release a share in your business, private equity investment is not suitable for you.

Expansion
The company is now established and requires capital for further growth and expansion. The company may or may not have made a profit at this stage. This may be a period of rapid growth and the company will usually require several rounds of capital injection as it achieves the milestones set in the business plan.

How does private equity work?
Private equity investors receive an agreed share of the company in return for the risk of investing. The investor is a business partner, sharing the risks and successes of the company. Funding through private equity is very different than receiving a bank loan. Repayments for bank loans must be made according to a contract, regardless of the success or failure of your business. Private equity investors hold a stake in your company and their return on their investment is dependent upon your business growth. Many private equity investors provide management expertise and experience, contacts and discipline. The investor has to be very careful about their investment because of the high risk in a company failing. They therefore have to check that the information provided is correct (due diligence) and they seek returns that are very high. In general, private equity investors are interested in companies which have the potential to significantly increase turnover within 2-5 years.

How does the investor realise their return?
The investor will want an eventual exit, there are a few ways they can exit the business and it is important to have an exit strategy agreed as early as possible. Ways for an investor to leave a company and realise the return on their investment include: 1. Sell the shares back to you for a profit 2. Sells shares to another investor 3. Sell when the whole company is bought by a larger company 4. Help list the company on the stock exchange

IPO (Initial Public Offering)
The sale or distribution of company shares to the public for the first time (i.e. listing on the Stock Exchange).

Management Buy-in (MBI)
These are funds provided to enable a manager or group of managers from outside the company to buy in to the company.

Management Buy-out (MBO)
These are funds provided to enable current operating management and investors to acquire an existing product or business from a public or private company.

Pre-listing (or pre-IPO)
Investment into a company where it plans to list on the Stock Exchange, usually within a period of a few months to two years.

Pre-seed / R&D
Refers to funds used to expand the concept and advance product development, usually during the research and development phase of the business.

Seed
Provided to companies which have not yet fully established commercial operations, and may also involve continued research and product development.

Start-up
The company is in the process of being set up or may have been in business for a short time. Such firms have not yet sold their product commercially and have no track record. Investee companies have completed the product development stage and require funds to initiate commercial manufacturing and sales.

What do investors look for in a company?
In order to gain private equity investment a company must be able to demonstrate: – A product or service with a unique selling point – A business plan showing growth prospects and the ambition of the company – An effective management team with relevant experience Efficient financial management – A planned strategy for offering a share in the company in return for investment

What is a Business Angel?
“Angel” investors tend to be wealthy individuals who may look to invest in a high-growth company that has synergy with their own business or competes in a market where they have succeeded. “Angel” investors generally invest in small businesses in deals considered too small for private equity firms. Typical “angel” investments are around $10,000 to $1 million. As “angel” investors generally invest in companies within their own expertise, the investor may seek a hands-on role in the management of the company or will look to act as the company’s mentor.

What is a private equity firm?
Private equity firms are fund managers who invest capital on behalf of institutional clients such as superannuation funds and insurance companies. They are exposed to the risk of the company failing and as a result, look to invest in companies which have the ability to grow very successfully and give higher than average returns to compensate for the risk. When private equity firms invest in a business they become part owners and generally require a seat on the company’s board of directors. They usually do not take day to day control.

What is private equity?
Private equity is finance provided in exchange for an equity stake in a company. Private equity is provided on a medium to long term basis and provides a capital base for future growth. Investors can provide strategic operational and financial advice based on experience with other companies in similar situations.

What is the difference between Private Equity Firms and Angel Investors?
Private equity firms are professional investors who dedicate all of their time to investing and building innovative companies. The angel investor is an individual who invests in companies for their own interest. Typically angel investors invest less than $1 million in any particular company, whereas private equity firms usually invest more than $1million per company. Angel investors are usually successful business people who have spare cash that they see achieving comparatively little in their bank accounts. The value of angel investors is that they often back and finance small businesses. Angel investors expect a return on their money of at least 30% and want equity as a security for risk. Angel investors generally invest in companies within their own expertise; the investor may seek a hands-on role in the management of the company or will look to act as the company’s mentor.

What is venture capital?
The term Venture Capital refers particularly to the private equity investments made at the very early stage of a business in order for the business to grow and develop. The terms Private Equity and Venture Capital are often used interchangeably.

What rate of return do Private Equity Firms expect?
Private equity firms tend to favour high growth companies that are likely to provide them with a high rate of return. The rate of return sought will vary with the risk: seed and start-up deals are considered very high risk and the minimum rates of return sought over the life of the investment will generally be around 30-40 percent per annum and above. As the perceived risk diminishes with the early expansion stage, expansion stage and management buyout and buy in deals, the minimum annualised rates of return may reduce to the 20-30 percent range. Investors generally look to exit the investment after three to seven years. The private equity firm only realises a return on their investment if the company goes public (IPO) or is merged or purchased by another company. In some cases the investment will be sold to another private equity firm.

Where do Private Equity Firms get their funds?
Most private equity firms raise their funds from institutional investors such as pension funds, insurance companies, endowments, foundations and high net worth individuals.

Who provides private equity?
Private equity is provided by private equity firms and by business angels

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Financial Modelling – Tips To Getting It Right

January 11, 2010

A sound financial model and projection is one of the core ingredients of a business plan.

Here are some thoughts on how to do it right.

1. Keep it real. Don’t overstate sales projections. It is a common enough mistake to make because human nature says we want to put the best case forward. The solution is to have various scenarios, assign some probabilities, and tell an investor honestly what needs to happen to reach these targets.

