Venture Capital - Summary of Main Points

Venture capital is a source of funding for young, fast-growing companies or  companies seeking to expand rapidly in a new direction.

Young companies often find it difficult to raise funds through a bank loan or overdraft. They are also too small to raise capital in the public market through flotation on the stock exchange.

The Venture Capitalists make money by owning equity (a proportion of the shares) in the company in return for the money they invest.

There are two main sources of venture capital money: Venture Capital Companies and Business Angels.

Business Angels are wealthy individuals who have spare money which they are willing to invest in small or medium-size businesses that they understand or wish to have some involvement in.

Venture Capital Companies control investment funds (financed by Institutional Investors); they use these funds to invest in small and medium sized businesses which they decide have a reasonable chance of making them a good return on their money.

Typically, venture capital companies make bigger investments than business angels and often specialise in certain business fields.

Venture Capitalists aim to make money through their investment, so they look for companies which have the potential to grow rapidly.

Potential companies often have a novel technology or business model and include many high tech companies developing innovative software or hardware.

Some of today's famous companies like Intel and Apple have had venture capital investments in them.

Because of the innovative nature of such companies, they have a high element of risk associated with them.

As many as two thirds may fail or just break even. However the small number of companies that are profitable often do extremely well, making up for the others.

Venture Capital investments are high risk because the capital invested is usually unsecured - if the business fails the equity investment is lost.

Hence venture capital firms look for a high return for their investment by owning a significant portion of the company; up to a third or more is not unusual.

Venture Capitalists also invest their time and skills in the businesses in which they own equity, working closely with the management.

They often require representation on the company’s board, so they have significant control over important decision making.

A close working relationship can be useful, as Venture Capitalists can provide business expertise and assistance with planning . 

It usually takes between three and six months to arrange a Venture Capital investment, but can take anything up to a year to complete.

Businesses seeking venture capital require expert legal and financial advice when negotiating the agreement. 

The process begins with the Venture Capitalists evaluating a company’s business plan.

The management team will need to show that their product is viable, that their growth plans are credible and that the balance of risk against expected profits justifies the investment.

The managers are then often asked to make a formal presentation to the team of Venture Capital Investors, where detailed questions can be asked and the managers themselves assessed.

When deciding whether to go ahead, Venture Capital Companies will look at the track record of the business, the market it is in, if the market is growing, the growth prospects of the company, if these can be sustained and whether the product can make a good profit.

They will consider the company’s unique selling proposition (UPS) - what is it about the business that will make customers come to them rather than to a rival firm?

A most important aspect is how efficient, experienced and ambitious the management team are and if the Venture Capital Company believes they have the ability to convert their plans into reality.

Once the Venture Capital Company has decided that the business is suitable for investment, they will consider which types of shares they will offer to buy, how many and for what price.

Venture Capital deals often include a mixture of preference shares and ordinary shares. Preference shares are non-equity shares which are entitled to fixed dividends. The board will pay this fixed dividend each year that its company makes a profit, even if they don’t pay ordinary shareholders.

Loans that can be converted into equity shares are also sometimes included as part of the structure of the deal. The loans yield interest on a regular basis, so there is a balance for the Venture Capital Companies between ongoing revenue streams and rewards at the end.

Once this has been decided, the Venture Capital company will send a letter setting out the terms of the proposed investment, conditional on due diligence.

Due diligence is something the Venture Capitalist Companies must carry out. During this process they will use legal and financial specialists to look in detail at the company’s accounts, bank statements, agreements and internal processes to ensure they are being given accurate and full information.

On the completion of due diligence, the deal is drawn up and a formal offer is made to the company.

Venture Capitalists are not interested in long term investments, most investments last between three and seven years.

Before making an agreement, the venture capital firm will have discussed ideas about how its exit will be achieved within a set timescale (exit strategy).

A common exit route is for the company to be listed on a stock exchange, at which time the Venture Capitalist Company will sell its shares; the company could also be bought by a larger company in a trade sale, refinanced by another institution or the management could buy-back the venture capitalists shares.  

Venture Capitalists of all types have tax incentives from the government, within certain rules, to encourage people to invest in start up and expanding businesses.