Private Venture Investing: "Questions an Investor Should Ask"

 
 
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 Overview | Terminology | Why consider the investment? | The sales pitch | Business plan | Managing the venture | Legal structure of the investment | Control the venture | Liquidity strategy | Financial position | Formal review of the opportunity | About the author | Lexicon | Investment checklist

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This information is intended as a general guide to the investor contemplating an investment in a "private company or project". It summarizes key questions to ask and issues to deal with before investing. This type of investment does not typically have approval by a securities regulatory body nor a prospectus.

There is a wealth of information available on investing in public companies and mutual funds. There is also an abundance of capable professionals who dispense advice on these matters. Much of what follows is applicable to evaluating any type of investment opportunity. This fact sheet is written with private company investment in mind and is referred to as "a private venture" investing.

Nothing contained herein is to be construed as specific investment advice regarding any investment opportunity, nor should the reader rely on the contents of this fact sheet for any purpose other than as general information. Investing is, by its nature, risky and anyone contemplating any form of investment should seek out qualified experts to advise on specific matters. Therefore, the interpretation and use of this material rests solely with the reader.

The development of this fact sheet was jointly funded between Alberta Agriculture, Food & Rural Development and Manitoba Agriculture. It was written by Cam Crawford from Coakwell Moore Chartered Accountants-Management Consultants of High River, Alberta, with the assistance of Sue Bannerman from INT Associates Inc.-Management and Training Consultants of Olds, Alberta.

A special Manitoba review committee made up of Manitoba Agriculture Specialists and Staff, along with representatives from Industry reviewed the material to ensure its applicability in Manitoba.

In cooperation with: Alberta Agriculture, Food and Rural Development

Private Venture Investing - An Overview

There are a number of factors that have contributed to an increased interest in private venture investing in recent years.

  • money market returns are at historical low levels and many investors are seeking out higher returns with private venture investments.
  • a consolidation of equity is occurring as the parents of baby-boomers transfer accumulated wealth to their sons and daughters.
  • certain local and regional economies are vibrant and growing; apparent opportunities abound. Interest and enthusiasm among entrepreneurs is very high in some locals.
  • public equity markets have produced significant gains for investors, some of whom are looking to diversify by investing profits into private venture investments.
  • significant amounts of labour sponsored venture capital funds (e.g. pension funds) have built up in recent years encouraging entrepreneurs to pursue ideas in the hope of attracting this and other sources of venture capital.
This publication will help you answer the following questions:
  • Why am I considering this investment?
  • Who is making the sales pitch?
  • Is there a business plan?
  • Who will manage the venture?
  • What is the legal structure of the investment?
  • Who will own and control the venture?
  • What is the investor liquidity strategy?
  • What is the current financial position?
  • Have you completed a formal review of the details of the opportunity?
Terminology

Like so many areas of knowledge these days, private venture investing has specific jargon and terminology that have different meanings and connotations. The lexicon at the end of the fact sheet is intended to clarify certain meanings, and at least provide the context in which the terms are used. The reader may wish to start by reviewing the lexicon and refer back to it while reading through the publication. Terms that are contained in the lexicon are identified in bold italic type throughout the fact sheet.

1.0 Why Am I Considering This Investment?

Beware of the lament of the once burnt, twice shy investor, "Why did I ever get involved in this mess?" The romance of venture investing fades rapidly against a backdrop of investor cash calls, poor results, overly optimistic projections, and unmotivated management, just to name a few. In all cases, the full amount of a venture investment is susceptible to loss. Security over assets (such as land, buildings and equipment) is often granted to a financial institution to cover loans. This means those assets are not available to secure the venture investment. If a venture's assets are liquidated in the future, in theory, investors are entitled to receive a return of their capital, but only after priority ranking creditors are paid. In reality there is seldom enough cash to go around, equity investors are often left on the short end of the stick.

1.1 Points to consider
  • What are my objectives in making the investment? Are these objectives consistent with other shareholders?
  • What do I expect to gain? What is the probable return on my investment (ROI)?
  • How much could I stand to lose? Is the risk of loss offset by the potential for return?
  • is there a balance between risk and return?
.Tips
  1. Have a clear set of objectives in considering an investment.
  2. Write your objectives down, if only to force you to seriously address this aspect.
  3. Beware of "can't lose" deals which just happen to find you. Remember, an experienced venture capitalist will review all ten deals before considering one, and only one in ten of those is likely to be pursued. That works out to roughly one-in-a-hundred investments made from opportunities reviewed.

