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Venture Capital

See Also:
Every Business Has A Funding Source, Few Have A Lender
Don’t Tell Your Lender Everything
Due Diligence on Lenders
The Relationship With Your Lender
What Does A Lender Want To Know?

Venture Capital Definition

The Venture Capital definition is a funding source for start-up businesses or turnaround businesses. There is typically more risk associated with these types of investments, but high returns as well.

Venture Capital Meaning

The Venture Capital meaning is when a lender, usually a private equity group or high net worth individuals, provides financing for a new business, a business that needs cash for growth, or a company attempting to make a turnaround. Associated with these different business needs are the different stages of venture capital.

Seeding Stage

The first stage for the companies that are just starting up is known as the seeding stage.

Growth Stage

The next stage is the growth stage for those businesses that are not quite ready for an Initial Public Offering (IPO), but are in need of some financing to get them to that point. Often times venture capital firms provide the funding for these companies knowing that they are high risk. However, these lenders usually earn a high return as these companies go public. This is because the lenders receive large compensation in the form of equity in the company or a large cash settlement. If a company is in a turnaround stage this is the highest risk of venture capital.

Exit Stage

The exit strategy in this stage often go for a much higher cash option or equity stake than even the first and second stages of company development. This type of capital is often necessary because the companies in need of this financing are not large enough to obtain the capital from the markets in the quantity needed.

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venture capital, Venture Capital Definition, Venture Capital Meaning

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Progress Billing Example

Find a progress billing example below.

Progress Billing Example


UNCONDITIONAL FINAL WAIVER AND RELEASE OF LIENS AND CLAIMS

OWNER: Business X, LLC.

PROJECT NAME: PRIORITY MANAGEMENT

For and in exchange of the sum of $, the sufficiency of which is hereby acknowledged, the undersigned Contractor, subcontractor, consultant, materialmen or laborer (hereinafter the “Undersigned”) warrants and represents as follows:

(1) The Undersigned has been employed by Business X, LLC. to furnish labor, materials, or services in connection with the construction of improvements on or to the above referenced project.

(2) The Undersigned has performed all labor, materials, or services required under its Contract, Subcontract or Purchase Order in full compliance with all terms and conditions thereof, and all applicable plans and specifications.

(3) Any and all contractors, subcontractors, laborers, suppliers and materialmen that have provided labor, material, or other services to the Undersigned for use or incorporation into the construction of the improvements to the Project have been paid in full for all amounts due and owing to them on the Project, or shall be promptly paid in full from the proceeds of the payment referenced above and there are no outstanding claims of any character arising out of or related to the Undersigned’s activities on or improvements to the Project. If this Waiver is signed by the Prime Contractor, then attached hereto as Exhibit A is a complete list of all subcontractors and suppliers retained by such party as of the date of this Waiver.

(4) The Undersigned waives and releases any and all liens, lien rights, claims of liens, and any other claims for payment for labor, material or equipment of any type or description that it may have against the Owner, the Owner’s Project Manager, the Owner’s Engineering Consultant, the Architect for the Project, the Prime Contractor (if this Waiver is signed by a subcontractor or supplier) and/or any person with a legal or equitable interest in Project, arising out of or in any fashion related to, any labor, materials or services furnished by, through or under the Undersigned on, or used in connection with, the Project, without exception.

(5) This Final Waiver and Release constitutes a representation by the Person signing this document, for and on behalf of the Undersigned, that the payment referenced above constitutes full and complete payment for all work performed and costs or expense incurred (including, but not limited to, costs for supervision, field office overhead, home office overhead, interest on capital, profit and general conditions cost) by, through or under the Undersigned relative to the work of improvements at the Project, including all retainage. More specifically, the Undersigned hereby waives, quitclaims, and releases any claim of damages due to delay, hindrance, interference, acceleration, inefficiencies or extra work, or any other claims of any kind it may have against the Prime Contractor (if this Waiver is signed by a subcontractor or supplier), the Owner, the Owner’s Project Manager, the Owner’s Engineering Consultant, the Architect for the Project, and/or any other person or entity with legal or equitable interest in the Project.

IN WITNESS WHEROF, the person signing this document, acting for or on behalf of the Undersigned and all of its employees, subcontractors, laborers, suppliers and materialmen, executes this document this _________ day of _____________________ , 20_______ .

By:________________________

Title: _______________________________

This instrument was executed and acknowledged before me on this ____________ day of ___________________, 20___ , by _________________________ , on behalf of said entity.

