Financial Markets and Institutions (2-downloads)

Venture Capitalists Lose Focus with Internet

Companies

Table 22.2 shows that there was a tremendous surge

in funds available for venture capitalists in the last half

of the 1990s. Much of the investing focus was on the

financing of dot-com companies. There are two serious

ramifications that result. First, it is likely that there are

only a certain number of worthy projects to finance at

any one time. When too much money is chasing too

few deals, firms are going to obtain financing that

would be rejected at other times. As result, the aver-

age quality of venture fund portfolios falls.

A second problem caused by the surge of money

into venture funds is that the ability of the partners to

provide quality monitoring is reduced. Consider the

case of Webvan, an Internet grocer that received

more than $1 

billion in venture financing. Even

though it was backed by a group of experienced

financiers, including Goldman Sachs and Sequoia

Capital, its business plan was fundamentally flawed.

In its short life, Webvan spent more than $1 billion

building automated warehouses and pricey tech

gear. This high overhead made it impossible to com-

pete in the grocery business, where average margins

are about 1%. Had the investment bankers been

actively monitoring the activities of Webvan, they

might have balked at developing an infrastructure

that required 4,000 orders per day per warehouse

just to break even. Not surprisingly, Webvan

declared bankruptcy in July 2001.

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564

Part 6 The Financial Institutions Industry

managing the equity fund investments. In addition, they get a share of the profits, usu-

ally pegged at 20%, when the firm is sold or taken back public. An additional perk is

that the profits for both CEOs and the partners are taxed at the 15% capital gains rate,

rather than the 35% rate they would suffer if the income was received as salary.

Life Cycle of the Private Equity Buyout

In a typical private equity buyout, a partnership is formed and private equity investors

are contacted to pledge participation. Each investor usually pledges at least $1 mil-

lion of capital and agrees to leave the funds under the partnership’s control for an

extended period of time, often five years or more.

The partnership now identifies an underperforming company that it believes can

be turned around by new management. Using the equity contributed by the partners,

the firm buys the outstanding public shares of the troubled company. A new CEO and

board is elected to run the company. The managing partners tend to be active par-

ticipants in the management of the firm.

Once the company is revived and showing improved revenues and profitability,

it will be either sold to another firm or taken public in an lPO. This is where the

investors in the private buyout earn their return. Because the company is now

stronger, it is expected to sell for much more than it did when initially purchased and

taken private.

S U M M A R Y

1. Investment banks are firms that assist in the initial

sale of securities in the primary market and, as

securities brokers and dealers, assist in the trading

of securities in the secondary markets, some of

which are organized into exchanges. The Securities

and Exchange Commission regulates the financial

institutions in the securities markets and ensures

that adequate information reaches prospective

investors.

2. Underwriting involves the investment banking firm’s

taking ownership of the stock issue by purchasing all

of the shares from the issuer and then reselling them

in the market. Issues may be oversubscribed, under-

subscribed, or fully subscribed, depending on

whether the price is set correctly.

3. Investment bankers assist issuing firms by providing

advice, filing documents, and marketing issues.

Investment bankers often assist in mergers and acqui-

sitions and in private placements as well.

4. Securities brokers act as go-betweens and do not usu-

ally own securities. Securities dealers do buy and sell

securities and by doing so make a market. By always

having securities to sell and by always being willing to

purchase securities, dealers guarantee the liquidity of

the market.

5. Investors may place an order, called a market

order, to buy a security at the current market price.

They may also set limits to the lowest price at which

they will sell their security or the highest price they

will pay for a security. Orders of this type are called

limit orders.

6. Some brokerage houses provide research and invest-

ment advice in addition to conducting trades on

behalf of customers. These are called full-service

brokers. Discount brokers simply place orders.

Brokerage houses also store securities, advance loans

to buy securities, and offer cash management

accounts.

7. Private equity investments include both venture fund

investing and capital buyouts of public companies. A

typical venture fund investment includes pooling

funds from investors to use to support a new company

until it is able to go public. In a capital buyout,

investors’ funds are again pooled, but this time they

are used to buy a controlling interest in a public com-

pany that is then taken private.

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Chapter 22 Investment Banks, Security Brokers and Dealers, and Venture Capital Firms

565

K E Y   T E R M S

capital buyout, p. 558

confidential memorandum, p. 551

definitive agreement, p. 551

due diligence, p. 551

early-stage investing, p. 562

fully subscribe, p. 549

Glass-Steagall Act, p. 544

initial public offering (IPO), p. 546

investment banks, p. 544

later-stage investing, p. 562

letter of intent, p. 551

limit order, p. 553

margin credit, p. 554

market makers, p. 555

market order, p. 553

mergers and acquisitions market,

p. 551

oversubscribed, p. 549

primary market, p. 543

private equity buyout, p. 562

prospectus, p. 546

prudent man rule, p. 561

registration statement, p. 546

seasoned issues, p. 546

secondary market, p. 543

Securities and Exchange Commission

(SEC), p. 546

seed investing, p. 562

short sell, p. 553

stop loss order, p. 553

syndicate, p. 547

tombstone, p. 547

undersubscribed, p. 549

Q U E S T I O N S