2.0 Who Is Making the Sales Pitch?

Often the founders of an opportunity will engage intermediaries to act as agents in raising project financing, other times the founders will attempt to raise funds themselves. Make sure you know who you are talking to, and if a commission is being paid to an intermediary. You should know the terms of engagement. Often the party "pitching a deal" is called the promoter. Securities law in most jurisdictions restricts the ability of intermediaries and promoters to charge commissions on certain types of private investment offerings. The prospectus, if available, will disclose the method used to calculate any commissions. However, this document does not comment on whether the commission is fair or not.

2.1 Points to consider
  • Are there any fees being paid to the people making the sales pitch?
  • Are those fees contingent on success of the money raising efforts?
  • Why are they talking to you?
  • How long has the opportunity been offered to others?
  • Who else is contemplating an investment?
  • Can you team up with other investors to review the opportunity together?
.Tips
  1. Never respond quickly to an investment proposal; high pressure tactics that suggest a tight time deadline should be avoided.
  2. Find out who else is considering an investment in the project and ask to talk to them. This may not always be possible, but if the promoters of an investment will let you talk to other potential investors, do so. If they won't let you do this, at least find out why they won't.

3.0 Is There a Complete Business Plan?

The business plan is the blueprint for the business venture. Stay away from business plans that are "in my head". By the same token, don't be fooled by a glossy, polished presentation that lacks substance.

3.1 Points to consider
  • What are the key aspects of the business plan?
  • What are the competitive advantages of the business or project?
  • What is the stage of the business or project: concept only, start-up, growth, turn-around, buyout?
  • How much money is being raised?
  • What will the money raised be used for? What amount of this money will be spent on tangible vs. Intangible assets (e.g. operating and start-up expenses)?
  • How much income will the company make if the business plan is successfully implemented?
3.2 Key Business Plan Contents
A detailed discussion on business plans is beyond the scope of this document; but generally a business plan should contain:
  • a one or two page executive summary of the entire business plan.
  • history of the business/project to date.
  • people profiles and an indication of their status (i.e. Board members, management, full-time and part-time employees, etc.) And company culture.
  • a clear description of the product or service, how competitive advantage will be established in the marketplace, and an analysis of the competition.
  • details of the marketing plan:
  • target market segments (groups of people that are potential customers), customer profiles,
  • market size (potential number and size of identified segments), geographic location,
  • penetration strategies (how will the product or services be advertised and promoted to a new or expanded market), integration, company size and rank,
  • start-up and promotional costs, etc.
  • have all regulatory requirements been met (environmental regulations, zoning requirements)?
  • is there an independent study of the technology or product? SWOT (Strengths, Weaknesses, Opportunities and Threats) analysis may be appropriate.
  • full details of legal structure and ownership.
  • full description of the ownership structure after the investment is completed.
  • details and sources of project financing requirements.
  • an analysis of risk.
  • full projected financial information for the venture including balance sheets, income statements and cash flow statements for at least 3 years.
  • details of the assumptions utilized in the projections (particularly the basis for revenue projections); this could be compared to some industry standards.
.Tips
  1. There are numerous books and other informational material on business plans, including some excellent brochure-type publications provided by financial institutions and professional firms. Learn what a good business plan should contain.
  2. Prior to being provided with a detailed business plan you may be asked to sign a confidentiality and non-disclosure agreement. This is a standard practice, but if you are not sure exactly what you are signing, ask your lawyer to review it with you and get a legal opinion.

4.0 Who Will Manage the Venture?

Although the profiles of the management and employees are a part of the business plan, this aspect is so important that it warrants separate attention.

4.1 Points to consider
  • Who are the key implementers of the business plan?
  • Do they have significant accomplishments in their past?
  • What are the terms of employment for these people? Who makes up the management team? (I.e. who is actually going to be running the business and how much experience and background do they have?) What is their level of management ability?
  • Are they full-time? Part-time?
  • Are there or will there be employment contracts in place with key people?
  • What will be their remuneration?
  • Is any of their pay made up of contingent remuneration?
  • Who are the current shareholders, officers and directors of the company?
  • Who are the key professional advisors to the project? Consultants? Lawyers? Financial?
  • These are important people to a venture.
Tips
The best idea in the world is likely to fail by poor management, and excellent management can make the best of even an ill-conceived plan. Don't underestimate the importance of the people involved in the project. Check them out ... ask your lawyer, accountant, and financial advisor, they can probably find someone that knows something about the people behind a project.