Notary Public


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See Also:
Progress Billing for a General Contractor

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Mezzanine Debt Financing (Mezzanine Loans)

See Also:
Recapitalizing Your Company Using Mezzanine Financing
Angel Investor
Venture Capitalist
Why Venture Capital
What is a Term Sheet

What is Mezzanine Debt Financing (Mezzanine Loans)?

Mezzanine debt financing is a subordinated and unsecured loan which typically features a warrant. This type of debt has higher interest rates because of its subordinated and unsecured status. It is not backed by collateral. In the event of debtor default, the claims of mezzanine lenders are senior only to the claims of common shareholders. Therefore, use mezzanine debt to finance startup companies with growth potential or to complement other forms of debt in a leveraged buyout.

Like other debt instruments, mezzanine debt includes a contract that stipulates the details of the loan. The contract describes the amount of the loan, the rate of interest and the interest payment schedule, the due date for principal repayment, and whether or not there is a conversion feature. The loan may also allow a portion of the interest payments to be accrued over the life of the loan and paid along with the principal at maturity. This feature is payment-in-kind.

Interest rates on mezzanine loans are substantially higher than other types of loans. This is to compensate the lender for the riskiness of making a subordinated and unsecured loan.


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Mezzanine Lender

Mezzanine lenders are often private equity funds or venture capitalists. Therefore, consider these mezzanine loans speculative investments. The debt instrument provides a stream of income and some downside protection, while the warrant feature offers the potential for upside gains.

Advantages and Disadvantages of Mezzanine Debt Financing

For borrowers, mezzanine debt financing allows companies with less collateral to secure funding for growth. On the other hand, the interest rates on this type of loan are comparatively high. So it is expensive source of capital.

For lenders, mezzanine debt instruments offer higher yields than secured or more senior forms of debt. Also, the warrant feature offers the promise of gains if the borrowing company’s equity increases in value in the future. On the other hand, there is a greater risk of default because the claims are subordinate and unsecured.

Mezzanine Capital

Mezzanine capital refers to subordinated and unsecured debt or preferred equity. It often includes a warrant, or a conversion feature, that allows the lender or investor to convert the debt or preferred stock into a specified quantity of the company’s common stock at a set price within a stated period of time.

Equity Warrants

The equity warrant feature of mezzanine capital allows the lender or investor to convert the loan or preferred stock into a specified quantity of the company’s common stock at a set price within a stated period of time. Design it to give the lender or investor an equity stake in the possible future success of the company.

Mezzanine Meaning

The word “mezzanine” derives from the Italian diminutive form of the word “middle.” Use it to describe the lowest balcony in a theater.

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Mezzanine Debt Financing, mezzanine loans
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Initial Public Offering (IPO)

See Also:
Finance Beta Definition
Stock Options Basics
Employee Stock Ownership Plan (ESOP)
Blue Sky Laws
Subscription (Preemptive) Rights

Initial Public Offering (IPO) Definition

An Initial Public Offering (IPO) is the process of selling a company’s stock to the public for the first time. Before the IPO the company is private; after the IPO the company is public. The IPO process is typically underwritten by a syndicate of investment banks. The process follows several steps, described below.

Advantages and Disadvantages of IPOs

Going public has at least two advantages: greater liquidity of equity and access to a larger pool of capital. There are at least three disadvantages to going public: dispersion of control, required adherence to regulations and public scrutiny.

IPO Process

The IPO process includes the following steps:

1. The company chooses a syndicate of underwriters (see below)
2. The company and the underwriters compose a preliminary prospectus (see below)
3. The SEC reviews the prospectus and approves the IPO
4. The underwriters determine the value of the firm and the structure of the IPO
5. The underwriters go on a road show to gauge investor interest in the IPO (see below)
6. The investors express level of interest and the underwriters set the offer price
7. The securities are distributed to the public (see below)

Underwriter Duties

In the IPO process, the underwriters – a syndicate of one or more investment banks – are responsible for registering the IPO with the SEC, valuing the company that is going public, structuring the issuance of securities, pricing the securities, and marketing the securities to potential investors. The underwriters also bear the risk of distributing the securities.

Preliminary Prospectus

The preliminary prospectus, or red herring, is a legal document that must be submitted to the SEC for approval prior to an IPO.

The document includes details about the company, including an explanation of the company’s operations and competitive position, and copies of its financial statements. The document also includes the details of the IPO, including the type of security (common stock, preferred stock, etc.) to be offered, the number of shares to be offered, and the anticipated share price.

