What is Venture Capital/Private Equity

What is Venture Capital/Private Equity?

Venture capital is a means of providing long term equity funding to young, fast growing companies. It is often called “direct investment” or “private equity investment”. There are three main types of private equity transactions: startup venture capital, development capital and buyouts.

Companies require funds to develop their business. Financial support can take the form of loans and/or equity capital. A company not listed on a stock exchange can obtain funds from banks or by issuing shares to private investors. Venture capital companies inject funds into the company in exchange for a proportion of its equity.

Venture capital firms are prepared to assume considerably higher risk by investing at the early stages of a company’s development in the hope that they can reap higher returns if the company meets or exceeds its projections.

Venture capital firms realise their returns when an investee company has built a successful track record to qualify for listing on the stock exchange. Other means of exiting from investments are management buy-backs through put options based on a pre-determined formula, private placements to interested third parties or an outright or partial trade sale.

What are the advantages of venture capital?

  • Young companies without a strong track record may have difficulty obtaining funds to finance expansion of their business. Banks may grant them credit facilities but usually require collateral, which they may not be able to provide.
  • Venture capital firms usually inject fresh capital into companies rather than providing commercial loans. This enhances the liquidity of the company without the burden of collateral or interest payments.
  • Venture capital firms may take majority or minority equity positions in a company and are long term investors. They usually require board representation and will take an active interest in the investee company’ affairs. While they are not involved in the day-to-day management of the company, venture capital firms are able to add value to the company by providing advice on business strategy, management, organization, financial systems, and access to their global network of contacts.
  • Professional venture capital firms, with their considerable experience, serve as useful sounding boards for companies in many strategic and management areas. They also provide senior level counsel on key issues and infrastructure support to assist young companies.
  • Having sound venture capital partners enhances the credibility of investee companies, which in turn helps them secure future financing.
  • Venture capital firms function as business partners of investee companies, sharing both the risks and rewards of the venture.

What are the stages of investment?

Most successful companies follow a similar pattern of growth. They pass through several phases of development and each phase requires financing of a different size and structure.

A business idea is conceived and the initial concept of the business is formed. The project is initially funded by the entrepreneur’s own resources.

The service or product is produced at this stage, but it has not been sold commercially. Investment in fixed assets and equipment for commercial production is now necessary. As the product has not been widely marketed or tested, its success is still in question. The risk is highest at this stage as the funding commitment is large and rate of failure is high.

The company is now established. Its products or services have been successfully sold and a track record has been built. The company is ready to expand and additional funds are required. At this stage, bank loans may be available but will likely require a level of collateral, which is beyond the means of a young company. As the company is growing rapidly and is branching out to new markets, it may require a series of fund raising. Equity investment at this stage is sometimes termed “expansion or developmental capital”.

The company has now built a track record over a few years with a trend for continuing success. In preparing for listing on the stock exchange, there may be a need to restructure and strengthen its balance sheet. At the same time, an endorsement by a reputable venture capital firm will attract greater investor interest. This is the last stage of venture capital investment where the risks are relatively lower.

A buyout is the acquisition of control over a business either through the purchase of shares or the assets and trading liabilities of the business. There are various types of buyouts: Management Buyout (MBO), Leveraged Buyout (LBO), Management Buyin (MBI), or a combination of all three. Buyouts are usually only applicable for existing businesses with sustainable cashflows. In a buyout, the venture capitalists will own the majority of the share capital and have strategic control over the company, leaving the day-to-day operations to management.

What is the usual size of venture capital investments?

The size of investments depends on the stage of development of the company and the type of deal. The seed/start up stage requires considerably less funds than the expansion/mezzanine stage. Startup venture capitalists usually invest between US$1m – US$5m per transaction and growth capital between US$5m – US$30m. Buyouts can range from US$20m to over US$1 billion transaction size.

The venture capital firm spends a similar amount of time in evaluating, monitoring and managing a small investment as they would a larger one. In fact, a small early stage investment may require more help from the venture capitalist. This does not mean that venture capital is not available to fund small early stage companies; there are firms that specialise in start up stage investments. This is particularly true for small companies involved in the high technology sector.

Where the investment requirement of the project is very large, several venture capital firms may join together to co-invest. In respect to buyouts, it is not uncommon for a lead investor to put together the transaction and to syndicate this down to other funds.

How do venture capitalists choose their investments?

Each venture capital firm sets its own criteria for making investments. They differ in their investment preferences in geographical areas, specific industries, size of investment, the stage of a company’s development, the expected returns, structure of the investment and the extent of involvement in the company’s activities.

The important criteria are:

Industry and Product
The venture capital firm identifies businesses with a competitive advantage in fast growing industries. “Niche” businesses with good margins are important factors.

The Company
The venture capitalist involved in the expansion and mezzanine stages will want to see several years of consistent growth and profitability and sound management. The company should also demonstrate a leadership position in the industry. For buyouts, it is important that the business is able to generate sustainable cashflows.

