Author: Jim Riley Last updated: Sunday 23 September, 2012
Venture Capital is a form of "risk
capital". In other words, capital that is invested in a project (in
this case - a business) where there is a substantial element of risk
the future creation of profits and cash flows. Risk capital is invested as
shares (equity) rather than as a loan and the investor requires a higher"rate
of return" to compensate him for his risk.
The main sources of venture capital in the UK are venture
capital firms and "business angels" - private investors. Separate
Tutor2u revision notes cover the operation of business angels. In these
we principally focus on venture capital firms. However, it should be pointed
out the attributes that both venture capital firms and business angels
for in potential investments are often very similar.
What is venture capital?
Venture capital provides long-term, committed share capital,
to help unquoted companies grow and succeed. If an entrepreneur is looking
to start-up, expand, buy-into a business, buy-out a business in which he
works, turnaround or revitalise a company, venture capital could help
do this. Obtaining
venture capital is substantially different from raising debt or a loan from
a lender. Lenders have a legal right to interest on a loan and repayment
the capital, irrespective of the success or failure of a business . Venture
capital is invested in exchange for an equity stake in the business. As
shareholder, the venture capitalist's return is dependent on the growth and
profitability of the business. This return is generally earned when the
capitalist "exits" by selling its shareholding when the business
is sold to another owner.
Venture capital in the UK originated in the late 18th
century, when entrepreneurs found wealthy individuals to back their projects
on an ad hoc basis. This informal method of financing became an industry in
the late 1970s and early 1980s when a number of venture capital firms were
founded. There are now over 100 active venture capital firms in the UK, which
provide several billion pounds each year to unquoted companies mostly located
in the UK.
What kind of businesses
are attractive to venture capitalists?
Venture capitalist prefer to invest in "entrepreneurial
businesses". This does not necessarily mean small or new businesses.
Rather, it is more about the investment's aspirations and potential for growth,
rather than by current size. Such businesses are aiming to grow rapidly to
a significant size. As a rule of thumb, unless a business can offer the prospect
of significant turnover growth within five years, it is unlikely to be of
interest to a venture capital firm. Venture capital investors are only interested
in companies with high growth prospects, which are managed by experienced
and ambitious teams who are capable of turning their business plan into reality.
For how long do venture
capitalists invest in a business?
Venture capital firms usually look to retain their investment
for between three and seven years or more. The term of the investment is often
linked to the growth profile of the business. Investments in more mature businesses,
where the business performance can be improved quicker and easier, are often
sold sooner than investments in early-stage or technology companies where
it takes time to develop the business model.
Where do venture capital
firms obtain their money?
Just as management teams compete for finance, so do venture
capital firms. They raise their funds from several sources. To obtain their
funds, venture capital firms have to demonstrate a good track record and the
prospect of producing returns greater than can be achieved through fixed interest
or quoted equity investments. Most UK venture capital firms raise their funds
for investment from external sources, mainly institutional investors, such
as pension funds and insurance companies.
Venture capital firms' investment preferences may be affected
by the source of their funds. Many funds raised from external sources are
structured as Limited Partnerships and usually have a fixed life of 10 years.
Within this period the funds invest the money committed to them and by the
end of the 10 years they will have had to return the investors' original money,
plus any additional returns made. This generally requires the investments
to be sold, or to be in the form of quoted shares, before the end of the fund.
Venture Capital Trusts (VCT's) are quoted vehicles that aim to encourage investment in smaller unlisted
(unquoted and AIM quoted companies) UK companies by offering private
investors tax incentives
in return for a five-year investment commitment. The first were launched
in Autumn 1995 and are mainly managed by UK venture capital firms. If
obtained from a VCT, there may be some restrictions regarding the company's
future development within the first few years.
What is involved in the
The investment process, from reviewing the business plan
to actually investing in a proposition, can take a venture capitalist anything
from one month to one year but typically it takes between 3 and 6 months.
There are always exceptions to the rule and deals can be done in extremely
short time frames. Much depends on the quality of information provided and
The key stage of the investment process is the initial
evaluation of a business plan. Most approaches to venture capitalists
at this stage. In considering the business plan, the venture capitalist will
consider several principal aspects:
- Is the product or service commercially viable?
