Venture capital is the investment of funds in a privately held company. Small to medium sized companies that are in a high growth cycle will often seek financing in order to further support the expansion of the business. These businesses typically are too small or early stage to secure significant bank financing and are looking for the added resources that a venture investment partner can provide.
Venture capital is often referred to as “patient capital” as investment capital is used to fund the growth of the business and is, therefore, tied up in the business during its growth cycle. It typically takes a minimum of four or more years before a company is ready for exit via an initial public offering or merger/acquisition strategy.
Venture capital investments may be primarily divided into six stages – Seed Financing Stage, Early Stage, Mid-Stage, Late-Stage, Mezzanine Stage, and Buyout Stage.
Due to the nature and goal of the investment (active management with maximum return potential), true venture capital investments typically take the form of an equity based investment structure. Simply put, an equity investment is the best way to maximize an investor’s return potential. Once a company is ready for exit, an equity structure generally provides for a far greater return to the investor. Managers will often also structure investments in the form of convertible debt. Convertible debt is essentially, a debt instrument that will convert at a set date or milestone into equity. This structure, while not providing quite as much return potential as a pure equity investment, provides the manager with the ability to still capitalize on the return potential of a equity structure while incorporating some of the security of pre-set payments that a debt structure provides.
Covington’s investment approach is pure venture capital – the majority of our investments are structured as equity and/or convertible debt structures. Unlike a pure debt investment structure, which is passive and generally provides for lower return potential, equity-based investment structures allow Covington to take a hands-on approach to investing and maximize return potential on each investment.
Why Venture Capital is Essential to Canada’s Economy
As at 2005, venture capital funds had deployed over $20 billion into the Canadian market. By providing essential capital to small and medium sized businesses, venture capital is a critical provider of employment. Small and medium sized business employ approximately 60% of the population and are responsible for close to half of Canada’s economic activity. (Source BDC Annual Report March 2006.)
How Venture Capital Investing is Unique
Unlike a typical mutual fund portfolio, where a manager will invest in a basket of stocks that trade on a public exchange and simply trade the stocks within their portfolio, venture capital investing is an active, hands-on form of investing. Venture capitalists often take a very active role in running the companies they invest in. They provide operational, financial, and strategic guidance that help position a company for future exit. Managers will often take a seat on the company’s Board of Directors and assume key roles on major decisions affecting the company’s future. It is the role of the venture capitalists to work with, develop and nurture their investments in order to maximize their growth potential and secure the best possible exit valuations. Due to the active role of the manager, the average venture capitalist will only manage 6-10 investments at any one time.
How Are Investments Chosen
As one of the leading venture capitalists in the country, Covington is presented with hundreds of business plans each year. Of these, we select less than 5 new investments each year – investments we feel represent the best opportunities to drive the returns of the overall portfolio. Prior to funding an investment, each potential investee goes through a rigorous review process known as due diligence. This process can take up to six months to complete and includes in-depth evaluations of key elements such as management, business plans, the market, how the business operates within and their position within that space. Covington employs a number of tools when assessing a potential investment, including a proprietary questionnaire designed by one of Covington’s strategic partners – the Ivey Robarts School of Business. This valuable tool assists Covington’s investment team in assessing management’s strengths and weaknesses during the due diligence process.
How Are Returns Generated
Returns on private company investments are primarily realized only after the company has been exited. An exit is an event whereby the company is either sold via a merger or acquisition, or goes public on a stock exchange (at which time the shares in the investment are freely tradable*). Investments are held at the original investment cost until a significant event such as a third-party transaction occurs and the investment is re-valued. These adjustments are known as unrealized gains and affect change the share value of the portfolio. Most venture capital funds generate the bulk of their returns from just a few key investments. Known as the 2-6-2 rule, the general rule of thumb is that for every ten investments, two will fail, six will break even, and two will provide breakthrough performance that will drive the entire venture portfolio. It is those two investments that provide for the strong returns that venture capital is known for.
*Often an investor must hold a portion their shares for a set period of time after the investment goes public (held in escrow). After a defined period of time or when certain milestones are met, the shares become freely tradable.
