Capitalization Phase of a Venture Capital Investment
Venture capital investment involve various well defined phases. The capitalization phase of a venture capital investment is often also the final phase if all has gone well.
Capitalization actually refers to the perceived value of a company as reflected in the total valuation of its shares of stock. The value is said to be “perceived” because it may often reflect investor confidence in the future reflected in increased sales value of the stock while falling short of the actual asset value of the business. This could work the opposite way as well with the perceived value being much less due to a lack of investor confidence in the future. It is this range of perceived value that creates investment opportunity for venture capitalist. The capitalization phase of a venture capital investment is when they take advantage of perception.
The key moment in the capitalization phase is the IPO or Initial Public Offering. Prior to the IPO, the ownership of the company is divided between the original owners and the investment capitalist. The investment capitalist has provided funding to get the company from concept to viability and profitability. The funding has been provided in return for equity in the company. The terms of the deal may include incentives for conversion of the stock holdings to public stock at the time of the IPO.
When the IPO occurs, a large amount of stock is sold to the public at a set price. Once the stock is sold, it begins to trade freely on public markets. The result of the IPO to the company is a sudden infusion of capital that does not have to be paid back as would a loan. Looking at the company ledgers from a pure accounting standpoint, the value of the company has increased dramatically because the new capital is not balanced by liabilities, but by increased owner equity.
The venture capitalist profits in two ways at the time of the IPO. They can basically cash out their original equity position in return for a much larger share of the post-IPO equity. Since many IPO’s are undervalued to attract buyers, there is a quick increase in price allowing the VC to cash out his investment for a large return. In some cases, the original deal might have included a cash out option that basically pays back the original venture capital investment, at a hefty rate of return, with funds received via the IPO. Many venture capital deals involve a combination that promises a certain return followed by a potentially larger one should the IPO stock have a dramatic increase in price.
The capitalization phase of a venture capital investment is the time when the target business is basically capitalized. It passes from basically private to public ownership. It is a time when profit potential is very high. It is the payoff for the risk and effort put in during the investigative and seeding phases of the project. The goal of the venture capitalist is to take a dream and make it a reality. The capitalization phase is when it is time to take the reality to the bank.