In this lesson, we're going to begin comparing and contrasting the different sorts of equity investors. There are three broad categories of equity investors, venture capital and angel investors, private equity investors, and institutional and retail investors. Let's first describe each of these investors keeping in mind that they're all buying common shares of the company. But what really differs is their their risk tolerance and their expectations of return. Now, venture capital is all about taking an early stage business and growing it into something fantastic. venture capital is different than any other types of equity financing in that it focuses on early stage companies, companies that are inevitably going to be losing money and may not even have revenues at all yet.

So venture capital investing is not for the faint of heart and it can actually Be a lot of work for the investors themselves. Venture Capital usually takes place after seed financing which may originate from your app FF money member, your family, friends and fools. But often prior to a commercialization venture capital may continue throughout the company's growth phase. The early stage nature of many venture capital investments makes the valuation of these investments less scientific and places a greater reliance on professional judgments. In the first round of financing, the venture capital company typically targets to obtain anywhere from a quarter to a third ownership in the company, based on whatever capital is required to hit, you know, the next major milestone. And because the company lacks a historical track record, it really has no tangible asset equity value yet, so the valuation to determine how many shares are issued to the venture capitalists are determined using a variety of others.

Other techniques such as an implied valuation based on say a previous financing, or perhaps by comparing this company with other transactions in the same sector, or perhaps just comparing the capital invested today with the funding that is required. Sometimes there may be financial models involved that use a discounted cash flow analysis or perhaps using a backward looking assessment of the potential exit value to back into a target IRR. venture capital financing is different than other equity type financing arrangements in that venture capital is a hits based business model, the investor recognizes that some of their investments may be worth zero, and therefore, the few investments that succeed must significantly succeed and offset all of these other potential losses. So, a typical venture capital fund may may say 10 investments so which You know, say six will eventually perhaps fail or a mountain Not much, three, maybe, you know, moderately successful, but only one of those investments is really going to be that home run, and may sell for many multiples of venture capitalists initial investment.

Now, venture capitalists are most often looking for disruptive technology that will produce gigantic returns of successful venture capital firms tend to have an area of expertise which enables the venture capitalists not only supply capital to the company, but expertise as well. venture capitalists are active into the decision making processes through their industry involvement, and they can supply the company with knowledge and connections to advance the company's business plan. Some of the common sectors for venture capital focus, include those that you see on the screen listed in front of you. Let's just walk through a quick example so that you get an idea as to how venture capital investors talk when they're making a an investment. So let's just say that ABC is the company and it needs $3 million of financing and approaches VC firm. VC firm determines that the value of the company is $10 million.

Based on the business plan and it's $3 million investment for rich it desires a 30% interest. So those are case facts. Now, venture capitalists often talk about pre and post money valuation of a company. The pre valuation is the value of the company before having received the investment from the venture capitalist. On the other hand, the post money valuation incorporates those funds received by the venture capitalists. As we work through this example, notice that the pre money valuation is $7 million or $1 40 per share.

Based on the founder retaining a 70% interest, so in other words, the venture capitalist will receive approximately 2.1 million shares for its investments. Let's just finish off our discussion of venture capital equity by looking at our dimensions of capital. The availability of venture capital is based on a pitch and a business plan much as the way you see it done on TV. The amount of venture capital money is relatively small, ranging from a few hundred thousand dollars to perhaps a few million dollars. The amounts may come in to the investi and trenches as milestones are hit, and this protects the investor from losing their entire committed investment. Now, the term of venture capital can be any period of time typically up to say 10 years because it can take several years for the company to move from inception to the point where the venture capitalists can realize a return through either an IPO Or the sale of the business to a strategic buyer.

Now, the cost of venture capital funding is significant. It's really determined in terms of the equity ownership stake that's given up by the founders and demanded by the venture capitalists. Now, the venture capitalists often takes a position on the board of directors and may in fact play a role in management to get the company going. And if you think they're just going to buy in with the same common shares that you issued yourself as the founder of the company, well think again, their shares are likely to have special features that provide them with things such as a cumulative dividend, a prioritization feature, a conversion feature, and other protection mechanisms that put them just in front of you as the founder. Now let's move on and talk about how a conversation with private equity investors would go recognize that there is generally three types of private equity funds that are out there.

Growth capital funds invest in companies to fund growth that may not be financed using debt financing. On the other hand, a turnaround fund identifies struggling companies that are often severely undervalued and make an investment there. Some refer to these funds as vulture capital. And finally, we have management buyout funds. And these funds tend to partner with strong management teams that seek to buy out the existing ownership. This may be in the context of a go private transaction or through a succession plan.

Private Equity will exit upon the maturity of the business, either by initiating an IPO or raising lower cost debt financing and then using the proceeds to return their capital. Let's go through the dimensions of capital from a private equity investors perspective. Now private equity favors established but not you At fully performing companies, which enables them to establish their position at a reasonable valuation, private equity tends to have more dollars behind them. So you will often find that we're no longer talking about hundreds of thousands of dollars or millions of dollars as we were with venture capital, but instead 10s of millions of dollars, hundreds of millions of dollars and even billions of dollars in some of these very large private equity deals. Now, private equity is a rapidly growing class of assets, but it still remains relatively unattainable to retail investors. retail investors can only really access private equity through investments in in private equity funds or through their pension plans.

