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Executive Summary
Finally, it is necessary to emphasize that the IT sphere, which is invested by Pinnacle Ventures is highly profitable and of great potential. The returns of this sphere are up to 100%, especially if potential projects are invested. The fact is that, there is proper research required for such kind of investment, as well as quick and firm decisions, as this sphere is highly competitive, and the other companies may outrun.
The characteristics of this business entail high levels of profits, this sphere is constantly developing, as investment require constant awareness about technical innovations and the physical characteristics of the invested projects. The particular project which is aimed to be researched in this paper is the Windvane investment. Venture debt, Venture capital, some forms of private equity will be assessed in the paper. Moreover, investment risks will be assessed on the basis of IRR figures, and the cash flow rates, along with the cash flow rates of other venture backed companies.
Introduction
First of all it is necessary to mention that the company Pinnacle Ventures is engaged in the sphere of capital funding concentrated on offering debt and equity financial support for the developing companies engaged in the sphere of information technology, cleantech and healthcare. The company defines its activity and profile as highly professional due to strength and diversity of the team, the creative and unique approach towards solving the problems and issues which may arise, and due to flexible financial alternatives, aimed to help the companies to achieve success.
It is emphasized that like traditional venture company Pinnacle raised funds and estimated deals. Nevertheless, instead of initial investment in the form of equity, Pinnacle is concentrated mainly on lending money to the companies which are in their start-up period, charging them interest and getting warrants that could later be converted to stock in the case of a liquidity event. Most initial investments ‑ usually in the range of $500,000 to $20 million ‑ were made in tandem with or following a company’s first round of venture capital equity financing. Moreover, similarly to other traditional venture capital investors, Pinnacle aimed to take part in the follow-on debt and equity investments among its successful companies.
Success in Building the Company
As for the activity of the company, and the creation of the professional team, as well as strict and well composed business line, it is necessary to mention that by the summer 2005 the Company has managed to raise two funds and was engaged in investing up to 50 technology and health-care companies. The financial success was measured in $100 million, and was closed in 2002. Additional $200 million were raised in a second fund which was closed in 2005.
Patrick Lee – the member of this highly professional team evaluated an opportunity to take part in a new deal. It is stated the following: “The company, Windvane Technologies, (Silicon Valley) had developed a wireless infrastructure technology and application for this technology. Originally, there was no revenue, no cash flow, and, consequently, any production could be manufactured in these circumstances. Nevertheless, Windvane raised its first round of funding ‑ a $7.5 million Series A round—from two top venture capital firms and was looking for a $5 million growth capital loan from a venture debt contributor. Lee emphasized that he had expected the essential interest in the deal from other venture debt providers, nevertheless, they missed this opportunity, and the potential and highly profitable project was fund-raised by Pinnacle Ventures.
As for the general issues of success in the sphere of ventures, it is necessary to mention that this sphere has essentially changed since its beginnings in the late 1980s and 1990s. It is emphasized that Silicon Valley Bank (SVB), Comerica Bank, and Comdisco Ventures, the venture arm of Comdisco, Inc., dominated venture lending until the downturn of the technology market beginning in the spring of 2000. Originally, the declines of the financial and stock markets is closely linked with the decline of the several large competitors such as Comerica, Transamerica Technology Finance, and GATX Financial, which based their activity on the rapid growth of internet. Finally, they were just blown out of the market.
Financial Figures
As for the financial image, it is necessary to emphasize that Pinnacle Ventures offered a wide range of financial products and services. Most of its initial investment are represented in the form of growth capital or the equipment loans. (Liebmann, 2004). As another team member Pelowski stated, approximately 65% of the company’s investments were in the form of growth capital loans, 10%–20% in the form of equipment loans, 5% were subordinated debt, and 10%–20% ‑ equity. Pelowski also evaluated that roughly 70% of Pinnacle’s debt investments were regarded as the A Series of round deals, 20% were the B Series, and the remaining 10% were later stage. (Murphy, 2005).
Pelowski Noted that the company had expected to make the more investment in the equipment sphere, however, the research showed there was no essential necessity in equipment within the most A Series stage start-ups. Lee added that the equipment sphere of business had changed essentially, and the circumstances are not so favorable that it had been expected. In the past, companies invested their servers and leased their PCs. Now they can possess servers and PCs on eBay or at Best Buy for very little. Taking into account these facts, Pinnacle Ventures team decided to make money in three ways.
Initially, it earned the incomes based on interests, received the warrants and earned the equity option to invest in the next round. Originally, the majority of the investments were made during the B round. The fact is that, this decision was grounded on the matter of receiving the equity right. Lee noted, “If we made a debt investment in the B round, it is unlikely we would do any equity afterward, because the equity would be priced too high. We try to own up to 5% of a company but probably only exercise our right in about 40% of the companies. When we exercise our right, we typically are writing a check for $500,000 to $1 million.”
As for the Internal Rate of Return it should be stated that 23% may be regarded as the high indicator of well-composed financial strategy, as qualification and unity of the team is the essential factor, which impacts this rate.