- Does the company have potential for sustained growth?
- Does management have the ability to exploit this potential and control the
company through the growth phases?
- Does the possible reward justify the risk?
- Does the potential financial return on the investment meet their investment
In structuring its investment, the venture capitalist
may use one or more of the following types of share capital:
These are equity shares that are entitled to all income and capital after
the rights of all other classes of capital and creditors have been satisfied.
Ordinary shares have votes. In a venture capital deal these are the shares
typically held by the management and family shareholders rather than the venture
Preferred ordinary shares
These are equity shares with special rights.For example, they may be entitled
to a fixed dividend or share of the profits. Preferred ordinary shares have
These are non-equity shares. They rank ahead of all classes of ordinary shares
for both income and capital. Their income rights are defined and they are
usually entitled to a fixed dividend (eg. 10% fixed). The shares may be redeemable
on fixed dates or they may be irredeemable. Sometimes they may be redeemable
at a fixed premium (eg. at 120% of cost). They may be convertible into a class
of ordinary shares.
Venture capital loans typically are entitled to interest and are usually,
though not necessarily repayable. Loans may be secured on the company's assets
or may be unsecured. A secured loan will rank ahead of unsecured loans and
certain other creditors of the company. A loan may be convertible into equity
shares. Alternatively, it may have a warrant attached which gives the loan
holder the option to subscribe for new equity shares on terms fixed in the
warrant. They typically carry a higher rate of interest than bank term loans
and rank behind the bank for payment of interest and repayment of capital.
Venture capital investments are often accompanied by additional
financing at the point of investment. This is nearly always the case where
the business in which the investment is being made is relatively mature or
well-established. In this case, it is appropriate for a business to have a
financing structure that includes both equity and debt.
Other forms of finance provided in addition to venture
capitalist equity include:
- Clearing banks - principally
provide overdrafts and short to medium-term loans at fixed or, more usually,
variable rates of interest.
- Merchant banks - organise
the provision of medium to longer-term loans, usually for larger amounts than
clearing banks. Later they can play an important role in the process of "going
public" by advising on the terms and price of public issues and by arranging
underwriting when necessary.
- Finance houses - provide
various forms of installment credit, ranging from hire purchase to leasing,
often asset based and usually for a fixed term and at fixed interest rates.
Factoring companies - provide
finance by buying trade debts at a discount, either on a recourse basis (you
retain the credit risk on the debts) or on a non-recourse basis (the factoring
company takes over the credit risk).
Government and European Commission
sources - provide financial aid to UK companies, ranging from project
grants (related to jobs created and safeguarded) to enterprise loans in selective
Mezzanine firms - provide
loan finance that is halfway between equity and secured debt. These facilities
require either a second charge on the company's assets or are unsecured. Because
the risk is consequently higher than senior debt, the interest charged by
the mezzanine debt provider will be higher than that from the principal lenders
and sometimes a modest equity "up-side" will be required through
options or warrants. It is generally most appropriate for larger transactions.
Making the Investment - Due Diligence
To support an initial positive assessment of your business
proposition, the venture capitalist will want to assess the technical and
financial feasibility in detail.
External consultants are often used to assess market prospects
and the technical feasibility of the proposition, unless the venture capital
firm has the appropriately qualified people in-house. Chartered accountants
are often called on to do much of the due diligence, such as to report on
the financial projections and other financial aspects of the plan. These reports
often follow a detailed study, or a one or two day overview may be all that
is required by the venture capital firm. They will assess and review the following
points concerning the company and its management:
- Management information systems
- Forecasting techniques and accuracy of past forecasting
- Assumptions on which financial assumptions are based
- The latest available management accounts, including the company's cash/debtor
- Bank facilities and leasing agreements
- Pensions funding
- Employee contracts, etc.
The due diligence review aims to support or contradict
the venture capital firm's own initial impressions of the business plan formed
during the initial stage. References may also be taken up on the company (eg.
with suppliers, customers, and bankers).
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