Hedge Funds as a Source of Venture Capital

Hedge Funds can be a great source of capital for small microcap companies. There are many such funds that specialize in funding small public companies. These types of funds are sometimes referred to as Private Placement Funds, PIPE (Private Investment in Public Equity) Funds, Regulation D Funds or even Microcap Funds.

Although these types of funds specialize in funding companies with under $300 Million in market capitalization, they mostly focus on companies with less than $100 Million in market capitalization, that cannot obtain significant amounts of bank financing for expansion. They have many different structures and even combinations of structures they use to fund companies.

Visit this section on Hedge Fund Formation if you are interested in starting a hedge fund or want to learn more about them and how they are structured.

You can also visit this section if you are interested in a Hedge Fund Definition.

Although they are generally a potential source of capital for small private companies, they usually do not invest in start-up companies. The reason for this is they need liquidity and don’t like to tie up their capital for long periods of time. With a little bit of research you can find a few that invest in private companies.

They tend to focus on the Exit Strategy associated with their investment just as much as they focus on the deal terms of their investment. The Exit Strategy is extremely important to them since they are supposed to be able to “hedge” against downturns in the market. If they have liquidity in their investments then that helps them to move out of a stock position before it drops too far.

The Exit Strategy preferred by Hedge Funds is the sale of free trading stock into the public market. The quickest way to accomplish this is for a private company they have decided to fund, to do a reverse merger.

A “reverse merger” is when an existing private company buys an existing public company with a stock symbol, which is usually a “shell company”. A shell company is a public company that although still in existence and having a stock symbol, is no longer operating a business. The business plan obviously failed and that company went out of business, but the public entity or “shell” still exists. This is the key ingredient in the “reverse merger”.

LeadDog Capital L.P. is one such fund that provides funding to public companies but also to private companies followed by a direct public listing or through Reverse Merger Funding.

There are many shells currently on the Pink Sheets and over-the-counter Bulletin Board. These shells went out of business because their business models failed and they ran out of capital. Sometimes investors take over these shells from bad investments they made or they buy shells to find good private companies to fund through a reverse merger transaction. This gives them their Exit Strategy and they make use of the shell.

Another effective tool that is used by them is a convertible security. The security converts at 10% to 30% below the closing bid of the stock at the time the investor sends a conversion notice to the company. The conversion notice requests that the convertible security be converted into common stock. Convertible Notes and Convertible Preferred Stock are often used. This “hedges” the investment so either way the investor makes a profit on the investment, unless of course the company goes out of business and the stock no longer trades. These financing structures have become known as “floating convertibles”, because no matter how low the stock price goes, the Hedge Fund still gets its 10% to 30% discount below market.

In addition to , Hedge Funds, check out Other Funding Sources to Consider for Venture Capital.