It should be stated that the fee structure of the company among the range of the partners is regarded as typical within the most venture companies, nevertheless, the innovations in the financial activity are welcomed, as the interest rates and the average pre-money valuations vary from year to year. This is generally explained by the instability of investment and financial market, however, the variations exceed these instabilities.
Thus, the reason is the implementation of the experimental structures and strategies. Taking it into account it is necessary to mention that at least eighty percent of the returns, which Pinnacle earned as the investment interests were reallocated to their partners (mainly, these are the invested companies and projects). The other 20% were spent on the development and the increase of technical and professional bases. 2.5% of the management fees were mostly allocated as the bonuses for the team.
Pelowski commented on Pinnacle’s returns, “On a cash-on-cash basis, we are projecting that our returns should reach two to two-and-a-half times total invested capital. Expressed in terms of Internal Rate of Return, we’re looking at something in the low- to mid-20s.” These expectations generally entail returns from interest, warrant coverage, and any potential return from the exercise of the follow-on equity investment option (Greene, Brush 2002).
Lee also emphasized that the venture capital companies, during their starting periods often follow their investments up to the second or even third round, and this trend essentially minimizes the risk for the Pinnacle Ventures, as these actions essentially minimize the risk, as well as the competitive capability of the company as too much efforts are spent for following the flow of the investment capital. It was also added that the venture companies with professional teams are generally expecting the returns from anywhere (these expectations are forecasted by the experts and included into the financial plans) up to five times.
The debt funds of Pinnacle are lower, as these funding presupposes lower risks. Consequently, on a risk-return origin, this perspective looks rather attractive, in spite of the fact that such attractive feature is also used by the competitors, and this slightly decreases the competitiveness of the company. Moreover, due to the fixed income part, the Pinnacle’s fund is rather profitable, and helps to perform much faster than a general venture fund, based on standard principles of expecting no more than three returns. (Ford, 2006)
Investors
The fact is that the investment sphere is the sphere with the complex structure and extensive hierarchy of the investors. Thus, the Pinnacle Ventures, in order to be able to support numerous projects and companies within their sphere, attract investors who wish to gain dividends for lending their money.
Thus, Pelowsky emphasized the following on this matter: “Evaluating a new deal is an art. There are so many things to take into account including the product, market opportunity, value of the technology, likely competitive advantages over the long term, margins and profitability, and the ability to scale. Each deal is different and, depending on the company, some of those attributes are more important than others. It is not a simple analysis”, ‑ consequently, there is strong necessity to have stable financial basis in order to have an opportunity to retreat, if the project or firm appears to be a loser (to make auto-stop, similar to FOREX principle). On this matter Lee elaborated the following evaluation strategy:
Initially, the company makes the research in order to see whether the deal with the investor fits the profile of the company. The Investor should agree to invest the early-stage company, and the Pinnacle should be interested in the invested market. The quality of the investor defines the investment level and the amount of the finances flown in the market. Then the company makes the research of the company (firm, project etc.) and defines the capability of the team, the opportunities, which the market can offer for the company and the origin of the technology. The research may go even deeper, if there is necessity on it, to study separate segments of this market.
In order to define the quality of the investor, the company aims to have its pretty balanced portfolio, and the information on the flow of their previous investments (this is a kind of industrial espionage, however, as a proverb goes “a la guerre com a la guerre”).
It is of crucial importance to meet with the request information of the company; consequently, the following step is to collect data on these requirements and particularities of the company (or project). Pinnacle Ventures team overviews the current balance sheet, cash flow, and income statement, but with early-stage Series A Company it is very basic.
Finally, when the invested facility is elaborated and the production launched, the next step is to observe the company very closely. When they are ready to perform the B series round within the following 18 months, PV is able to provide additional capital investment, thus setting up closer relations.
Dicks (2004) emphasizes that the transactions are structured in a relatively straightforward manner. In assessing the size of a loan, Pinnacle sought to limit pro forma debt to equity ratios to 67%. If a company comes in asking for a loan that will get them one month of runway, it is probably not worth their while.
The overall quality of the investments may be traced in the following table:
Average Investment and Valuation Data 1997–2005 ($ millions)
Thus, the quality of the investments is within the 50 and 95% of the return during the early stage. Originally, it is regarded as the high quality investments, as few companies manage to attain such results (Beenhakker, 2001).
As for the evaluation of the risks in the investment of Windvane Company, it is necessary to mention that the figures of this research appear to be rather attractive. The fact is that the IRR of the company is 51%, and, while assessing the size of a loan, Pinnacle considered restricting pro forma debt to equity ratios to 67%. The overall returns should be at least 2 times higher than the invested sum, and the IRR should reach 20-25%.
Originally, the main aim of the investment is to balance the requirements to be competitive and not burden the Windvane Company with financial pressure and at the same time to get a healthy return for pinnacle and its limited partners. The analysis of the IRR of the Windvane and the overall cash flow of Pinnacle reveals that the risks are minimum, nevertheless, the additional factors, such as the financial condition of the Windvane as the start-up company may be regarded as the most crucial for this question.