The venture capital firm does not take an active role in the day-to-day operations of the company. It invests in the company and its management to achieve the company’s strategy and objectives. The venture capital firm must be confident of the capability, the integrity and the drive of the leader and the depth of its management team.

Return on Investment
The venture capital firm accepts higher risks on its investments in return for a higher return on its funds. Given the high failure rate of venture capital investments, the lack of liquidity and dividends for several years, the venture capitalist would normally expect a return in excess of 25% (depending on the stage of investment).

Availability of Debt Financing
In LBO’s, the extent and terms of debt financing play a major role in structuring and completion of the transaction.

How to choose and approach a venture capital firm?

In selecting a venture capital firm, the young company should attempt to identify a suitable match by finding out the investment preferences of particular venture capital firms in terms of the stage and size of investment, geographical location, and industry sectors.

In accepting venture capital, the company should understand that the venture capitalist is its his business partner and will demand a more disciplined and professional management style. As the partnership will last several years, it is important for the company to select a venture capitalist that the company believes it can work well with.

The young company must provide information that clearly explains its business and potential, its strategy and how management will achieve its projections. A creditable business plan is critical to “selling the investment”.  

What makes a good business plan?

A good business plan is essential in facilitating the evaluation of a company seeking funding by venture capital firms. It should contain the following:

  • Background of the CompanyDescription of the company’s history, shareholding, majority shareholders and recent developments.
  • Business operationsCurrent business and operations, product details, business organization structure and operating process, size/scale, major suppliers and procurement sources, marketing and distribution channels.
  • IndustryA review of the industry, including regulatory changes, entry and exit barriers, the competitive environment, market outlook and potential technological development.
  • ManagementEvidence of a committed management structure and team, with description of key management members’ experience, credentials and capabilities.
  • Future strategy and plansClear delineation of business goals, medium and long-term expansion strategies, competitive advantages of the company and how they can be best used to achieve the expansion strategies.
  • FinancialsPast performance, a detailed analysis of financial and operational forecast and how new funds will be used.
  • Proposed investmentA description of the proposed investment transaction, including size and structure of the investment being sought, the projected return on investment, the intended funding period and any exit route.

Willingness on the part of the company seeking funding to provide full information is generally looked upon favourably by the venture capital firms, and will greatly facilitate the evaluation.

How do venture capitalists invest their money?

The investment process, from the initial evaluation stage to completion of documentation, usually takes a minimum of three to six months.

Initial Evaluation
The request for financing, business plan (for companies already in operations) and audited financial statements must first be submitted to the venture capital firm, which will then determine the merits of the proposal. During this process, many applications for funds will be turned down, as they do not fit into the venture capital firm’s investment criteria.

Initial Negotiation
When a venture capitalist firm is interested in a young company, it will negotiate the general terms and structure of the investment with the company and submit its recommendation to its investment committee for initial approval.

Due Diligence
When the initial investment proposal is approved, a memorandum of understanding on the broad terms and structure will be agreed upon. It will be necessary at this stage for the venture capitalist firm to verify the facts and assumptions presented in the proposal. They will conduct further independent investigation on the product and its technology; the market and its competitors; and the distribution network. Often the help of outside consultants and market research are sought. The financial plans are reviewed rigorously. During this process, full disclosure by the company is important, and the company’s staff, suppliers, customers, banks, accountants and lawyers may be interviewed.

Final Negotiation and Completion
Many issues will be covered, but the key points may be:

Using the data and insight obtained during the due diligence process, the venture capitalist will undertake a “valuation” of the company by application of price to earnings multiples, asset valuation and other required return calculations.

The decision will be made on the amount of investment and whether it should take the form of equity, quasi-equity or other hybrid instruments (common shares, preferred shares, convertible loans, warrants, options). In buyouts it is normal for a new company to be formed to acquire the assets and trading liabilities. Debt financing if available will be simultaneously injected into the transaction at completion.

The extent of the venture capital investor’s participation in the affairs of the company will be determined. This could involve representation at the board level, the appointment of a financial controller or other key management personnel, disclosure requirements, minority shareholders’ protection and rights.

Upon formal approval of the investment by the venture capitalist’s investment committee, legal documents will be prepared and signed. The shareholders’ agreement will spell out the rights and obligations of both parties covering the terms of the investment, voting rights, sale arrangements, dividend policy, and venture capitalist’s approval on matters that may affect the business plan.

The venture capital firm’s representatives on the company’s board will be able to participate actively on all major decisions. The venture capitalist will also monitor its investment closely through regular reviews of financials and operations with management. It is usual in buyouts that the venture capital firm will control the board of the company.

Venture capitalists typically exit the investment between 3-5 years after the investment date. Companies should be clear that venture capitalist firms require an exit strategy be agreed before the investment is made and is constantly reviewed during the investment holding period.