1.What is venture
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
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.
2.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.
3. 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
4. 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
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.
5. 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
- 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:
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.
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.
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
- 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
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 andan Commission sources - provide financial
aid to UK companies, ranging from project grants (related
to jobs created and safeguarded) to enterprise loans in
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
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,
The good news about gains tax is that you only pay it when
you make a profit.