Venture capital

Author: Jim Riley  Last updated: Wednesday 24 October, 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 relating to 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 notes, we principally focus on venture capital firms. However, it should be pointed out
the attributes that both venture capital firms and business angels look 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 of 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 a shareholder, the venture capitalist's return is
dependent on the growth and profitability of the business. This return is generally earned
when the venture 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 funds are
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 investment process?

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
made available.

The key stage of the investment process is the initial evaluation of a business plan. Most
approaches to venture capitalists are rejected 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 criteria?

In structuring its investment, the venture capitalist may use one or more of the following
types of share capital:
Ordinary shares
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 capital firm.

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 votes.

Preference shares
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.

Loan capital
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 areas.

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 positions
- 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).