Each year, UK private equity firms supply billions of pounds of venture capital to form, develop and reshape ambitious UK companies with high growth prospects. Private equity is committed, long term and risk sharing. It provides companies with the personal experience of the investors and a stable financial base on which to make strategic decisions. A wide range of sources, types and styles of private equity are available to meet many different needs.
A suitable case for equity
Your business is most likely to be suitable for a venture capital investment in the following circumstances:
- You want a minimum investment of at least £250,000.
- Smaller amounts may be available in special cases, but it is often easier to raise £5 million than it is to raise £500,000.
- You can offer the investors the possibility of a high return.
- This usually means a compound return of at least 30% to 40% per annum on their investment. Most of this return will be realised as capital growth.
- You have a balanced, experienced and professional management team.
- Your management team needs to have a successful track record.
- You need to show commitment. In practice, venture capital firms usually measure this in terms of personal investment. They are likely to want a significant part of management's personal earnings to be strongly linked to business performance.
- All key personnel must be contractually tied in on mutually agreed terms. For example, an advertising agency will find it difficult to secure venture capital if key creative people could leave.
- Existing businesses should have a successful track record. The venture capital firm must be sure your business will generate sustainable and predictable cash flow and profits in the near term if not already profitable.
- Most venture capital firms provide expansion financing. This allows an already successful company to achieve the next stage in growth by, for example, increasing capacity to meet demand or developing new products.
- Finance is often provided for management buy-outs (MBOs) and management buy-ins (MBIs). An MBO allows an existing business to be acquired by its current management team. With an MBI, an external management team buys in.
- Some exceptionally promising start-ups can attract venture capital to finance their development and marketing costs.
- You are able to provide an exit. Most venture capital firms will want to realise their profits, typically within three to seven years. The most common exits are:
- a trade sale to another company
- refinancing of their investment by another institution
- a listing of the shares on an exchange, for example OFEX, AIM or the Stock Exchange Main Market
- repurchase of the venture capital firm's shares by management.
Even if the venture capital firm is not going to exit, it will want to keep this option open.
The drawbacks of venture capital funding
- Venture capital imposes certain constraints.
- You will have to generate the cash needed to make the agreed payments of capital, interest and dividends.
- Specific legally binding covenants will be included in the investment agreement to protect the venture capital firm. For example, you may have to agree to limit the amount you are paid, or to be prohibited from involvement with other companies with conflicting interests. You may be required to obtain the venture capital firm's approval before making certain major decisions.
- The venture capital firm may require a nominated representative on your board, typically as a non-executive director. This director may want to provide hands-on management if things are going wrong, but will usually only be involved in strategic decisions.
- The venture capital firm will expect regular information and consultation to check how things are progressing (for example, monthly management accounts and minutes of board meetings).
- Acquiring venture capital involves considerable expense.
- Total costs of 10% or more of the amount raised are not uncommon for smaller investments, and 5% for larger amounts.
- You will need professional advice.
- You will usually be required to pay the venture capital firm's costs.
- Acquiring venture capital involves considerable management time.
- The whole process typically takes six to twelve months, though it can be much faster.
- It is not unusual for business performance to decline during this time as management is distracted. This should be addressed.
- Investment deals can fail at the last moment. The most common reasons are:
- There is failure to agree a price or other key terms. This is especially common when several investment firms join together (syndicate) to provide the necessary finance.
- Legal problems cannot be resolved.
- Trading performance declines substantially during the process of raising investment.
Types of private equity finance
- Ordinary shares give the venture capital firm ownership of an agreed proportion of the company. The venture capital firm's return is made up of a combination of dividends (if any) and the increase in the capital value of the shares.
- Ordinary shares are cheap for the company to finance in the short term. Dividends can be zero (unless the investment agreement specifies otherwise) but may be a contractual share of profits.
- Negotiations over the proportion of shareholding that the venture capital firm receives for an investment can be long and difficult.
- You will tend to value your company, and thus your shares, more highly than outsiders will.
- Preference shares are similar to debt, as they pay a fixed dividend and are repaid on specified dates. But they are unsecured.
- Unlike debt, preference shares protect you against having to pay out cash while the company is making losses (for example, while you are entering a new market).
- You are prohibited by law from redeeming (repaying) preference shares or paying dividends on them unless the company has generated sufficient profits (distributable reserves) to do so.
- Debt consists of overdrafts, loans, hire purchase, leasing and other borrowings.
- Debt is usually secured against specific assets (e.g. your premises or debtors).
- If the company is unable to pay the capital repayments or the interest on time, the lender can sell those assets. This may cause the company to cease trading.
- Usually you borrow from a bank, rather than from a venture capital firm. But some firms can provide loans, leasing and hire purchase as well as equity finance.
- Convertible loans.
- Determine how much finance you need to raise and what your timescales are.
- How much other capital do you have access to?
- Could you raise finance by other means – for example, by selling and then leasing back property or other assets?
- What level of capital and interest payments (and preference share dividends) can your cash flow support?
- Prepare a professional business plan.
This needs to convince potential investors that your business has good prospects and that you know what you are doing.
- Involve an accountant or other professional advisor.
- You must have evidence to support your financial projections. This includes details of your assumptions and how sensitive your projections are.
- Identify potential investors.
- Your accountant or corporate finance advisor may know suitable firms.
- The British Private Equity & Venture Capital Association (BVCA) (www.bvca.co.uk) publishes a directory of members and a guide to raising venture capital. The directory lists each member's preferred investment amounts and industries.
- Contact selected venture capital firms.
- It is most productive – but not essential – to approach them through a professional advisor who has previously worked with the venture capital firm.
- Prepare a concise executive summary of your business plan – typically no more than six pages – to circulate to them.
- Confirm that they have some interest. Do they make investments of the amount you seek in your type of business?
- Send them your business plan and arrange an initial meeting.
- Prepare a concise, persuasive presentation.
The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.