Capital comes in many forms. Generally, it can take the form of debt (personal and bank loans, credit card debt) or equity (common stock, preferred stock, etc.). Debt is based on an obligation to repay; equity is a piece of the action.
In addition, capital can be short term (e.g., cash-flow assistance to accelerate cash from receivables) or long term (debt with a life tied to a capital asset, like equipment or real estate). There are also hybrid forms of debt and equity—e.g., convertible debt that can be turned into equity—or preferred stocks that track the value of certain distinct classes of assets on the balance sheet.
The next question is, who provides the capital? Friends and family, banks (which are loaning out depositors’ money, not making investments in equity), venture capital and private equity are well-known choices. But venture capital and private equity are fundamentally different and driven by different investment criteria. For these reasons, their view of the value of a company can be dramatically different.
Venture capital focuses generally on companies that are either pre-revenue (a company pursuing an idea, concept, product, service, etc., but not yet generating any significant revenue), or not generating enough cash flow to pay most, if not all, expenses.
The value a venture capital firm ascribes to a company is based on an assessment of its competitive advantage, including any intellectual property that creates a competitive barrier. A VC will evaluate a company based on its likely value at the time of sale (“exit”), generally five to seven years after investment. If a company has a great idea (e.g., Google) and it is hard for companies to compete with it (e.g., software that is secret or patented), the lack of cash flow will not deter a VC. And from a company perspective, it might actually be advantageous to NOT have cash flow, in order to avoid a private-equity valuation methodology.
Private equity invests in companies that are cash-flow-positive, i.e. generating enough cash from revenue to pay expenses, and have excess cash. PE firms evaluate cash flow and judge the ability to increase cash flow post-investment, by making additional capital investments and operational improvements and by making additional acquisitions to increase the company’s size and efficiency. These acquisitions are generally referred to as “bolt-ons.”
As companies grow to a certain size, there is an increase in the multiple that a buyer is generally willing to pay—so called “multiple expansion.” So a PE investor has an incentive to cause portfolio companies to grow, not only to improve economies of scale, but also to expand the multiple they are paid at exit.
PE values its investments based on cash-flow multiples and growth projections. Generally, valuation is a function of multiples of EBITDA—earnings before interest, taxes, depreciation and amortization. So if you are running a startup that is pre-revenue and certainly pre-cash-flow-positive, you actually are better off with the VC valuation approach. This is why people who raise VC capital generally think it is better to have no revenue (but lots of people begging to get your product).
If you are looking for a PE investor, however, your choices are more along the lines of sell out now, or stay invested in the company alongside the PE firm, betting that the firm will get the company to higher performance levels, through operations improvements and bolt-on acquisitions.
Most PE firms have no interest in companies with less than $5 million of EBITDA; they just don’t move the needle on fund returns, given the size of the fund, and generally require more time and effort to get to scale. A few PE firms, however, do invest in companies below $5 million.•
Neff is a senior adviser to Evolution Capital Partners and is of counsel to the law firm of Bingham Greenebaum Doll LLP.