Friday, December 17, 2010

Venture Capital (Equity) vs. Bank Loans (Debt)

What is APR? APR stands for Annual Percentage Rate.  It's the interest rate quoted by banks in their loan documents. An APR is determinable only when the term or duration (i.e., n in a calculation) and the total repayment are predetermined. The APR for small business (and medium business) bank loans will depend on the length of time the company has been operating, the revenue, operating profit, net profit, and EBITDA (earnings before interest, taxes, depreciation, and amortization - a standardized measure of cash flow) and the consistency of these finance/accounting numbers. The less consistent, the more risk. The more consistent, the less risk. Why? Consistency makes the numbers more predictable and the bankers more confident they'll be repaid. That, of course, assumes that the market and industry are relatively stable. So bankers seek a guaranteed return on their investment (loan) in a business. An APR of 15% means that the bank expects an annual return of 15% on their loan to your company. You have a fairly stable business, their risk is moderate (hence the higher interest rate), and their reward is moderate. A bank further mitigates its risk by securing the assets of the business and/or the business owner(s) as collateral for the bank loan.

In contrast, if you asked a venture capitalist for the APR on their potential investment in your business, they would give you a blank look....or look at you like you were crazy. Why? There isn't one. Venture capital is equity. There is NO APR. It's a win or lose proposition. They either make a return because the business is successful and is later sold or goes public or they don't because the business goes bankrupt, shuts down, or is sold for a loss. Venture capitalists measure their returns as a function of the company’s (or venture's - hence the name venture capital) future performance.  Unlike a bank loan, neither the term nor repayment amount is predetermined (known in advance) in venture capital. The business owner/entrepreneur's risk is limited because there is no personal liability, i.e., no personal guarantees or personal assets used as collateral. Due to the increased risk, the venture capitalist gets an ownership stake in the company. In return for this ownership participation, venture capital firms expect a return of 300% - 500% minimum. If they do not expect to reap that type of reward, they will not invest.

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