Where is the Capital venturing anyway?

We’re all familiar with how buying shares of stock in a company represents ownership in that company. We buy a share, the company gets a little infusion of cash, and we are now owners along with everyone else who bought shares of that company. When a company is small or just starting out, they need to get a little more creative in order to keep the lights on. Some companies start in a garage to keep overhead down and other owners max out their credit cards and tap their friends and family for a loan to keep doing what they are doing. For the next step up, when the cash flow needs are a little larger than what the Bank of Mom & Dad can handle, business owners can turn to something called “venture capital.” Well, some of those business owners can.

Women are opening businesses at a rate that is nearly parallel with men (for every 10 male drive start-ups, 8 women are jumping off the business cliff). Unfortunately, we see some stark differences when we look at the funding those businesses receive. Women-owned businesses secure less than 5% of the money venture capitalist invest with the rest going to male run companies, even when those business plans have substantially more “interesting” assumptions about growth potential, profitability, and corporate governance that those of the women run companies.

And why might this be, you ask? For a little background, we need to understand what a venture capital fund is and how it works. Essentially, a group of well-off people get together and form a company whose whole purpose is to lend money to start-up companies in exchange for part ownership in that company and, with luck, a big payday when the company is either purchased or “goes public” and gets shares of its own to list on a stock market. Traditionally, these venture capital firms have been run by men (primarily white) and since the whole “our past creates our bias” thing has some basis in fact, these men invested in men. Thankfully, more and more women are taking a look around and getting out their checkbooks.
And why might all this be important? We have some great data that illustrates how the return on venture capital invested in women owned business is higher than when those dollars are otherwise invested. The return on money invested in a company run by women and men together is also higher than money invested in a company run by all men. Further, given that roughly half of the money invested by venture capitalists over the last decade evaporated when the companies imploded, perhaps investing in something different with the dollars might generate a larger benefit – what’s the saying about doing something over and over and expecting a different response?
Since we are discussing venture capital let’s also chat about the other end of the investing spectrum. If venture capital is the mechanism to help launch a company and potentially become a publicly traded stock, private equity is the mechanism that takes many companies off the publicly traded markets (and sometimes to their death).

Once again, we are looking at a conglomerate of wealthy people who get together and form an investment company. This time, however, the whole purpose is to purchase other companies, run them (and charge management fees and sometimes performance fees), and either sell them to other private equity firms or relaunch them as public companies. There are lots and lots of private equity firms in the US; some large (KKR, with literally dozens of firms under management and some $692 billion in assets) and some relatively small (747 Capital with its baby $850 million of invested assets and a fairly focused investment objective (small cap growth companies)). Each private equity firm has their own requirements for becoming an investor (usually a significant Networth ($XXX+ millions), a sizeable buy-in ($250k to $25 mil), and a long, long investment timeline (10+ years)).

There are some pros to either investing in or being purchased by a private equity firm but there are also some cons, and some shady stuff for good measure. On the “Pro” side, when a company is struggling, a private equity firm might come in and purchase the company with the intention of sorting through the issues and making the company profitable again (assuming it ever was to begin with). Away from the pressure to continue to sustain earnings for the shareholders, companies can make more unpopular moves that are healthier for the company but perhaps less enthusiastically supported by the many stockholders. On the flip side, if additional cash flow is needed to make some of these changes, it can be harder for a privately held company to raise that cash. Very often, a firm will need to “court” a buyer for whatever division they’d like to sell, or they might need to provide very favorable payback rates if they are looking for a cash infusion to right the ship.

Once a company is held by a private equity firm, corporate transparency fades to black with little to no requirement for reporting on basically anything (perhaps a little strongly worded but not actually that far off the mark). Want to pay the management company (private equity firm) an oversized level of fees – no problem. Want to give the top two executive exorbitant pay raises while ignoring other executives – have at it. Feel like leveraging the company to the hilt, regardless of its ability to make the payments – right this way folks.

And, unfortunately, while there are some positive and uplifting stories of private equity firms rescuing a company in distress, there are far more stories of the Grimm Fairy Tale version when a company is purchased, leveraged to the hilt, then left to die in something akin to a modern-day Gibbet. Ten of the 14 largest retail bankruptcies were companies owned by private-equity firms (think Toys “R” Us with 33,000 workers laid off and gobs of debt on the books). So, there you have it – the growth, to boom, to potential bust-cycle of our current marketplace.