Venture vs. Vulture Capitalists
By William Cate
Published July 1999
[http://home.earthlink.net/~beowulfinvestments/] [http://home.earthlink.net/~beowulfinvestments/globalvillageinvestmentclubwelcome/]
In the last issue of EFS (V3#10), my Venture Capital article
reflected the current experiences of three small Silicon Valley companies.
My article generated comments from four Venture Capitalists. In essence,
there are Venture Capitalists and there are Vulture Capitalists.
Venture Capitalists fund one company in every 2,500 companies that
query them. Their preferred exit strategy is the private sale of the
company. They are willing to hold their equity in an investment for years.
They believe that they bring management and financial skills to the company
that will enhance the company's probability of success. If two-of-seven
investments (29%) succeed, they make money.
Vulture Capitalists fund one company in every 100 companies that
query them. Their preferred exit strategy is to take the company public.
They intend to recover their risk capital quickly. They bring sales skills
to the company. Their goal is to make money on every investment.
I've come across Vulture Capitalists offering toxic convertibles.
They act as Merchant Bankers offering bridge financing. They offer
secondary Private Placement financing to high flying, usually Hi-Tech
public companies.
The Merchant Banking loans require the repayment of the loan and
interest from the underwriting. The Merchant Banker demands a large bloc of
free stock for making the loan. The Merchant Banker dumps the stock quickly
into the Market. About two years ago, the SEC moved to stop this practice.
Any outside party considering doing Bridge Loan financing for a bloc of
stock is asking for trouble from the SEC. Without the stock incentive, the
bridge loan is too risky. After all, only half the IPO's are underwritten.
Unless you are the underwriter, you can't be certain that the underwriting
will happen.
A Convertible Debenture (CD) is a loan that can be converted into
shares of the public company. If the lender loans the public company a
million dollars at Prime plus 3, they will make a profit. A CD loan allows
the lender to convert the loan into shares of the company. If the CD allows
the loan to be converted at $4/share and the company's share price goes to
$10, the lender makes more money on the stock sale than from the
conventional loan. Convertible Debentures are popular in Canada because the stock issued is free trading. They haven't been popular in the States,
because the lender gets restricted (144) stock.
Toxic Convertibles are Convertible Debentures with an unspecified
exercise price for the shares. The lender can convert the stock at the
current trading price of the shares. This allows the lender to sell short
the stock against the CD while recovering the loan and interest. The short
sale of stock depresses the company's share price. The lower share price
allows the lender to sell short more stock. It's a downward cycle for the
public company's stock. The CD is used as insurance against an upward surge
in the company's share price. The Toxic Convertible lender can't lose.
If a public company does a toxic convertible, by the time they
repay the loan, their stock is trading for pennies a share. The public
company fails and the lender makes a multiple of the principal of their
loan.
The moral of this story is that public companies should be wary of
Vulture Capitalists. Read and understand every word of every Agreement,
before you sign it.
To contact the author: Visit the Beowulf Investments website: [http://home.earthlink.net/~beowulfinvestments/] Or, visit the Global Village Investment Club Website:
[http://home.earthlink.net/~beowulfinvestments/globalvillageinvestmentclubwelcome/]
About the Author
He has been the Managing Director of Beowulf Investments [http://home.earthlink.net/~beowulfinvestments/] since 1981 and is the Executive Director of the Global Village Investment Club [http://home.earthlink.net/~beowulfinvestments/globalvillageinvestmentclubwelcome/]