Obtaining venture capital

Why venture capital

Venture capital firms (VCs) provide financing in return for a proportion of your shares. They take a higher risk than banks, so they expect to receive higher returns. Business angels are wealthy individuals who do the same – although they will usually expect a higher degree of personal involvement than a VC. VCs and angels will often lend you money as part of their investment, as well as providing share capital.

So if you are:

• running a successful business that needs money to grow – for example, to increase capacity to meet existing demand, or to develop new products or markets
• members of an existing management team looking to buy out the existing owners (a management buy-out, or ‘MBO’) or an external management team looking to do the same (a management buy-in or ‘MBI’)
• an exceptionally promising start up looking for funds for development and marketing

and you can’t fund your plans from other sources such as bank borrowings, sale and lease back of premises or other assets, or your own resources, venture capital (also known as private equity finance) may be the answer – but always take advice before approaching a VC or business angel.

Disadvantages of venture capital

Only you can decide whether it is worth giving up part of the ownership of your business in return for finance to take it to the next level. Disadvantages are:

• You must generate the cash needed to make the agreed payments of capital, interest and dividends. This can create great financial pressure.
• You will have to agree to certain restrictions as part of the deal, such as the amount you are paid and your involvement with other businesses, and you will usually need your investor’s consent to major decisions.
• Your investor may insist on putting a representative on your board (or having power to do so if financial targets are not met). For VCs, this is usually a non-executive director who will only take an active part if things go wrong. A business angel will usually want to be on the board himself, and will play a more active part.
• You are under greater scrutiny generally, particularly in relation to your compliance with your duties and responsibilities as a director, eg to act in the company’s best interests, and disclose personal interests in your company’s affairs.
• Your investor will expect regular information and consultation to check how things are progressing. For example, monthly management accounts and minutes of board meetings.

What investors want

A minimum investment

Ordinarily, you should be looking for a minimum investment of at least £250,000 – preferably £500,000 – to be taken seriously by VCs (unless you are a special case, ie you are virtually guaranteed to provide exceptional returns). A business angel will be prepared to invest lower amounts in the business.

A 20 to 30 per cent stake

Many VCs are restricted, by the terms on which they are allowed to invest, to no more than 10 to 20 per cent of the shares in any one business. Few will want more than a 30 per cent stake.

A business angel might be willing to take a higher stake, if the growth prospects are sufficiently enticing. But you would have to be very certain you could work together before giving the angel a stake of more than 30 per cent.

The key question in either case is whether the stake they want is worth the money you need.

A high return

VCs or angels will usually want a compound return of at least 20 to 30 per cent per annum on their investment. Some of this will be dividend and interest payments, but most will be realised as capital growth when they sell your shares. It’s therefore important that you can provide your investor with an exit route (see below).

They will often take a combination of ordinary and preference shares, and debt. Their ordinary shares will have the same voting and dividend rights as yours, and a share of the assets left (if any), if the company has to be wound up.

Their preference shares will give them a guaranteed income as a ‘first call’ on the profits – for example, the right to a ten per cent preferential dividend (eg 10p per £1 share) on their preference shares before any dividend is paid on the ordinary shares. Preference shares may also be ‘redeemable’, ie the investor can cash his shares in and get his money back on a fixed date or series of dates.

As well as the usual company law rights that go with their shareholding, the investment agreement is likely to give them additional rights, such as power to appoint a director to your board. You need to be absolutely sure that you understand and can live with all the rights their stake gives them.

An exit route

Most VCs will want to sell their stake within three to seven years. The most common exit routes are:

• A trade sale to another company.
• Refinancing of their investment by another institution.
• A listing of the shares on an exchange that enables them to be offered to the public, such as PLUS (formerly OFEX), AIM (the Alternative Investment Market) or the Stock Exchange Main Market.
• Repurchase of the investor’s shares by management, or by the company itself.

Discussions with your investors, as their time for exiting approaches, will include agreeing steps to prepare for their preferred exit route.

Threshold requirements

VCs and business angels are inundated with applications every week. You must meet minimum threshold requirements before it is even worth applying.

You must have a successful track record – if it is not already profitable, the business must have a strong chance of generating sustainable and predictable cashflow and profits in the near future.

You need a balanced, experienced and professional management team, who:

• Are putting their own money into the business.
• Are prepared to link a significant portion of their earnings to performance.
• Are contractually tied in – for example, an advertising agency will find it difficult to secure venture capital if key creative people could leave.

If management have been involved with failed businesses in the past, disclose the extent to which they were responsible, and what they have been doing since. If the failure was more than ten years ago, and either they were only peripherally involved or have since rebuilt their fortunes, you probably do not need to worry about it. If it was more recent, you will have to work hard to convince investors that you are worth backing.

You need an excellent business plan – take advice and be prepared to spend time and trouble on it. It will be your selling document, and you will only get one chance at presenting it to each potential investor.