5.0 What Is the Legal Structure of the Investment?

In Canada, all provinces have detailed securities laws that prescribe the manner in which investments can be sold. Frequently, offerings are improperly structured, contravening laws that are primarily designed to protect the investor. Generally, securities law requires that a prospectus or some other form of offering document be prepared by those promoting an investment, unless certain exemptions from those requirements are applicable. The prospectus does not comment on how good the investment is but rather it ensures securities law has been met. If you are subscribing to an investment under such an exemption, make sure you understand what you are doing.

There are a number of different ways the ownership of a venture could be structured, including:
  • limited company
  • partnership
  • limited partnership
  • joint venture
Each of these possible structures has significant implications for the investor and you should obtain qualified professional advice in order to understand what these implications are for your particular circumstances.

5.1 Points to consider
  • How is the investment legally structured?
  • Is there a formal offering document?
  • Are there upper and lower limits for the offering?
  • What happens if not all the required investment capital is raised?
  • Are you investing in debt or equity?
  • If equity, is it subordinated debt? Convertible debt?
  • Is some or all of your investment going to be secured by assets?
  • Could you be legally required to put up more money in the future?
  • Do you know all classes of ownership and how shares are paid?
Tips
  1. At a minimum there should always be a subscription form for an investment.
  2. Never simply hand over a cheque to someone promoting an investment.
  3. Have the subscription form reviewed by your legal and financial advisors before you sign. In addition, there is some protection available by paying your investment into a lawyer's trust account, pending the closing of an investment and possible other conditions. This practice is often followed, but make sure you understand the conditions of trust placed on the lawyer who receives the funds. The lawyer is often working for the company raising the money and once the trust conditions are met, the funds can be released from trust. Or an investor may want clarification when they deposit the money in trust and have their own conditions placed on the funds or they may want to have their own independent legal advice involved.
  4. Make sure that you understand what will happen if all of the funds are not raised. Will you get your money back, or will you become an investor in an underfunded project? In addition, make sure you understand whether you will have a legal obligation to put more money into the project in the future.

6.0 Who Will Own and Control the Venture?

Ability to control the direction of the project is an important issue. In many cases the founders remain in control of project direction as long as the business plan is being followed to the satisfaction of the investors. However, if the business plan is derailed or serious problems encountered, often the investment structure provides for the investors to have a bigger say, and in some cases, even to take control of the business. For investments in companies (i.e. as opposed to partnerships or other forms of investment structure), this matter is often dealt with through the makeup of the board of directors. Corporate law provides for rights of minority shareholders and these shareholders should be aware of these rights.

In most cases, the founders of a project are entitled to a carried interest in the equity of the business or project as compensation for getting a project where it is warranted to seek out investment capital. There is no standard approach in dealing with this aspect of a venture investment structure. Each situation invariably has its own unique circumstances that impact the extent of the carried interest for the founders.
  • Founders of early stage projects are usually entitled to a lesser carried interest than founders of more mature projects.
  • The greater the potential for return from a project, generally the greater the entitlement of the founders to a carried interest.
6.1 Points to consider
  • How much cash have the founders invested in the project?
  • Are the founders getting ownership in the business to compensate them for their non-cash investment of time and effort?
  • How much will your investment be diluted as a result of the founders getting an interest for their sweat equity?
  • Who will control the venture after the money has been invested?
  • Is there room for negotiation in the project structure, or is it fixed?
  • Will you be entitled to representation on the board of directors?
  • Do you want to be on the board of directors?
  • Are you expected and do you want to make a contribution beyond money (e.g. professional advice, time, etc.)?
  • Do you have valuable contacts or knowledge that could improve chances of the project's success?
  • Do the founders have warrants and/or provisions on the investment and how do these affect control of the investment?
.Tips
  1. Many of the above and other related issues are dealt with in an unanimous shareholders agreement in a private venture investment. This is a critically important document that details the agreement (in advance) by the shareholders as to how certain important issues will be dealt with.
  2. Seek out competent professional advice if you do not understand the exact workings of the provisions of the Unanimous Shareholders Agreement.
  3. Being a director can be a great way to know everything that is going on and possibly influence direction. But directorship also has a significant potential downside. Make sure you understand this downside before accepting an appointment as a director.
  4. Often it is a good idea to structure the investment such that founders start out with a lower relative equity position, but can earn a higher proportion of ownership, usually via a share option arrangement, if an when the business produces profits. A founder may want full value for their investment and anything beyond this through a "bonus".

