While Dragon’s Den has inspired many entrepreneurs to pitch to their ideas to investors, in real life the world of venture capital isn’t quite how it’s portrayed on TV. For a start, professional investors will never make an on the spot decision without knowing the background. Behind the scenes, even Dragons’ Den candidates undergo a due diligence process.
What’s more, venture capital isn’t just about launching weird and wonderful gadgets. Venture capitalists are equally interested in the people behind the products. In fact, many companies that receive funding have no products at all as they are in the service sector. Venture capital is all about business growth.
What is venture capital?
Essentially venture capital (VC) provides funding to grow a business – whether that’s to help a start-up get off the ground or an established business to fund expansion.
Venture capitalists provide investment in exchange for a stake in your business and achieve their returns when they sell the stake – perhaps to management, another company, another investor, or through a stock market flotation.
Unlike a bank loan, which requires you to have sufficient cashflow to repay it over three to five years, you do not have to repay a VC investment – unless of course you want to buy back your stake at some point in the future. Even where dividends are part of the terms, the business will only pay them if you can afford it. Therefore venture capital is good for businesses which take a long time to generate revenue.
Another difference is that venture capitalists commit for the long term – unlike a bank which is entitled to call in its money if you breach the terms. And venture capital is not secured on your assets, whereas a bank can put your company into receivership if you fail to keep up repayments.
Venture capitalists share the risks and rewards. The more profitable your business, the more their shares will increase in value and the greater their returns. However should your company fail, the VC will be behind the banks in the queue for repayment and, like you, stand to lose their investment.
VCs are true business partners who will look at the company from the same perspective as the management team. It is in their interests to help you succeed. One of the biggest benefits is the advice and experience they bring to the business. Regardless of the sector, businesses share common problems. My own firm, for example, has investments in over 400 companies – we have first-hand experience in dealing with virtually every situation.
What companies are suitable?
However venture capital isn’t suitable for everyone. Businesses need to fulfill four key conditions:
• High growth prospects – because VCs make long-term investments, they need fast-growing businesses to achieve the returns they seek. Therefore, your business must be capable of being scaled up quite quickly, and you and your team will need the ambition to drive its growth.
• A unique selling point – VCs don’t want to invest in a business that can lose its market share overnight. There must be some way to defend your position such as intellectual property that can be protected or an industry with high barriers to entry.
• A good management team – the venture capital industry is very much about people and the quality of management is critical. Backing a new venture is always risky but if the management is inexperienced, it’s doubly so. Ideally management should have relevant industry experience, a track record for making money and a full range of complementary skills.
• Owners that are willing to share the equity – the VCs will own part of the business alongside you, though usually you will retain a majority shareholding. However do remember that you are not ‘giving away’ equity – the VC firm is buying it off you.
Behind the scenes
If you are still interested in venture capital investment, it is helpful to understand how VCs operate as it shapes the way they do business with you. Venture capital firms raise money from investors – either institutional investors such as pension funds and insurance companies or wealthy individuals. Once they have secured sufficient investment, they will ‘close’ the Fund and start looking for companies to invest in.
Typically a Fund will have a life of around ten years. VCs will try to invest as much as possible within the first five years of a Fund to allow companies time to develop and grow before selling their shares and returning the proceeds to their investors.
The 1990s was a golden era for venture capital with billions invested in technology firms but, since then, investors have become more risk averse. Fortunately the public sector has stepped in. Today over half of all VC investment in Europe comes from public sources, in particular the European Union.
While these funds are run by fund managers in the same way as private VC funds, they may be less time sensitive. The criteria may also differ slightly – they may be allocated to particular geographical areas and may target outcomes such as job creation, in addition to business growth.
Before you approach investors you will need to prepare a business plan, which outlines all the information investors will need in a clear and concise format. You will need to include sections about your product or service; the market your company serves and the customer base; the management team, their background and skills; how the business operates; financial statements and projections; and finally, the amount of finance you require and how you believe the VC firm could, ultimately, exit their investment.
You can then start to draw up a list of potential firms. You should investigate whether there are any funds specifically focused on your area, perhaps public sector funds, and find out who the fund managers are – venture capital firms with an office in your region are likely to be more open to approaches from local firms. You should also look out for VC firms which specialise in your particular industry, whether or not they are locally based. Your accountant or other adviser may be able to recommend suitable firms.
Usually VCs indicate on their websites the type of businesses they are looking to invest in, and some even allow you to apply online. If your proposal is rejected, try to find out why. It could be simply that your business does not fit with their specific criteria but, equally, it could indicate that you need to redraft your business plan or rethink your approach.
If you make it past the first hurdle, it should not surprise you to find that VCs want to take time to get to know you. After all they will be effectively your partner in the business, so both sides need to be sure they can get along. No matter how good your prospects, if the relationship isn’t right, the VCs will not commit.
As things progress, the fund managers will look closely at your business plan and will initiate a process of due diligence – usually carried out by an independent firm of accountants – to stress test your projections and carry out background checks.
You will also be sent an offer letter setting out the terms of the proposal. You will need to take independent legal advice and may wish to renegotiate some of the conditions. Provided the due diligence findings are satisfactory and once the terms are agreed, the lawyers will then draw up completion documents. While the process can be completed within a matter of weeks, three to four months is more realistic.
As part of the deal, one of the fund managers may be appointed to your board and the VC and maybe also an independent non-executive director to fill any skills gaps – usually someone who has held a senior position within your sector. However the day to day running of the business will be up to you.
Venture capital is proving a lifeline for many businesses in today’s market. Even where VCs can’t provide the full amount required, they can often bring in other investors and even help you attract bank funding. Their investment and support can supercharge your business and help it grow much faster than would otherwise be the case. You will end up with a smaller slice of the cake – but that slice is likely to be a lot bigger than the whole cake could have been without them.
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