Venture Capital funds buy shares in young companies that are at a fairly early stage of their growth. Companies that raise funds this way will normally be generating revenue but may not yet have reached profitability or be breaking even on a cash flow basis. However, some VC firms also back start-ups. Venture capital investments typically range from a few hundred thousand pounds up to £2m-plus.
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The Informed Funding two-minute guide: Venture Capital
- What is venture capital funding?
Venture capital (VC) funds are run by professional fund managers who invest in young businesses (sometimes including seed-stage companies) with the aim of accelerating their growth through a combination of cash, industry expertise and contacts. Venture capital mainly consists of equity investment, meaning that the VC will buy shares in the company that it will eventually sell in order to generate a profit. VC funds usually aim to hold their shares for at least three to five years and may take part in follow-on rounds of fundraising alongside new investors if the company’s growth is such that it needs additional capital. The VC will ultimately aim to exit by selling some or all of its shares to another investment fund, to a corporate buyer who takes over the business or to the public if the business is floated on the stock exchange.
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- What sorts of companies do VCs look for?
VC investors aim to identify companies with very high growth potential that, if successful, are therefore capable of generating very high returns on their initial investment. In practice, this often means companies in fast-growing, technology-based industries such as software, online products and services, medical and green technologies and so on. It is generally more difficult for companies in mature industries that have lower overall growth rates to attract the attention of VC investors.
- How much can I raise this way?
VC investments vary significantly in size but generally the minimum is about £500,000 and the maximum can be several million pounds if the potential of the business warrants. Because VCs are professional fund managers who invest on behalf of other organisations (including pension funds, insurance companies and branches of the government) they carry out extensive due diligence on each potential deal using professional advisers including lawyers and accountants. The cost of this professional advice tends to mean that it is not economic for a VC fund to undertake small deals, which is why early-stage funding rounds are often carried out by business angel investors who carry out more of their own due diligence and so keep their costs down.
- What are the advantages of securing VC funding?
Success in securing VC investment represents an important endorsement of a business and its management team because the process will have involved extensive professional scrutiny of the business and its growth plans. VC investment is likely to bring with it access to important new contacts and sources of expertise and advice for the founders as they seek to develop the company. Having a VC fund as an investor may also make it easier for the company to secure debt finance, particularly if the debt needs to be unsecured.
- What kind of due diligence is involved in a VC investment?
VC deals involve extensive professional due diligence that can last for several months. The fund will scrutinise the business plan on which the investment proposal is based as well as the backgrounds of the management team. Although a committed management team with relevant experience will be well placed to seek VC funding, founders who have already achieved success as entrepreneurs in previous businesses are at an advantage where VC investors are concerned. They will also expect to see the management team commit their own money to the company.
- How long does the process take?
Having made contact with a VC firm and submitted your business plan, you should expect to receive a response within a week or two. If your proposal is rejected, try to establish why it failed as that will help with future attempts. If the VC is interested, it will suggest an initial meeting to ask further questions. If successful that will lead to discussions about the value of the business and the ultimate terms of the investment, as well as detailed due diligence on your business plan and the management team. All told, you should expect this to last several months.
- Do I need professional advice?
VC agreements are complex and involve giving legally binding “warranties” that certain facts that you have disclosed are true and complete. You will therefore need your own lawyers, accountants and financial advisers to help in the negotiations. Apart from protecting your interests, this will allow you to devote as much time as you can to running your business rather than being occupied full time with the fundraising process. Many VCs will be reluctant to deal with a management team that is not receiving independent professional advice.
- What will the final agreement consist of?
The exact terms of the investment will be set out in the legal documents signed at the end of the process. These will include the Shareholders Agreement, which specifies the terms of the deal; the Articles of Association, which set out the rules for the running of the company; as well as any formal disclosures of information that the company makes as part of the agreement and that it guarantees are true and complete. These so-called “warranties” are legally binding and can give grounds for legal redress in the event of disputes.
- Will a VC fund expect seats on the board?
Yes, in almost all cases. A VC fund will usually take at least one board seat.
- Need to know:
- Any investment by a VC fund will involve the existing shareholders undergoing a significant degree of dilution as their overall share of the equity is reduced by the new money. VCs will generally expect a large minority stake as a minimum.
- Although the management and other early investors, such as business angels, will hold ordinary shares, VCs will normally insist of having at least part of their equity investment in other classes of share that have enhanced, or preferred rights, meaning that the holders rank ahead of ordinary shareholders in certain situations and may have guaranteed preferential access to dividends or other profit shares. These “preferred” instruments will usually be convertible into ordinary shares.
- VCs may also provide part of their investment in the form of debt. As well as paying interest, this debt may have warranties attached to it that give the VC a right to buy further shares in the company in future at a pre-set price.
- The costs of both sides’ due diligence in the VC deal are usually paid by the company receiving the investment. Professional fees will be taken out of the sum ultimately invested in the business, meaning that the founders’ stake is reduced slightly further in order to cover these costs.
- Raising finance via equity will result in strengthening of the balance sheet of the company as cash will be raised without increasing the liabilities of the company.
- Raising finance via equity may be a preferable route as it leaves the option of debt financing available for the future. However, depending on the conditions attached to preference shares, these may need to be treated as debt in the financial statements.
- If convertible debt is issued to VCs this will require a split accounting treatment whereby a portion of the amount raised is treated as equity and the other portion as a liability.
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