7.0 What Is Your Liquidity Strategy?

An often forgotten aspect of a venture investment is the investor liquidity strategy. Having the business or project succeed is one thing, getting your money and gains back out is a separate issue. Often the interests of the founders can be at odds with the interests of other investors. Founders, who depend on the business for their livelihood, may be motivated to reinvest profits in growth; investors on the other hand typically want some or all of their investment returned at a point in time. The liquidity strategy should also deal with two other issues: (1) a disaster in an investor's family (i.e. death of the investor or a real need for the investment to be returned) and (2) the ease of sale of the investment down the road if an investor wants to realize on the investment.

7.1 Points to consider
  • How and when will you get your money back out of the investment? Is this disclosed in the shareholders' agreement?
  • Have you analyzed the investment from the viewpoint of investors exiting and newcomers entering?
Tips
While it is often difficult to establish an exact liquidity strategy at the time of investment, there are certain measures that can be put in place as part of the structure to ensure investor interests are protected in this regard. In some instances, structuring an investment as preferred shares with a requirement that the shares be redeemed by the company after a specified level of net earnings has been reached is just one example of how this matter can be dealt with.

8.0 What Is the Financial Position?

Financial information dealing with the past is generally referred to as historical financial information. Information dealing with the future is typically called projected financial information. Both are extremely critical in assessing the opportunity.

Historical information will portray the financial path taken to date and results realized. It can give you a good sense of current financial stability or lack thereof. If an individual is investing a significant amount of money, he/she may wish to delve a little deeper into the company's historical financial information to look at the past financial stability as an indicator of management.

Projected financial information needs to be very cautiously reviewed and analyzed. With the advent of computer modeling, extensive financial projections can be readily developed and presented very professionally. But beware, the accuracy of computer financial models can easily be distorted by even the smallest flaws in the logic of the assumptions that go into the model, or the calculation methods used. It is also perhaps too easy to build a model on assumptions that go something like this: If I could only get « of 1% of the market for this product, look what I can do!" Too much effort goes into the math and not enough attention is devoted to developing the plan to capture the market share. This reinforces the fact that investors need to understand the assumptions for projections made in the business plan.

The projected financial information is also the cornerstone of a detailed value analysis which the investor should perform to establish the upside potential from the investment. Quite simply, the value analysis extrapolates a future value for the business assuming it is able to achieve the anticipated results and calculates the individual investor's share of that value based on what percentage the investor owns. One method to calculate this out is to take the investor's share of value and divide it by the amount originally invested to get a rate of return on the investment. Divide that rate by the numbers of years from date of investment to the effective date of the value analysis, and you have an annualized return on investment (ROI), expressed as a percentage (see Lexicon for example calculation). The anticipated ROI must be high enough to justify the investor assuming the risk of loss. Internal Rate of Return (IRR) is another value analysis technique which is slightly more complex than ROI but it reflects the time value of money (see Lexicon for example calculation). Projected and historical (past 5 years) earnings per share and price-earnings ratios (plus other indicators) will also assist in the analysis of the investment.

8.1 Points to consider
  • Are audited historical financial statements available?
  • What is the current financial position of the business?
  • Is it operating now?
  • Is it making money?
  • If it is losing money, how much money is being lost each month? What is the burn rate? What is the turn-around strategy and who controls it?
  • Has a reputable firm of accountants issued an accountant's report on the financial statements?
  • Is the venture up to date on tax and other required filings?
  • When is the business expected to become profitable
  • What is the expected return on investment (ROI)?
  • What is the payback period for the investment?
  • If the business plan is successful, how much will my investment be worth? How will profits be paid out (e.g. retained earnings, etc.)? How does the business compare to industry standards for (1) returns; (2) leverage; (3) and payables and receivables? (Industry standards publications are available at your local library.)
Tips
  1. Look for a report appended to historical financial statements by independent accountants, recognizing that the credibility added by independent accountants varies based on the nature of their report on the statements, as well as from firm to firm.
  2. The above points have been simplified for purposes of illustration, there are many additional factors that can impact the completion of a value analysis on an investment. You should seek out qualified assistance in analyzing and interpreting all financial information pertaining to a prospective investment.

9.0 Have You Completed a Formal Review of the Details of the Opportunity?

Prior to making the final commitment to an investment, a formal due diligence review should be completed. Have a lawyer conduct corporate and personal searches on those involved in the opportunity. Have a financial expert check out historical financial information, projections and the like.

