Venture capital is one venue where shareholder value can be minimized as the risk will then be shared with other parties.
Let’s understand some basics of venture capital:
(a) What really is venture capital?
- Venture capital is a form of “ risk capital” where the capital is invested in a project/business with substantial element of risk relating to the future creation of profits and cash flows.
- Furthermore, this “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.
- They have the characteristic of long-term in nature and “committed” capital, to help unquoted companies grow and succeed.
There is a significant contrast between a loan versus venture capital funding.
In the case of a loan, the lender has a legal right to both interest and principal repayment irrespective of the success or failure of a business.
For the Venture capital, it 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.
(b) What kind of business is attractive to venture capitalists?
Normally, venture capitalist can assist an entrepreneur when he/she is looking to:
- start-up,
- expand,
- buy-into a business,
- buy-out a business in which he works,
- turnaround or revitalise a company,
However, venture capitalist prefers 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 norm, 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.
Areas That Venture Capitalists Are Interested In:
- Internet
- Information Technology
- Semiconductors
- Electronics
- Telecom And Networking
(c) What usually is the length of investment in a business by venture capitalists?
Venture capital firms usually look to retain their investment for not more than five (5) years.
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.
(d) Where do venture capital firms obtain their money?
Similar to any management teams vying for finance, venture capital firms raise their funds from several sources like pension fund, insurance companies, financial institutions ( note that many venture capital companies are actually subsidiary arm of financial institution)
Hence, venture capital companies also need to demonstrate a good track record and the prospect of producing returns greater than can be achieved through fixed interest or quoted equity investments.
Of course, there is always a back to back element when coming to venture capital companies’ investment preference. Don’t forget that they too are committed 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.
(e) 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 besides venture capitalist equity include:
- Normal Banking facilities like overdrafts, short to medium-term loans at fixed or variable rates of interest;
- Merchant banks which organize the provision of medium to longer-term loans, usually for larger amounts than banks;
- Finance houses – 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).
- 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).
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