Principles of Managerial Finance

CHAPTER 7 Stock Valuation 315

angel capitalists (angels)
Wealthy individual investors
who do not operate as a business
but invest in promising early-
stage companies in exchange for
a portion of the firm’s equity.

TABLE 7.2 Organization of Institutional Venture Capital

Investors

Organization Description

Small business investment Corporations chartered by the federal government that can

companies (SBICs) borrow at attractive rates from the U.S. Treasury and use

the funds to make venture capital investments in private

companies.

Financial VC funds Subsidiaries of financial institutions, particularly banks, set

up to help young firms grow and, it is hoped, become major

customers of the institution.

Corporate VC funds Firms, sometimes subsidiaries, established by nonfinancial

firms, typically to gain access to new technologies that the

corporation can access to further its own growth.

VC limited partnerships Limited partnerships organized by professional VC firms, who

serve as the general partner and organize, invest, and manage

the partnership using the limited partners’ funds; the profes-

sional VCs ultimately liquidate the partnership and distribute

the proceeds to all partners.

formal business entities that maintain strong oversight over the firms they invest

in and that have clearly defined exit strategies. Less visible early-stage investors

called angel capitalists(or angels) tend to be investors who do not actually oper-

ate as a business; they are often wealthy individual investors who are willing to

invest in promising early-stage companies in exchange for a portion of the firm’s

equity. Although angels play a major role in early-stage equity financing, we will

focus on VCs because of their more formal structure and greater public visibility.

Organization and Investment Stages Institutional venture capital investors

tend to be organized in one of four basic ways, as described in Table 7.2. The VC

limited partnershipis by far the dominant structure. These funds have as their

sole objective to earn high returns, rather than to obtain access to the companies

in order to sell or buy other products or services.

VCs can invest in early-stage companies, later-stage companies, or buyouts

and acquisitions. Generally, about 40 to 50 percent of VC investments are

devoted to early-stage companies (for startup funding and expansion) and a simi-

lar percentage to later-stage companies (for marketing, production expansion,

and preparation for public offering); the remaining 5 to 10 percent are devoted to

the buyout or acquisition of other companies. Generally, VCs look for compound

rates of return ranging from 20 to 50 percent or more, depending on both the

development stage and the attributes of each company. Earlier-stage investments

tend to demand higher returns than later-stage financing because of the higher

risk associated with the earlier stages of a firm’s growth.

Deal Structure and Pricing Regardless of the development stage, venture

capital investments are made under a legal contract that clearly allocates respon-

sibilities and ownership interests between existing owners (founders) and the VC

fund or limited partnership. The terms of the agreement will depend on numerous