This final, formal review can uncover deal-breaking information that you should not ignore. Above all else it will help substantiate the character and trustworthiness of the people you are investing in.

9.1 Points to consider
  • Have you formally confirmed representations made during the sales pitch and investigation phases?
  • Have you been lied to or have claims been exaggerated by the promoters?
  • Have all legal documents (contracts, agreements, leases, etc.) been reviewed?
  • Are all tax filings (income tax, payroll, GST, etc.) up to date and have these filings and related assessments been reviewed?
Tip
Seek independent verification from reliable sources of representations made to you during your assessment of the opportunity.

About the Author

Cam Crawford is a partner in High River, Alberta based Coakwell Moore Chartered Accountants - Management Consultants. Education and professional qualifications include:
  • BComm (University of Calgary - 1976)
  • CA (KPMG - 1976)
  • CMC (Coakwell Moore - 1988)
  • FCA (Coakwell Moore - 1997)
  • Cam specializes in management and consulting, specifically in the areas of business planning, financing and growth strategies, for a variety of clients many of which are in the agri-business and related sectors.
  • Cam is also a founding director and chairman of the board of AgriVest Capital Corporation, a Calgary based privately funded venture capital company specializing in agri-business projects.

Fact Sheet Lexicon Private Venture Investing
  • The purpose of this lexicon is to provide context for some of the terms used in this document. These are not intended to be precise definitions.
  • Board of directors
    The group of people, elected by the shareholders of a company, who make major decisions regarding the conduct of the company's business. Directors have a duty to shareholders to manage the affairs of the business in a prudent manner. Control of the board of directors is often a key issue in private venture investing.
  • Burn rate
    The amount of overhead and other costs in excess of revenue that a business will incur, usually considered on a monthly basis. Typical of a start-up business, the burn rate is extremely critical for the investor, as it will dictate how long the business or project can survive on available cash resources. The burn rate should be established in advance and monitored very closely.
  • Business plan
    In a nutshell, the business plan should clearly explain the what, why, when, who and how of the project. It should be a comprehensive explanation of the opportunity, the people involved, the money required to implement the plan, where it will come from and what financial results the opportunity is likely to produce.
  • Carried interest
    A term often used to describe the interest that the founders will be given in a project. This is to recognize the value of the idea and concept behind an opportunity. It also should identify the non-cash contributions the founders have made to the project. Investors in a project should carefully consider the extent to which their investment, usually paid for with cash, will be diluted by the carried interest (usually issued for non-cash consideration).
  • Closing of an investment
    The specific date and process by which cash is invested, share certificates (or other documents evidencing the investment) are issued and agreements are signed. Often conditions are set by both sides in the course of negotiating an investment, and dates by which the conditions must be met or waived are set, allowing for a more orderly negotiation. Any questions or uncertainties about making an investment should be resolved prior to closing.
  • Common shares
    The class of shares in a company that typically carry the voting rights to elect the directors and participate in the growth of a company; although other investment vehicles (preferred shares, convertible debt and others) can have the same features. In the event of a liquidation of a company's assets and for other purposes, common shareholders always rank behind other types of shares. They also provide the ability to make claims on residual assets after everyone else has made their claims. The trend in venture investing today is to move away from investment strictly in common shares, towards some sort of "hybrid instrument" (see below).
  • Competitive advantage
    Perhaps one of the most important aspects of a business plan. How will the product or service gain market share, recognizing that it is not good enough to be only as good as the competition, it will have to be better. However, in commodity-based investments like agriculture, competitiveness may be viewed more from an internal point-of-view than external. Claims of competitive advantage should be fully reviewed and challenged.
  • Confidentiality and non-disclosure agreement
    A formal agreement that potential investors are often asked to sign prior to being provided with information about a business opportunity. This is a standard practice that a potential investor should expect, as long as what is being signed is clearly understood. The potential investor should be particularly cautious in signing this type of agreement if the investment project is in any way related to an existing business that the investor may own.
  • Contingent remuneration
    That portion of future remuneration (to be paid to a founder for example) that will be based on profitability of the project or business. It is often used to deal with a situation where the founders want a larger carried interest than the investor is prepared to agree to. Contingent remuneration can be paid in cash, equity, or some combination thereof, with the common thread being the fact that it is based on future achievement, usually the accomplishment of predetermined milestones or level of results.
  • Convertible debt
    A term used to describe debt financing that has a feature allowing the debt to be converted to equity, often at the option of the investor, in the event of a default on repayment terms. Other times the conversion feature can be granted as a "sweetener", providing the investor with the option of converting debt to equity if results are good. Sometimes the investee company can have the option to convert the debt. There is often little distinction between certain convertible debt and certain types of preferred shares, both often referred to as "hybrid investment" vehicles.
  • Debt
    Typically an investment that is written on terms similar to a bank loan. The debt will usually specify the nature of security for the debt, an interest rate and repayment terms. Straight debt is not often used in venture investing. If debt is used in venture investing, it most often contains terms and provisions that make it a hybrid of debt and equity.
  • Due diligence review
