Venture capital is finance provided to high-growth private companies which are at an early stage in development or are seeking to expand.
Venture capital (VC) is a form of private equity, and venture capitalists (VCs) invest in companies which generally have few assets or are not yet profitable. VCs will not expect to generate the majority of the return on investment directly from the trading profits of the company, but rather from its growth and eventual sale or listing on a stock market. This type of investment is therefore risky, but can generate exponential returns for the VCs.
Venture capital can come from a variety of sources - some of which are referred to below - but regardless of the type of investor, the structure of the investment will be broadly the same.
Business angels
Business angels are wealthy individuals who will generally invest relatively small amounts (for example, £100,000) in order to get a business on its feet and perhaps to support it to its first institutional funding round. There are networks of business angels that invest together to support slightly larger funding requirements.
Corporate venturing
Corporate venturing is where a large corporation takes an equity stake in a developing business. For example, many of the large well-known telecoms and technology companies will invest in small businesses, with the intention of benefiting from the relationship to provide value to its own business. Corporate venturers can invest significant sums, often millions of pounds, either on their own or as part of a syndicate with other investors.
Venture capital funds
Venture capital funds are managed funds, often consisting of institutional finance. They can also be raised from venture capital trusts (VCTs) - venture capital funds listed on the stock market and funded by private investors - or from enterprise investment scheme funds (EIS funds). Venture capital funds are managed typically by a firm that will identify, review and negotiate the terms of the investment on behalf of the funds themselves. Venture capital funds invest millions of pounds into companies they back, either alone or in a syndicate with other investors. Venture capital investments are often made in stages over the lifetime of a company's development; these stages are often referred to as seed, Series A, Series B, etc.
Other parties involved in venture capital investments
Corporate finance advisers
To help you prepare your business plan, understand the valuation of your business and negotiate this valuation with potential investors you can employ corporate finance advisers. Most of the large accountancy firms have corporate finance arms, and there are also smaller boutiques that specialise in particular sectors or geographical areas.
Due diligence advisers
In order to protect the value and to understand the growth potential of the business, the VC will want to investigate the company's employees, products, intellectual property, trading and legal standing. The VC may carry out this process itself, or it may employ professional or industry experts to compile reports on these areas. The approach taken will often depend on the amount being invested and the individual approach of the VC.
Lawyers
Both the VC and the company receiving investment will appoint solicitors. The solicitors will generally be responsible for identifying and dealing with any legal issues that might affect the valuation of the business, and ultimately for negotiating and documenting the terms of the investment. It is important to appoint solicitors with sufficient experience and expertise in VC transactions to advise the company and its management team properly. The law firm should also have a certain level of sector knowledge in order to understand the value in the business of the company, and therefore what is important in the context of the deal.
Key documentation
Common issues
There are a number of matters which might prevent a venture capital investment from completing smoothly. The following are some of the most common:
- Valuation
It is very difficult to value private companies. Unlike public companies quoted on a stock market, there is no 'market price' for shares in private companies, and VCs therefore have to use other valuation methods. These will normally include looking at comparable businesses or applying a multiple to the company's revenue or profit. It is in all parties' interests to ensure that the valuation methodology used is as robust as possible. Clearly, the company and its management will wish to argue a higher valuation, but ultimately, over-valuation will cost the ordinary shareholders through the operation of provisions such as liquidation preference and anti-dilution.
- Share ownership clarity
Start-up companies sometimes fail to take appropriate advice when issuing shares to its management team. It is vital that the ownership of shares and options is absolutely clear to incoming investors. Failure to take proper advice can not only result in complications in relation to the investment but also in significant adverse tax consequences for individual shareholders.
- Liquidation preference and anti-dilution
One of the main problems in companies securing multiple funding rounds is that each round will often (depending on the negotiating power of the parties) wish to have equal or greater rights than those attaching to the previous round. It is not difficult, therefore, to see that this can result in the value attributable to ordinary shareholders being squeezed out completely. Thus, it is important to ensure that these provisions are properly negotiated, so as not to leave the company and its ordinary shareholders in a weak position in future rounds or on a sale.
- Value protection
The value of most companies obtaining venture capital investment will be in their IP and people. Failure to protect IP properly via contractual and registration arrangements, or failure to ensure that key personnel are employed subject to terms which properly protect the company, will require these issues to be rectified prior to the investment completing. This often leads to frustration and delay during the investment process.
- Understanding expectations
A venture capital investment necessarily means founders will need to relinquish an element of control of their company. Lawyers will be able to advise on what is reasonable/common in the market. It is a founder's prerogative to argue against these principles, but it will often result in frustration and delay, and may not actually change anything. Contract negotiation can be confrontational if not handled correctly. It is important at this formative stage of the relationship between VC and company to put the documentation and liabilities into commercial context.
Tax considerations
The company
The tax treatment of the company invested in is of interest to the VC as it will affect the amount of return on the investment. Any expenditure that is tax deductible will ultimately reduce the tax liability of the company or its group, and so is desirable for all. Any interest paid on any debt will be tax deductible as long as the debt is on arm's-length terms and is not considered excessive by HMRC. If the debt is not on arm's length terms, transfer pricing rules may apply, and deductions in respect of the excessive interest be denied. Dividends paid are not tax deductible.
VCs
Each VC will have different tax considerations which may influence the proportions of debt and equity that the VC is prepared to invest. Tax considerations are of particular importance to VCTs and EIS Funds. Preferential tax treatment is given to investments by VCTs and funds or individuals who qualify for relief under EIS. In both cases, the investors will wish to ensure that their investment will qualify under the VCT or EIS rules. The tests under the VCT and EIS rules last for some years, so it is usual for the company and the management shareholders to be subject to undertakings designed to ensure that it will continue to qualify under the rules for the requisite periods.
Managers
Any individuals who are resident in the UK who take shares or securities will be subject to capital gains tax on any gain from their investment. However, any employees or directors (managers) of the company or its group who take shares will be deemed to have acquired "employment related securities", and as a result managers have to pay the full unrestricted market value for their shares on day one (i.e. ignoring any restrictions that may apply to the shares which reduce the value). If there are restrictions that affect value, and the manager only pays the restricted price, then the manager will be exposed to income tax charges which will crystallise on certain trigger events, including sale, and will also be subject to a special set of income tax rules.