Road Show

A road show is when the underwriters travel the country, or the even the world, to pitch the IPO to potential investors. The idea is to determine whether investors are interested in the offering. And if so, then they need to determine how many shares they will purchase and what price they are willing to pay. The investors are typically large institutional investors – mutual funds and pension funds.

IPO Pop

Underwriters take on significant financial risk when they commit to an IPO. If the market is not interested in the offering, then the underwriters may be stuck holding securities nobody wants.

In order to ensure market interest in the offering, underwriters will often deliberately under-price the securities for the initial public offering. They sell it for cheaper than it is worth. So when the shares go public, investors buy up the bargain-priced shares. This causes them shoot up in value on the first day of trading. You may know this as the “IPO pop.”

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Initial Public Offering

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Initial Public Offering

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Financial Leverage

See Also:
Finance Beta Definition
Finance Derivatives
Hedge Funds
Hedging Risk
Financial Ratios

Financial Leverage Definition

In finance, leverage refers to using borrowed capital or financial derivatives to magnify the results of an investment.

The value of a leveraged investment is greater than the value of the original capital contributed by the investor. When leveraging an investment, the potential gains are greater than they would be without leverage. Likewise, the potential losses are also magnified with leverage.

The idea is to borrow funds and then to invest those funds at a rate of return that exceeds the interest rate on the loan. If the investor is able to borrow money at 5%, and then invest it at 7%, that investor can pocket the difference. And if such an opportunity exists, the investor would want to lever up as much as possible – that is, borrow as much money as possible at 5% to invest at 7%.

There are several ways to utilize financial leverage. The investor can take out a loan, a company can increase leverage by issuing debt instruments, an investor can borrow funds on margin from a broker and invest those funds, and investors or companies can engage in financial options contracts. These are some of the methods available for utilizing financial leverage.

Leveraging Example

For example, image you have $100 dollars to invest. And you are very certain that the stock you’ve picked will go up by 10%. With your measly $100, a 10% increase will give you only ten bucks of profit.

If, however, you are able to borrow enough money that you can invest $100,000 dollars in your chosen stock, then the expected 10% increase will yield a more significant amount, $10,000.

On the other hand, leveraging has a downside. Let’s say you borrow the $99,900 dollars and invest it, along with your original $100 dollars, in your chosen stock. But instead of going up 10%, it goes down 10%. Now you may be in big trouble. You’ve lost your $100 dollars and you owe the lender $9,900 dollars.

Levered Firm 

Leverage also refers to the amount of debt a company takes on. If a company borrows a lot of money, via bank loans or by issuing bonds or other debt instruments, that company is considered highly levered. A company’s debt-to-equity ratio is one way of measuring how much leverage a company has employed.

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Weighted Average Cost of Capital (WACC)

See Also:
Capital Asset Pricing Model
Cost of Capital Funding
Arbitrage Pricing Theory
APV Valuation
Capital Budgeting Methods
Discount Rates NPV
Required Rate of Return

Weighted Average Cost of Capital (WACC) Definition

The weighted average cost of capital (WACC) definition is the overall cost of capital for all funding sources in a company. Weighted average cost of capital is used as commonly in private businesses as it is in public businesses.

A company can raise its money from the following three sources: equity, debt, and preferred stock. The total cost of capital is defined as the weighted average of each of these costs.

Weighted Average Cost of Capital Meaning

Weighted average cost of capital means an expression of the overall requited return on the company’s investment. It is useful for investors to see if projects or investments or purchases are worthwhile to undertake. This is equally as useful to see if the company can afford capital or to indicate which sources of capital will be more or less useful than others. It has also been explained as the minimum return a company can make to repay capital providers.

WACC Formula

The most popular method to calculate cost of capital is through using the following Weighted Average Cost of Capital WACC formula.

WACC = Ke *(E/(D+E+PS)) + Kd*(D/(D+E+PS))*(1-T) + Kps*(PS/(D+E+PS))

Where:
Ke = cost of equity
Kd = cost of debt
Kps= cost of preferred stock
E = market value of equity
D = market value of debt
PS= market value of preferred stock
T = tax rate

Ke reflects the riskiness of the equity investment in the company. Then, Kd reflects the default risk of the company. Finally, Kps reflects its intermediate standing in terms of risk between debt and equity. The weights of each of these components reflect their market value proportions and measure how the existing company is financed.

Weighted Average Cost of Capital Calculation

Weighted average cost of capital calculation, though sometimes complex, will yield very useful results.