    The formal process of validating representations made during an investment investigation. Lawyers often are involved to perform company searches and background checks on the founders. Accountants often review historical financial statements and tax filings, as well as review the accuracy and suitability of financial projections that form part of the business plan.
  • Employment contracts
    A very important aspect of a venture. Investors in particular want some commitment that key employees are tied to the business or project by contract. Although it is often difficult for the employer to enforce the terms of employment contracts, to make an investment without key employees being committed to contracts would be ill-advised. Employment contracts should clearly define: term, remuneration, duties, confidentiality issues, conflict of interest guidelines, termination provisions and other relevant details.
  • Entrepreneurs
    A widely applied term, often used to describe passionate business types that are prepared to go to the ends of the earth to make a business or project succeed. The term also has come to mean almost any business person in any size or stage of company, dedicated to acting dynamically with an open mind in pursuit of a corporate mission.
  • Equity
    Funds are typically advanced by investors to a venture by equity, debt or a combination thereof. An investment vehicle that combines elements of debt and equity is often referred to as a "hybrid investment". Equity is the broad term usually used to describe share capital of various types that a company could issue. When used in the context of shareholders equity, the term would include the money paid in for shares plus the retained earnings of a company.
  • Formal offering document
    Usually developed in accordance with detailed securities rules, the formal offering document is often complex with serious legal overtones. Most investment opportunities in the public equity markets are accompanied by this type of document. Many venture investments are promoted by an offering document of some sort as well. The offering document is a very important item in any investment, detailing many key structural aspects of the invest opportunity.
  • Founders
    A term used to describe the people who have played a key role in bringing an opportunity to the stage of seeking investment capital. Founders are often looking for a carried interest in the venture to recognize the tangible and intangible contribution they have made to the project.
  • Historical financial information
    Financial statements, income tax filings and other documents that detail financial history. Financial statements reported on by independent accountants can have varying degrees of assurance added by those external accountants. The assurance depends on whether the accountants have "audited", "reviewed" or simply "compiled" the financial statements.
  • Intermediaries
    A term used to describe people or companies that raise funds for ventures, almost always being paid a commission or other form of success fee when the money is raised.
  • Internal Rate of Return (IRR)
    A method to analyze investments which reflects and accounts for the time value of money. IRR is the discount rate which makes the net present value of revenue flows equal to zero or the investment equal to the present value of revenue flows. To calculate IRR often requires the use of Present Value (PV) tables which are available in most business management textbooks. A simple example calculation of IRR is:
  • A producer is considering making an investment (I) of $500,000 with anticipated annual revenue (R) of $100,000.
    PV = present value
    i = internal rate of return (IRR)
  • 1. Calculate the percentage rate (i) or IRR where I=PV.
    I=PV
    I=PV Factor (Annuity) (L,i) x R
    $500,000 = PV Factor (Annuity) (10 yrs., i?) X $100,000
  • 2. Rearrange formula
    • PV Factor (Annuity) (10 yrs., i?) =
    • $500,000
      $100,000
    • = 5.000
  • 3. Look up PV table for 5.000 at 10 years to find i (IRR).
    i = ~ 15%
  • 4. Therefore, on this investment, the IRR is approximately 15%. Often in making a decision, investors will compare IRR to the cost of capital (interest or opportunity cost) to determine if it is a viable investment or not. Of course, risk must also be factored in when making a decision on any investment.
  • As stated above, this is a simple example. When inconsistent or irregular cash flows over time are considered, this process becomes more complex. For this document, the above example illustrates IRR.
  • Investor cash calls
    A practice followed with some venture investments whereby investors can be called upon to advance more money into a project, most often upon certain conditions being met or project milestones being accomplished. This is a potential deal structuring concept to be dealt with c cautiously. Structured correctly a staged investment plan can be an effective tool to ensure that the founders are meeting their targets.
  • Investor liquidity strategy
    Quite simply, the liquidity strategy details how the investors will get their money out of the venture in the future.
  • Joint venture
    A structure often used to pursue a one-time project with a specific target wind up date. A joint venture is generally not recognized as a separate legal entity, as opposed to a partnership which is. Revenues, expenses and asset ownership usually flow through a joint venture to the participants since the joint venture itself has no legal status. Partnerships and joint ventures can appear to be very similar but in fact can have significantly different implications for those involved.
  • Limited company
    The most common form of business structure, the limited company is characterized by limited liability for shareholders (i.e. a shareholder's liability is usually limited to the amount of their investment in the company). It is a separate entity for income tax and legal purposes. The company usually elects a board of directors to run the business.
  • Limited partnership
    A partnership (see below) in which certain partners are afforded limited liability, with such limited liability usually being the amount of their investment. The partnership is usually run by a general partner who does not have limited liability. Like a regular partnership, this is a separate legal entity but revenues, expenses and certain other financial transactions and income tax related amounts "flow through" to the partners. This type of structure is often used for tax shelter investments.
Money market
Generally means the vast array of financial products that earn interest (as opposed to capital gains or dividends) for the investor, although many variations of this type of investment exist. T-bills, most bonds, GIC's and the like would be characterized as money market investments. A money market rate of return is a term often used to describe a low risk rate of return available to an investor. partnership