Large pension plans like the CalPERS and in California or Omar's or cast depot in Canada are huge players in this arena. These funds manage a focus portfolio of private equity investments. Now private equity investors tend to hold These securities as long term investments for periods of anywhere from three to seven years, and the securities themselves during this period are likely to be relatively illiquid. Now private equity typically seeks a return on their investment between say 18 and 25%. So it's by no means a cheap source of financing. So the key is really to find a Private Equity Partners whose interests are aligned with your own and brings both expertise, management and money.

So private equity investors often stay close to their investment through extensive upfront due diligence and later through continually monitoring their investments. Often they have seats on the board of directors. Private Equity may also participate in the strategic aspects of the business by negotiating, financing or negotiating other strategic corporate transactions. including making introductions to potential advisors, customers, suppliers buyers. So that's how our conversation with private equity investors will typically go. Let's move on to our third category of equity investors.

And this comes when a company taps into capital markets. going public means issuing its common shares to the public through a process called an initial public offering. Now, there's generally two purposes of an initial public offering. Now, the first one is to raise additional capital to fund the growth of the company and this is what would be referred to as a primary offering. The secondary purpose is to provide liquidity to the founding shareholders and this is what would be referred to as a secondary offering. Now to make an initial offering of securities through a stock exchange, the company must meet the rules of this exchange that it wishes to be listed.

On these rules will vary between exchanges, which specify that the company must be of a certain size and a certain number of shareholders or thresholds along these lines. In addition, the company will need to satisfy the requirements of the regulators, which is often done by filing a prospectus. Now, perspectives contains information to potential investors about the company. Another method of obtaining a public listing is can be achieved by conducting what is called a reverse takeover. And RTO is when a private company purchases a controlling interest, or the controlling shares of a reporting issuer that has few or no active business. These companies are commonly called shells, so both methods will achieve the same results but the mix of costs are going to vary.

Preparing a prospectus requires a significant number of professionals from lawyers to underwriters to accountants there Also costs associated with the initial listing fees. In the case of a reverse takeover, This avoids the cost of a prospectus, but may require the preparation of what is called a circular, which describes the transaction to the relevant shareholders. There may also be the cost associated with the illusion from the existing ownership in this shell company. So both of these types of transactions have a degree of complexity to them. That will require you to at least start thinking about it six months to a year in advance before you can begin executing it. underwriters function as the broker for the company shares by finding buyers.

The price for the shares is determined between the company and the buyers and it's the responsibility for the lead underwriter in a successful offering to help ensure that the price support for the shares is there once they begin trading. Now many underwriting agreements call for what is called a green shoe, legally called an overall allotment option. And this gives the underwriters the right to sell additional shares of a registered security offering at the offering price. Generally for a period of unlimited number of days after the the IPO date, the green shoe can vary in size and is often up to 15% of the original number of shares offered, and is included on this rationale that it's a price stability mechanism. However, from the company's point of view, generally management tries to minimize the size of the green shoe. And of course, the underwriters want to make it larger because it's another potential source of profit for them.

Now, the terms of the underwriting agreement may vary in terms of who takes the risk of selling the IPO at the particular price, as well as the size of the underwriting commission costs. Which can vary between five and 12% of the offering proceeds, not an insignificant amount. Now a bought deal occurs when an underwriter purchases securities of an issuer before the preliminary prospectus is filed. The underwriter in this situation is acting as a principal rather than an agent. And there's other types of underwriting agreements as well that may shift the risk and the burden of the issuance between the underwriter and the issuer. But most deals done these days are done on a bought deal basis.

Public equity investors typically have a lower expectation of return than our venture capital and our private equity investors. And this helps drive down the cost of equity. public companies tend to have an established track record associated with them less they never go public without a compelling story that sells the initial shares to the public in the form First place. The second reason is by virtue of being a listed entity on a trade exchange, the value in the liquidity of the company is enhanced. This means that investors can buy and sell shares over short periods of times, sometimes multiple times in the same day. This feature alone drives down the cost of equity for a public company.

The cost of public financing can range from say the mid single digits for a large safe blue chip company, like a utility or a real estate income trust to the high teens for a small capitalization company. From a company's perspective, all these sorts of investments represent permanent sources of capital, and there's typically no terms or condition attached to the common shares unless they are of a special class. An example would be multiple voting shares issued to founders to make Take control of the company. Regardless of whether the investors choose to hold or sell their positions does not change the fact that the shares are issued and outstanding and the company has received the net proceeds on issuance. Investor Relations is a function inside the finance group that coordinates the company's communications with its investor base. A key objective of the investor relations is to ensure that as closely as possible, the share price reflects the intrinsic value of the company.

When the share price trades at a substantial discount, the company faces a risk of becoming a takeover target or significantly diluting existing shareholders if it needs to raise additional equity financing in the future. So in closing, bear in mind, the financing lifecycle that we discussed in our opening lesson, understanding the maturity level of your company are going to help you to approach the right sorts of investors and seek the right terms and conditions for the issuance of share capital. In our final lesson, we're going to put together all these lessons and walk through a case study of a financing strategy. Until then,