The cash flows of the venture backed firm, and the cash flow implications of a venture debt loan assessments reveal that the company can not be regarded as the perfect object for the investment (in comparison with the other venture backed companies) nevertheless, the high stability and constant venture debt signifies that the investment as well as warrant coverage, and any potential return from the exercise of the follow-on equity investment option appears to be a good decision.
It should be stated that additional runway from the venture debt, even if only a few months, enables the company to reach a major new milestone that will in turn allow your company to raise equity to repay the debt on much more attractive terms.
Moreover, Windvane will run out of cash when they still have $5m of venture debt to pay off. They’ll either have to go out of business, or raise a new equity round to pay off the debt. Still, the increase of the active cash reserves of Windvane would solve this problem.
Returns to venture capital, venture debt, and other forms of private equity assessment are assessed from the viewpoint of the risks and the interest rates which make the joint image of the investment success. Originally, there should be no necessity on venture debt increase, and the fact that it stays stable (jointly with the figures on IRR), as well as private equity forms such as Limited liquidity and Investment Control (investments of limited partnership principle) signify that the risks are minimal.
Competition and Profitability
The issues of competition are the most contradicting in this sphere, as the competitors often share the information on various projects, if they are out of the interests of these companies. However, if the Ventures act within the same sphere, there are various difficulties arise. The competitors of PV experienced various stages of their activities. Thus the most prominent fall was that of Comdisco Ventures, a $1 billion division of a traded firm that lent forcefully to high-risk start-ups for the period of the boom years.
It is emphasized in Blackman (2008) that by 2001, the market value of the division’s investments had plunged and its high-profile parent company was forced to declare bankruptcy. Other well-established competitors such as Lighthouse Capital Partners, Western Technology Investments (WTI), and a smaller firm named Costella Kirsch remained in the space but, unlike Pinnacle, had origins in the equipment-leasing business and had only recently expanded their business to include growth capital loans.
Business Characteristics
The analysis of business characteristics generally entails various factors: HR, Customer care, financial policy, income summary, financial flow, etc. The case study about the Pinnacle Ventures offers only financial information. Thus, the venture lending data is the only factor to characterize this business. The competition factor has been already estimated, though, the financial information of the competitors would be required for the full analysis.
Values of the Company and its Effect on the Daily Performance
The main value of the company is the preserving of the high quality of the team and steady development of the investment basis. Thus, the daily performance of the company entails self education, qualification improvement and expansion of the partners’ network, as well as finding out the information about competitors and potential objects of investment.
It is necessary to mention that there is also high quality customer treatment policy within the values of the company (investors are regarded as the customers, as they are the essential financial support for the company), thus, properly arranged communication with customers, professional consultants on the matters of IT and financial spheres are available for the investors.
Lessons to be learnt
Originally, there are various lessons that should be learnt in order to avoid the destiny of Comdisco Ventures. The first and the foremost lesson should be to derive lessons from the faults and successes of the competitors. The fact is that, the information on the faults, even of the company from different sphere may contain important information, which will help to avoid similar situation in the technological investment.
Another lesson is the necessity not to get stuck only in the IT sphere, as, in spite of great potential, it is not insured against the fall. Thus, it is necessary to think over the engagement in some related sphere, in order to expand the activity and increase the customers’ base.
References
Beenhakker, H. L. (2001). Investment Decision Making in the Private and Public Sectors. Westport, CT: Quorum Books.
Blackman, C. M. (2008). Prudent Investment Practices: CPAs Who Provide Investment Advice to Their Clients Will Be Held to a Fiduciary’s Civil Standard of Conduct. Thus, It Is Prudent to Know and Understand Best Practices for Fiduciaries. Journal of Accountancy, 205(1), 25.
Bosworth, B. P. (1993). Saving and Investment in a Global Economy. Washington, DC: The Brookings Institution.
Dicks, J. W. (2004). The Wrong Way to Run a Bank Investment Program, and How to Change It. ABA Banking Journal, 86(8), 60.
Ford, N. (2006). Investment with a Human Face: Is the Foreign Direct Investment Going into Africa Currently the Right Sort of Investment? Can It Help Raise the General Economic Standards in African Countries or Does It Have Little or No Impact? Neil Ford Discusses the Ideas of an Irish Businessman Who Says Investors Need to Change Their Perspective and Help Themselves by Helping Africa. African Business 28.
Greene, P. G., Brush, C., & Hart, M. M. (2002). The Corporate Venture Champion: A Resource-Based Approach to Role and Process. Entrepreneurship: Theory and Practice, 23(3), 103.
Kirsner, S. (2005) “Venturing into Debt, Buying Time,” Boston Globe. p. C1.
Liebmann, L. (2004). Managing IT Investment: Less Isn’t Always More. Business Communications Review, 28, 52.
Murphy, A. (2005). Scientific Investment Analysis (2nd ed.). Westport, CT: Quorum Books.
Russ, G. (2006) “Something Ventured: Venture Lending Makes a Comeback,” Dow Jones Newswires.
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