Like a limited company, but unlike a joint venture, a partnership is a separate legal entity. Partnership law is complex and in many cases partners can find themselves liable for debts of the entire partnership (see comments above on limited partnerships). For this reason alone, regular partnerships typically are often not used in venture investing. Reporting on financial returns for income tax purposes is also very different between a partnership and a corporation.

Payback
Usually expressed in number of years, payback is calculated as the investors cumulative share of earnings over a period of time divided by the amount of the original investment. The length of an acceptable payback period varies from investor to investor and from project to project.

Preferred shares
A special class of shares in a company that could have a variety of features. Preferred shares often have a fixed dividend rate, always rank in preference to common shares and are convertible into common shares upon the occurrence (or non-occurrence) of future events. Preferred shares can be voting or non-voting, and usually do not participate in growth in equity in the same manner that common shares do. It is often difficult to distinguish differences between certain preferred shares and hybrid debt instruments.

Professional advisors
Seldom does a venture get to the point of being ready to accept outside investment capital without the assistance of qualified professional advisors. Accountants, lawyers, consultants, engineers and others are often a crucial part of the team. You can often tell a lot about a venture by the "company" it keeps.

Projected financial information
A future oriented portrayal of some or all of the anticipated earnings, cash flow and financial position of a venture. Created using a set of assumptions, the projected financial information is usually prepared to demonstrate potential. While the credibility of projected financial information can be established to some degree by evaluating the validity of the underlying assumptions, it is important to recognize that projected financial information is built on "what if scenarios".

The certainty that can be brought into historical financial statements through verification (by an audit for example) cannot be obtained with projected financial information. Thus, assessing the appropriateness of the underlying assumptions of the projected financial information is of paramount importance.

Promoter
The person or company that is promoting the investment. This term has certain legal meanings under securities law, but is generally used to describe anyone who has a vested interest in raising investment capital for a venture, either because they are a founder or because they are being paid a commission on the funds raised.

Prospectus
A complex and comprehensive document that accompanies many large investment offerings, prepared primarily to enable the investment to be bought and sold without restriction. Costly to produce, a prospectus is seldom prepared in private company investments. Business plans, project summaries and other such documents are often called a "prospectus", however these documents would not generally meet the standards for a prospectus as defined in securities law. The prospectus provides full disclosure of information related to the investment particularly the standards used. It makes no comment on how good the investment is.

Public equity markets
A general term to describe the "place for investing funds in publicly traded companies". This could mean individual companies listed on a stock exchange, mutual funds that invest in public companies, or other similar types of investments. The common denominator for investments on this type would be the linkage to a public stock exchange, generally an indication that the investment has met the prescribed, and often rigorous, standards of a stock exchange listing. Many of these standards are designed to protect the investing public by ensuring full disclosure of all significant matters.

