Understanding Venture Capital
Venture capital is a type of investment that is used to fund companies with high-growth potential, including startups. Under a venture capital agreement, you effectively sell the investor a stake in your company in return for finance.
Venture capital is not like debt finance. Investors share the risk with you, intending to make high returns on their investment when they exit the arrangement. Since their returns depend on your ability to grow, investors expect to have a say in your business decisions. They usually invest for the medium to long term, with a typical investment period being between five and seven years.
In this guide, we take a look at the pros and cons of using venture capital to finance your company. We also provide tips on how to approach investors.
Is venture capital right for your company?
Venture capital firms have strict rules about the kinds of company that they will invest in. Generally, investors look for:
- A sound business model, with a clearly defined market and a clear competitive edge.
- High-growth potential.
- A balanced, experienced and highly competent management team.
- An achievable exit opportunity in five to seven years.
You should only consider financing your company through venture capital if you are willing to give up ownership of part of your business.
Advantages of venture capital
- The investor provides advice and support to help your company succeed.
- The investor provides valuable expertise and often has a network of useful contacts.
- Venture capital firms often work with other finance providers or business advisers. They may be able to create a broader finance package for your company.
- You can use the investment solely to grow your business. This is because there are none of the cash flow challenges associated with repaying capital and paying interest as there are with debt finance.
- The investor shares the risks with you. If you run into problems, the investor will work with you to try and solve them.
Disadvantages of venture capital
- Securing investment can be time-consuming, complicated and costly.
- You’ll have to give up shares in your company.
- You’ll need to give up some personal control over the business direction. You’ll usually also need to work with a non-executive director appointed by the investor.
- The management structure might have to change, bringing in new people to fill gaps in expertise – all of which adds to the cost.
- The investment agreement will include requirements that have been put there to protect the investor’s interests. For instance, you might need their approval for major business decisions.
An up-to-date business plan is essential for presenting your company to potential investors. A good business plan should:
- Show that there is a market and a realistic strategy to develop your company.
- Detail the right people needed to put the plan into action.
- Show how much money is needed, for how long, and why it is required.
- Provide detailed financial forecasts to show how investors will be able to achieve an attractive return on their investment.
An interested investor will want to meet you and the management team to discuss the business plan in more detail. This is a significant opportunity to impress the investor with your knowledge and understanding of your business.
Negotiating the investment deal
The main areas for negotiation are:
- The amount of money to be invested, and the percentage ownership that the investor will receive.
- The structure of the funding package.
- The investor’s key investment terms.
- The costs of items such as due diligence and legal fees, and who will meet these costs.
Once you reach broad agreement, the investor provides an offer letter outlining the main terms of their investment proposal. This will be subject to due diligence and signing the contracts.
You will be in a stronger position to negotiate a more favourable deal if more than one investor is interested in your company.
Next, the investor will want to go through due diligence. This means investigating and assessing what they have been told about your company and its potential. Due diligence typically involves a review of:
- Current financial details and forecasts.
- Compliance with legal and tax obligations.
- Contracts with customers, suppliers and employees.
- Details of any litigation.
- Assets and intellectual property owned.
- Business management processes.
Due diligence is the stage at which many deals fail, so you must be well prepared for the process. Accountants usually visit your company to carry out due diligence.
The investment agreement
The investment agreement is a formal document based on the investor’s offer letter. The agreement legally binds your company and the investor to the agreed terms. It is drafted by the investor’s lawyer and is then subject to negotiation to make sure that the terms are agreeable. It’s a good idea to take legal advice during this part of the process to make sure you understand the terms in the agreement.
The investment agreement usually includes:
- The amount and form of the investment.
- The specific rights of the investor.
- Warranties to confirm that the information provided to the investor is true.
- Indemnities so that you accept liability if certain events happen.
The terms of the investment agreement will require your company’s articles of association and any existing shareholder agreement to be amended to reflect the specific rights of the new investor.
The investment process is complete once both parties sign the investment agreement, and the funds are paid to your company.
Investors’ exit routes
Investors typically exit from their investment after five to seven years. There are three main exit routes:
- A buy-out of the investor’s stake by the company or the other shareholders.
- A trade sale. Another business buys the whole company, enabling all the investors, including you, to get their investment back.
- Flotation on a stock market (often known as initial public offering, or IPO). This is the preferred route since it can lead to the biggest gains, but it’s also the least common because most companies simply do not grow enough to float.
The investor generally reserves the right, in the absence of a suitable alternative, to sell their shares to a new investor, although this rarely happens.
Hints and tips
- Get advice from a professional adviser before starting to look for venture capital. This can save time and effort, especially if they advise that venture capital does not suit your business.
- Before starting the process, make sure that your company is being managed as efficiently as possible, with effective systems in place to maximise profitability and efficiency.
- Make sure that all records are up to date and all necessary business controls are in place.
- Don’t underestimate the amount of time needed. Even after finding an interested potential investor, the investment process typically takes between three and six months. While it can sometimes be quicker, it can also take much longer.
DISCLAIMER While all reasonable efforts have been made, the publisher makes no warranties that this information is accurate and up-to-date and will not be responsible for any errors or omissions in the information nor any consequences of any errors or omissions. Professional advice should be sought where appropriate.