2. State assumptions clearly in the projection, so the investor knows what it is based on (fact, opinion or fiction).

3. Make it easy to adjust and show the consequences – what if sales are lower, what if churn is higher, what if our costs decrease, what if our main customer leaves? Investors are a (justifiably) cynical bunch, so you need to be able to lay out a best case and a worst case scenario.

4. Show the impact of growth on cash flow. As sales increase, what is the increased need for further capital. This will show an investor not only how much they’ll need to put in, but when.

5. Acknowledge knowledge gaps. If you don’t know something, that is OK. Explain the gap in the knowledge and either how you’ll get the knowledge, or its likely impact if you don’t. If you claim to know everything, it’ll be clear you are not being honest.

6. Focus on readability – it’s easy to get wrapped up in the complexity of your own spreadsheet and end up with a wall of numbers which is incomprehensible. KISS (Keep It Simple Stupid). Use clear labels, colour code, space, and remove less material variations (put them elsewhere). Separate inputs and variables from calculations – so the user can see what they can adjust.

7. Get in a pro. You may be surprised by what you can achieve in Excel. For a small investment (a few hundred to a few thousand dollars) you can may build something which becomes a key factor in winning over an investor. Remember the quality of the brief to the programmer may have a major impact to the success… don’t assume they know anything about your industry. Explain everything.

8. GIGO (Garbage In Garbage Out). Get good input figures.

Scotia Macleod provides financial modelling services as part of its corporate advisory role.

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Venture Capital – 2009 Industry Overview

December 25, 2009

avcal_cover2009 AVCAL Venture Capital Report

2009 – A year in summary 2009

AUSTRALIAN PRIVATE EQUITY AND VENTURE CAPITAL ASSOCIATION LIMITED (AVCAL) AVCAL was established in 1992 as a forum for participants in the private equity and venture capital industry. AVCAL is the central voice of the Australian industry and its membership includes almost all the domestic, regional and global private equity and venture capital firms active in Australia.

This is the report of 2009 as prepared by Ernst & Young – The survey results are based on the FY2009 activities of 63 Venture Capital and Private Equity firms, representing $24.5b in funds under management.

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Introduction to Angel Investing

December 24, 2009

Tom McKaskill is one of the most well known and respected Australian authors on the subject of raising capital. Enjoy this ebook download!

Introduction to Angel Investing ebook

Angel Investing

Angel Investing

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Writing An Effective Venture Capital Business Plan

December 11, 2009

Writing an effective venture capital business plan can be a challenging task to say the least. Business plans for venture capital require strength, determination and quality since you are going to be talking to the investors that hold the key to the future of your company in their hands.

Unfortunately, no more than 2 to 5 percent of companies looking for venture capital actually succeed with their goal.Some fail on the first attempt and give up, others learn from the experience, correct the mistakes they made with their first venture capital business plan and strategies and go back to the venture capitalists for a second, third and forth time before they get the growth capital they require.

The small percentage (2-5%) that succeed in getting a venture capital investment for their business probably know something that the others don’t!  Those that are successful in getting venture capital know how to position their companies in front of the venture capitalists, they know how to present them to capture the attention of their prospective investors and in many cases this is done in the first instance by the presentation of aneffective venture capital business plan.

It is obvious that this is no small achievement given the small number of people that are successful in finding growth capital from investors, so what did they do?

Here is a closer look at a few things that you can do:

1. Position Your Company – This means being in a successful industry with the potential for growth, ideally one that the prospective venture capitalists know well. Having a chain of ten successful stores is a very strong recommendation and would help your prospects as would the vision of ten successful stores presented in the right business plan to the correct group of venture capitalists.

2. Venture Capitalists Want A Sense of “WOW” – The initial response to your VC business plan needs to create a WOW factor.  An effective business plan is one thing, but a business plan that makes people sit up and take notice is another.  Having a WOW factor in your business plan doesn’t have to mean you set unrealistic goals, it just means that the vision you have, and your mechanism for implementing it are in line and that the venture capitalists reading your business plan can envision it coming to place with the correct injection of growth capital for your business.  The presentation may not be everything, but without it, there is nothing.

Business plans for venture capital will have the most unique approach of all. Venture capital business plans cannot be “canned”. Entrepreneurs who use business plan templates at this level of funding just won’t get this level of funding, its as simple as that.  The people who are reviewing these proposals have seen hundreds if not thousands of business plans and know which ones are genuine and which ones are from the wanna-bees.

A venture capital business plan presentation must be sophisticated, complete, accurate and, yes, it must also be dynamic. It must represent the company just like an ad in The Financial Review or The Australian would represent the company.

More than any other type of business plan, yours must have a solid foundation of marketing stats. Research, research, and more research.

You should create the most outstanding business plan possible. Sometimes there is no second chance at some venture capitalists, so make that first impression count.

Create an outstanding website. Whether your company’s business is based on the internet or not, a strong presence here is essential to convey your professionalism and seriousness to the potential investors.

It’s an mistake to believe the catchphrase that venture capitalists don’t invest in companies, they invest in people. Without doubt, an exceptionally strong management team with a so-so product will get a better response than a weak entrepreneur with a good product. The theory is that it’s easier to improve a product than it is to improve the people behind it. So strut your stuff — the VCs are watching. (This means you should “make that business plan so outstanding that they can’t refuse it, no matter what the product is.”)

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