Return On Investment (ROI)
A term used for calculating the return, usually expressed as an equivalent annual percentage, on the amount invested in a venture. A simple example will illustrate one approach to calculating ROI:
  • Investors put up $4 million
  • Over the first three years of operation the company loses $3 million
  • In the next two years the company makes a profit of $5 million
    The ROI for this investment at the end of five years is:
($5 million - $3 million) X 100%
5 years

$4 million
= 10% annual ROI

The annual calculation is a "simple average" ROI percentage. A "compounded" rate of return would be a slightly lessor amount.

Share option
A right to acquire shares in the future, usually at a fixed price. Often issued to founders and other key players in the early stages of a company's development. This practice can be good for the company, because issuing relations does not require a cash outlay. Those receiving the options also stand to gain if they can increase the value of the underlying shares. Customarily, share options are used for employee remuneration arrangements. Share options are very similar to warrants, with certain subtle legal differences.

Subordinated debt
Debt that has been ranked behind other debt for purposes of security, preference on repayment, or some other term. For example, investors will sometimes invest in debt that has been subordinated to the bank, meaning that the bank gets repaid before the investors.

Subscription form
A legal document by which investments are purchased, containing important details about the nature of the investment.

Sweat equity
A term used to describe the contribution (other than cash) that founders have made to a project, and for which the founders usually want to get compensated.

Unanimous shareholders agreement
A very critical agreement in many cases with private venture investing. This agreement includes bylaws by which a company will be run, as well as dealing with the procedures for buying and selling of company shares; for example, in the event of a shareholder dispute, a death or other such eventuality.

Value analysis
Given the risk involved, value analysis is the critical assessment that the venture investor should perform to establish whether the investment is worthwhile. In its simplest form, the value analysis is a calculation of the future estimated value of the venture times, the investor's percentage ownership. This amount is compared to what is being invested.

Warrants
Similar to options, warrants give the holder the right to buy a share or other security at some future point in time, usually at a fixed price. Often used as a "sweetener" in a deal to entice investors to participate. For example, an investor buys a certain number of shares and gets warrants granting the right to purchase additional shares in the future at a fixed price, if the investor so chooses. Warrants are very similar to share options, with certain subtle legal differences.

Checklist For Investment Evaluation

Evaluate The Opportunity
Yes
No
I have listed and defined my personal objectives for this investment.
I know my probable return on investment (ROI)
I know the payback period for the investment.
I have discussed this project with other current and potential investors.
I know how long this opportunity has been available.
I understand the financial plan and believe the assumptions and projections are reasonable. If No, has the plan been reviewed by independent professional advisors?
Is the marketing plan realistic?
I understand when the business is expected to become profitable.
I know when I can expect a return on my investment in interest or dividends.
I know how and when I will get my capital back.
If I am purchasing equity, I know what I am purchasing (common shares, preferred shares)
I know if there are warrants or share options attached.
If I am purchasing debt, I know if it is subordinated debt? Convertible debt?
Evaluate The Risk
Yes
No
I know how much I could lose and the risk of loss on this investment.
If the project involves development of a new product, process or other technical innovation, is there independent confirmation that it works?
All the regulatory requirements have been met. (Environmental, zoning, patent searches, etc.)
I know what the funds raised will be used for.
Is the business operational now?
If it is losing money, I know the burn rate.
I know how much my investment will be diluted as a result of the founders getting an interest for their sweat equity.
I think the founders have invested an appropriate amount of cash in the project.
I know what level of involvement is expected of me.
If I want to be on the board of directors, am I entitled to representation?
I understand the legal structure of the investment. If No, I have had professional advice on the subscription form or prospectus.
I know if some or all of my investment is secured by assets.
Could I be legally bound to put up more money in the future?
I understand the legal structure of the venture and the significance of the structure on my current and future risks.
Is adequate insurance in place for assets, key personnel and directors?
Are all tax filings (income tax, payroll, GST, etc.) Up to date and have these filings and related assessments been reviewed?
Evaluate The People
Yes
No
I know and trust the people who are making the sales pitch to me. Or I have confirmed their reputation with credible third parties.
I know what and how the promoters are being paid (if anything).
I know the history of the key implementers of the business plan.
I know the terms of employment, contractual and salary agreements for the key personnel.
I know the reputations of the current shareholders, officers and directors and key professionals to the project.
Has a lawyer conducted corporate and personal searches on those involved in the opportunity?
 
 
 
 
For more information about the content of this document, contact Rick Dehod.
This document is maintained by Rita Splawinski.
This information published to the web on January 2, 1998.
Last Reviewed/Revised on October 9, 2015.