Many new business ventures are considered too risky for traditional bank lending (term loans, overdrafts etc.) and it is this gap that Venture Capital usually fills.
Venture Capital could be described as a means of financing the start-up, expansion or purchase of a company, whereby the venture capitalist acquires an agreed proportion of the share capital (equity) of the company in return for providing the requisite funding. To look after its interests the venture capitalist will usually want to have a representative appointed to the board of the company.
The venture capitalist‟s financing is not secured – he takes the risk of failure just like other shareholders. Thus, there is a high risk in providing capital in these circumstances and the possibility of losing the entire investment is much greater than with other forms of lending. The venture capitalist also participates in the success of the company by selling his investment and realising a capital gain, or by the company achieving a flotation on the Stock Market in usually five to seven years from making his investment. As a result, it will generally take a long time before a return is received from the investment but to compensate there is the prospect of a substantial return.
Venture Capital has grown in popularity – for instance in the UK in 1979 venture capital investments amounted to GBP20m., whereas this had grown to GBP1,000m. by 1991.
STAGES OF INVESTMENT
The various stages of investment by a venture capitalist can be defined as follows:
- Seed Capital – finance provided to enable a business concept to be developed, perhaps involving production of prototypes and additional research, prior to bringing the product to market.
- Start-Up – finance for product development and initial marketing. Companies may be in the process of being set up or may have been in business for a short time but have not sold their product commercially.
- Expansion – capital provided for the growth of a company which is breaking even or possibly, trading profitably. Funds may be used to finance increased production capacity, market or product development and/or provide additional working capital.
Capital for “turnaround” situations is also included in this category.
- Management Buy Out (MBO) – funds provided to enable current operating management and investors to acquire an existing business.
- Management Buy In (MBI) – funds provided to enable a manager or group of managers from outside the company to buy into the company.
Venture Capitalists may specialise in areas in which they will invest. These may relate to:
- Preferred Business Sectors – e.g. consumer services, Information Technology, property etc.
- Stage of Investment – many venture capitalists will finance expansions, MBO‟s and
MBI‟s but far fewer are interested in financing “Seed Capital,” start-ups and other early stage companies, due to the additional risks and time/costs involved in refinancing smaller deals as compared with the benefits.
- Regional Preferences – the preferred geographical location of the investee.
- Amount of Investment – varies with the stage of the investment. Start-up and other early stage investments are usually lesser in amount than expansion and MBO/MBI investments. RWF
Before deciding whether an investment is worth backing the venture capitalist will expect to see a Business Plan. This should cover the following:
- Product/Service – what is unique about the business idea? What are the strengths compared to the competitors?
- Management Team – can the team run and grow a business successfully? What are their ages, relevant experience, qualifications, track record and motivation? How much is invested in the company by the management team? Are there any non-executive directors? Details of other key employees.
- Industry – what are the issues, concerns and risks affecting the business area?
- Market Research – do people want to buy the idea?
- Operations – how will the business work on a day-to-day basis?
- Strategy – medium and long-term strategic plans.
- Financial Projections – are the assumptions realistic (sales, costs, cash flow etc.)? Generally, a three year period should be covered. Alternative scenarios, using different economic assumptions. Also state how much finance is required, what it will be used for and how and when the venture capitalist can expect to recover his investment?
- Executive Summary – should be included at the beginning of the Business Plan. This is most important as it may well determine the amount of consideration the proposal will receive.
METHODS OF WITHDRAWAL BY VENTURE CAPITALIST
The various means by which an investment may be withdrawn after a number of years include:
- The company is acquired by another company (probably through an arranged deal). A management buy out occurs and the venture capitalist‟s shares are purchased by the existing management team.
- A management buy in occurs.
- The investment is refinanced, possibly by another venture capitalist organisation.
- The company obtains a listing on a Stock Market.
- A minority equity stake is purchased in the company, possibly by a customer or other company in the same industry. This is sometimes referred to as “Corporate Venturing.” The company is liquidated.