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.
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.
- National or 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. BUSINESS PLAN
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 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 or even a five 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.
TYPES OF FINANCING STRUCTURE
There are various ways in which a deal can be financed:
- Debt in Addition to Equity – a proportion of the required finance is obtained from a debt provider (e.g. Clearing Bank, Merchant Bank, Factor, Government sources etc.)
- Mezzanine Debt – loan finance which is half-way between equity and secured debt in that it either takes a second charge on the company’s assets or is unsecured. Due to the higher risk the lender requires a higher rate of interest.
- Stage Financing – the venture capitalist provides rounds of finance when certain achievements are met – e.g. product development, product launch, expansion of manufacturing facilities etc.
- Preference Shares – these may include Redeemable/Convertible/Participating shares.
- Ratchets – these enable management to increase (or avoid a reduction in) their equity holding when the company reaches specific financial stages in its business plan (e.g. Preference Share redemption targets).
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 buyout 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.
Balderton Capital Management, with $19bn. in assets under management is one of Europe’s largest. In March 2008 it made more than nine times its initial investment when it sold a 15.7% stake in Bebo to Time Warner for $140m. It had made the investment less than two years earlier.
The following is from an interview with Barry Moloney, MD Balderton Capital Management
29.11.2009 The Sunday Times, England
Balderton sold a stake in MySQL, a software company, to Sun Microsystems for a hefty multiple and then made ten times its original stake when Cisco Systems bought Scansafe, an online security business. Yoox, an online fashion retailer and another Balderton investment, will be the first IPO on the Milan bourse for 18 months. Next year Balderton could yield one of its biggest ever paydays when the online betting exchange Betfair debuts on London’s Stock Market.
Balderton’s model is “labour intensive” investing in early-stage companies with a view to big returns. The goal for every investment is nine or ten times return. Of ten investments we would expect three or four to lose money and three or four to return twice or three times our money. Then we would expect two of the ten to make a return of eight, nine or ten times. It’s not a fool-proof formula, however. In the past two years Balderton had two spectacular blowouts Payzone and Setanta Sports. Payzone is still a live investment but the company is so burdened with debt that equity holders are likely to be wiped out in an upcoming restructuring. A $75m – $80m. loss at Setanta Sports is balanced by an earlier $50m. gain that Balderton made from NASN, the sports network that Setanta sold to ESPN. The risk did not pay off but that’s par for the Venture Capital course – if you are not prepared to take risk, you shouldn’t be in the game.
Balderton has 67 investments, many of them in the “new economy” – wonga.com, a loans company; Bling Nation, a mobile payments company; figleaves.com, which sells lingerie and LoveFilm, a movie rentals business. It has backed a disproportionately high number of Irish companies, with almost a quarter of its total funds ($450m) invested in them.