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Beyond the balance sheet

What you need to know prior to raising Venture Capital funding

Ercan Demiralay 05/9/2017 5 minute read

Ercan Demiralay explains what venture capital funding is and how it works.

Having established your business as a viable operation you will have enjoyed payback as your organisation entered a period of growth. The rate of expansion will likely have continued to increase potentially to the point of fast growth. This will have made the business harder to manage leading to frustration and pressure to maintain turnover targets while meeting financial commitments. 

The reason for this is with growth can come with significant operational issues. The result will leave you needing to make an investment to maintain the rate of expansion and take the business to the next level. Depending on your funding requirements, one of the options at this stage may include raising venture capital finance.

This means the potential of working with venture capitalists. They are a particular type of investor, some of whom have had key early roles in developing today's most successful organisations. Think Facebook, PayPal, Picturehouse Cinemas and Zoopla. We've written this blog to explain what venture capital is, it's purpose and how it might work to get your business to the next stage of growth (see Shirlaws diagram model below).

How to best prepare for raising venture capital finance

The stages model courtesy of Shirlaws

For SMEs traditional institutions such as banks are likely to charge significant interest on any loans and/or demand security in the form of physical assets. However, many of today's organisations are information/service based meaning most of their assets are intangible.

Then factor in that both banks and capital markets (such as stock and bond markets) are highly regulated so as to protect their public investors. This means more often than not these avenues of funding are inappropriate to most SMEs because the rules are more appropriate to larger corporate organisations who have the money, time and resource to be able to adhere to them.  

Other earlier forms of finance (such as friends or family, overdrafts and business angels) will help an entrepreneur bring a concept to life. The VC's aim however, is to help further commercialise entrepreneurs current concepts and innovations. 

VC's focus on organisations at an adolescent stage because as per the stages diagram, this is usually where the most rapid and substantial growth will take place in the business journey. It's also the phase where there's the most significant chance of failure. That means taking on risk for the potential of very high returns should the investment prove successful.

How a venture capital fund works

Venture capital firms consist of:

  • General partners
  • Limited partners

General partners responsibilities are two fold. Firstly, they will find what they think are good businesses and negotiate on the terms and conditions for investment. Secondly, they will then work with the owners of those businesses to fulfill their growth objectives.

Limited partners consist of both the people and organisations that put up the capital for the general partners to make those investments. Examples of limited partners include pension funds and hedge funds. A VC fund tends not to invest the money of its partners rather that of limited partners. General partners may of course invest their own money but this usually makes up a very small amount of the total size of the fund.

VC funds make money via what is called the carry (carried interest) and management fees. If an investment is successful then the share of the profits is distributed to partners. This is the carry and it usually works along the lines of 80% distribution to limited partners with 20% going to general partners.  

Management fees are often charged at 2-3% per year to limited partners. However, undertaking the actual investments doesn't come under this charge meaning there can also be arrangement fees of 2% for each investment made.

 

 

Such charges are quite common because the tax reliefs for investors are generous however, they require a minimum investment period of 5 years for them to enjoy the tax free dividends and capital gains on offer. Finally there are also performance fees which can be structured in numerous ways such as the level of uplift in the net asset value of the fund.

The expectation from investors is a return of around 25% - 35% per year over the lifetime of the investment. This is a crucial point for business owners because the critical question is how do venture capital funds go about choosing organisations to achieve such significant returns?

The answer lies both in their investment portfolio and how their deals are structured, another key area you need to understand if you're seeking this type of investment.   

 

The nature of venture capital money and its usage

From this we can establish that money is the dominant theme for the backers of VC funds. Their sole purpose is to make a significant return on their investment. That means Venture Capital isn't necessarily long term in nature, usually lasting not much more than 10 years although there are exceptions.

The role of venture money is to invest in the infrastructure of a business to further commercialise it's innovation and potential. This often takes the form of bringing the following into an organisation:

  • Boosting working capital
  • Purchasing fixed assets such as buildings, equipment, land and/or machinery
  • Developing the sales and marketing functions
  • Back office infrastructure

Once the business reaches a certain size and/or has developed a credible reputation then a VC firm will look to exit. This can take several different forms namely:

  • The businesses management buy them out, termed a repurchase
  • Stock market flotation
  • Sale to other investors
  • Liquidation - worst case scenario 

A key takeaway here is the power of people. VCs are looking for entrepreneurs who they believe will be able to run and take an organisation to the next phase of development. Confidence in you as the owner and the ability of your management team to deliver to the point where they can exit, are essential. That's because with so much vested interest in your success, VC's will be looking for people and teams that they can work with. 

By understanding the nature of venture capital, how it works and what venture capitalists are looking for you'll be able to gauge whether this finance option is right for your business. If that's the case then you'll also understand their motivations and pressures - key components to address and solve in any potential future pitch for funding.

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The content of this post is up to date and relevant as at 04/09/2017.

Please be aware that information provided by this blog is subject to regular legal and regulatory change. We recommend that you do not take any information held within our website or guides (eBooks) as a definitive guide to the law on the relevant matter being discussed. We suggest your course of action should be to seek legal or professional advice where necessary rather than relying on the content supplied by the author(s) of this blog.

 

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