Negotiating the deal

Don’t underestimate the management time required to find and negotiate a deal. An investment can take three to six months to complete (though it can be much faster) and, during this time, business performance can decline.

First, choose advisers. Obtaining venture capital is a major step, so always select advisers who are corporate finance specialists. Request – subject to confidentiality – a list of the venture capital deals they have personally completed in the last 12 months.

Work with them to determine how much finance you need, and when, and the level of interest and dividend payments your cashflow can support (you must have evidence to support your financial projections, including details of your assumptions and how sensitive your projections are). Also work with them to prepare a professional business plan, including a concise executive summary of, typically, no more than six pages.

Use your advisers to identify potential investors (the British Venture Capital Association publishes a directory, listing each member’s preferred investment amounts and industries). Your advisers can contact candidate investors to get an indication of how much each usually invests, and what they will expect in return (though at this stage, everything they say will be subject to further negotiation and ‘due diligence’). For example:

• Roughly what percentage of the company they will expect to own in return for their investment.
• What additional requirements they will want to impose.
• Whether they will supply finance in a lump sum or in stages, increasing investment as the company reaches specific targets.

Create a list of preferred investors and contact them through your advisers, circulating your executive summary. Remember you are ‘buying’ this money, and you should shop around and, maybe, use more than one supplier. You will be in a much stronger negotiating position if you can interest more than one potential investor, so approach a number. Send the full business plan to those who express an interest and arrange an initial meeting and/or presentation.

Prepare in advance for the lengthy due diligence process (typically one to three months), during which the potential investor’s advisers will examine your company’s books, records and managers, so you can provide key information quickly, such as:

• Financial details: For example, the real value of your assets and liabilities; how realistic your profit and loss forecasts are; how good your financial controls are.
• Legal details: For example, whether the business is involved in any litigation; what the key supplier and employee contracts are; whether the business has good title to its premises and any intellectual property.
• Key business factors: For example, what the business trends are; how well the business is managed.

Use your advisers to help negotiate valuations, the financial structuring of the deal, and tax implications. Your solicitor will draw up and negotiate the main terms of the investment agreement, which is likely to include:

• The amount and form of the finance to be provided and the rights the investor(s) will have.
• Warranties confirming that the information you have provided is true. If the business later fails and it is proved that you gave misleading information, the investor will usually have the right to claim compensation from whoever provided the warranties (typically you).
• Indemnities, where you agree to accept liability in certain circumstances. For example, if the company is sued in regard to pre-existing contracts.
• Service contracts that tie in key members of management and staff.
• Provision for payment of the investor’s costs – ensure you only pay in the event the investment is completed.

Your solicitor will also advise on other legal issues such as service contracts for key employees and conflicts of interest in the case of management buy-outs.

Nothing will be finalised until the agreement is signed. In particular, the final terms may not be negotiated until the last minute when you are desperate to complete the deal.

Why negotiations fail

The most common reasons are:

• Failure to agree a price or other key terms (this is especially common when several investment firms ‘syndicate’, ie join together to provide the necessary finance).
• Legal problems cannot be resolved.
• Trading performance declines substantially during the process of raising investment.

Professional advice and fees

Total costs of ten per cent or more of the amount raised are not uncommon for smaller investments, and five per cent for larger amounts. You will usually be required to pay the VCs costs too. At a very rough estimate, a successful small company in a conventional business would probably have to pay between £10,000 and £25,000 in fees, to raise £250,000.

You will need an accountant and a lawyer. There are also brokers who claim to offer introductions to venture capital sources, although their services are variable in quality and can prove expensive.

Lawyers and accountants will charge on the basis of hours worked, while brokers usually charge a percentage of the sum raised.  Some may also expect a bonus payment for success in raising capital for you. You will have to pay professional fees even if you do not succeed in raising the money.

If it goes wrong

If you suspect you can’t comply with the investment terms, tell your investor what is happening, and what you propose to do about it. They would rather know than be kept in the dark.

If they are not happy with your explanations and proposals, there will be very little that they can actually do – apart from dumping the shares for the best price they can get, and passing the word around. (That could blight your attempts to raise new capital for years to come, so do not take it lightly.)  If your outside investors hold debt, however, they may (depending on the terms), be able to force you to repay it. Whether they will do it will depend, at least to some extent, on whether they think you are reliable and trustworthy, and are prepared to back your efforts to turn the situation around.

Second-round financing

By the time you need second-round financing, you should have an established track record and management team, and you should be able to get the money on easier terms. You can either go to your existing investors or approach new ones.

If you need more money in the short term (eg within two years), because you miscalculated how much you would need, or the returns are coming in more slowly than you anticipated, or something else has gone wrong, neither your existing investors nor potential new investors are likely to help. Both investing institutions and business angels are hard-headed, and you are most unlikely to be able to tempt them into throwing good money after bad.

Always take legal advice.