For example, a company finances its business 70% from equity, 10% from preferred stock, and 20% from debt. Ke is 10%, Kd is 4%, and Kps is 5%. The tax rate is 30%. The required rate of return of this company according to the WACC is shown below:

(70% * 10%) + (20% * 4%) + (10% * 5%) = 8.3%

That means the required return on capital is 8.3%. So, a company pays 8.3% interest for every dollar it finances.


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Weighted Average Cost of Capital Examples

For example, Tim is creating a web 2.0 startup business called Webco. Tim, an avid user of the web and recent college graduate, has quite a bit to learn. As a result, he relies off of his networking ability and mentors to receive much needed advice.

Tim has prepared a full business plan. He is now moving his company to the next level by beginning to find capital providers. He has an expected range of the returns each source of available capital will require. Now, Tim needs to use the weighted average cost of capital method to decide whether his company will be able to receive capital from certain providers.

Example Results

After doing some research, Tim is prepared to make his calculation. His results are below:

Tim’s company is considering financing its business 70% from equity, 10% from preferred stock, and 20% from debt. Ke is 10%, Kd is 4%, and Kps is 5%. Then the tax rate is 30%.

(70% * 10%) + (20% * 4%) + (10% * 5%) = 8.3% = WACC

That means the required return on capital is 8.3%. So, a company pays 8.3% interest for every dollar it finances.

Tim’s company, according to his calculations, will not be able to create the returns required to work with the mix of capital which is listed above. He resolves to do more research and then come back at the problem with a new approach.

Overall, this satisfies Tim. Though he has not seen the results that he was looking for, he was able to avoid a costly mistake by creating a plan before he began. He has confidence that despite this setback his career has a bright future.

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Weighted average cost of capital, WACC Formula

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Cost of Capital Definition

See Also:
Arbitrage Pricing Theory
Capital Budgeting Methods
Discount Rates NPV
Required Rate of Return
APV Valuation

Cost of Capital Definition

The cost of capital definition is a company’s cost of funding. Depending on the company’s capital structure, the cost of capital will incorporate its cost of debt as well as its cost of equity. Cost of debt refers to the company’s cost of raising funds through debt financing; whereas, cost of equity refers to the company’s cost of raising funds through equity offerings.

The cost of capital of a business represents the market’s required rate of return on capital invested in that company. It equals the rate of return on a project or investment with similar risk. A company’s cost of capital is the rate of return the company would earn if it invested its capital in a company of equivalent risk.

For a corporate project, cost of capital equals the rate of return on an investment or project of similar risk. The project cost of capital is the required rate of return, or hurdle rate, for the project. The expected returns of the project or investment must exceed the project cost of capital for the project to be deemed a worthwhile investment opportunity.


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Determining the Cost of Capital

Evaluating a project or investment requires determining the cost of capital. The investment will be attractive as long as the expected returns on the project or investment exceed the cost of capital. The cost of capital can be the cost of debt, the cost of equity, or a combination of both.

Cost of Debt

A company’s cost of debt represents its borrowing costs on loans, bonds, and other debt instruments. It is the company’s debt financing costs. A higher cost of debt means the company has poor credit and higher risk. A lower cost of debt implies the company has good credit and less risk.

Calculating the cost of debt is relatively simple. It is the interest rate on the company’s debt obligations. If the company has numerous differing debt obligations, then the cost of debt is the weighted average of those interest rates.

Cost of Equity

Cost of equity refers to the market’s required return on an equity investment. It is the return required to get investors to purchase shares of a company’s equity. Furthermore, investors will demand a specific return for invested capital given the risk of the equity investment. The cost of equity, which compensates investors for time value and a risk premium, is that required rate.

You can either calculate the cost of equity by using the capital asset pricing model (CAPM) or the dividend capitalization model. It can also be estimated by finding the cost of equity of projects or investments with similar risk. Like with the cost of debt, if the company has more than one source of equity – such as common stock and preferred stock – then the cost of equity will be a weighted average of the different return rates.

Cost of Equity Formula

The following formula is the dividend capitalization model, or the cost of equity formula.

Ke = ( D1 / P0 ) + G

Ke – cost of equity
D1 – next year’s dividend
P0 – current stock price
G – dividend growth rate

Weighted Average Cost of Capital (WACC)

Combining the cost of equity and the cost of debt in a weighted average will give you the company’s weighted average cost of capital, or WACC. This rate can also be considered the required rate of return, or the hurdle rate of return, that a proposed project’s return must exceed in order for the company to consider it a viable investment.

If you want to find out more about how you can add more value to your organization, then click here to download the Know Your Economics Worksheet.

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