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VENTURE
CAPITAL
FUNDING
A Practical Guide to
Raising Finance
STEPHEN BLOOMFIELD
VENTURE
CAPITAL
FUNDING
A Practical Guide to
Raising Finance
STEPHEN BLOOMFIELD
RECOMMENDED BY
I NST IT UT E OF D I R EC TORS
To GEB, PEB and KEB for what they put up with and to the many people in many companies who
helped me write this book – even though they didn’t know it.
This book has been endorsed by the Institute of Directors.
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© Stephen Bloomfield, 2005
The right of Stephen Bloomfield to be identified as the author of this work has been asserted
by him in accordance with the Copyright, Designs and Patents Act 1988.
ISBN 0 7494 4291 3
British Library Cataloguing-in-Publication Data
A CIP record for this book is available from the British Library.
Library of Congress Cataloging-in-Publication Data
Bloomfield, Stephen.
Venture capital funding : a practical guide to raising finance / Stephen
Bloomfield.
p. cm.
Includes bibliographical references and index.
ISBN 0-7494-4291-3 (alk. paper)
1. Venture capital. 2. New business enterprises—Finance. I. Title.
HG4751.B557 2005
332’.04154—dc22
2005016426
Typeset by JS Typesetting Ltd, Porthcawl, Mid Glamorgan
Printed and bound in Great Britain by Cambrian Printers Ltd, Aberystwyth, Wales
Contents
Introduction: some objectives and definitions
1 Background issues
The funding gap – myth or reality? 9
2 Why do you want funding?
Defining what venture capital is – and is not 22; Shareholder
change 33
1
7
21
3 Know your enemy: the venture capitalists considered
38
The myth of patient money 39; Pressures on the venture
capitalist 41; Factors and issues affecting venture capital fund
policies 42; Fund size and structure 43; Horses for courses 59;
From the fund to the individual – background and experience 60;
Fund remuneration 62; Investment by fund managers 62
4 The mechanics of doing the deal
Stages of the process 65
64
5 Seeing the finishing line – from the starting position
Stars and bars 81; The major routes out 82; The P/E trap 83;
80
iii
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Contents
Reasons to be helpful – part 1 85; Reasons to be helpful –
part 2 86; The dark side 87
6 Dealing with existing shareholders (and stakeholders)
The effects of change 90; The best structure 91;
Shareholders 93: Other stakeholders 94
89
7 Building – and displaying – the management team
Four elements of a management team 101
99
8 The key issues of discovery: the ‘due diligence’ process
110
9 The choice of investment vehicle: existing business or
newco?
135
10 Legal stages: where the going gets tough
The process step by step 152
152
11 Post-investment considerations: culture shock
The failure of mutual comprehension 167; Costs 167;
Additional scrutiny – and the consequences 168; Requisite
skills 169; Board atmosphere 170; Increased formality 170;
The false hope of synergy 171; Outside involvement 172;
Personnel change 173; Tactical actions of the investor 174;
Further funding 175; The problems with angels 176;
Non-problems 177
165
12 Realization of the investment
179
Flotation – IPOs 182; Trade sales 184; The dark side: corporate
collapse 188
13 Summary: do you still want venture capital?
In defence of other funding 191; Overall verdict 198; In
defence of VCs 198; The point of departure 203; General
conclusion 206
Appendix 1 Glossary of terms
Appendix 2 Useful addresses
Index
Index of advertisers
vi
190
208
212
214
218
Introduction
Introduction: some objectives
and definitions
Mythology, n: The body of a primitive people’s beliefs concerning
its origin, early history, heroes, deities and so forth as distinguished from the true accounts which it invents later.
Ambrose Bierce, The Devil’s Dictionary
Most informed business people will know something about venture
capital – or more likely some of the myths about venture capital: the
rudiments of finance are part of the currency of business conversation.
But much of the detail of what actually goes on when an investment is
being made is unknown by most outsiders.
Since nature abhors a vacuum, myth rushes in to fill the gap left by
the absence of knowledge – and some of the mythology, for instance
about the instinctive rapid decision making or the managerial toughness of the venture capitalist, has been cultivated by some venture
capitalists themselves. What really happens is that like every profession
or commercial activity, a shorthand grows up around common
1
Venture capital funding
activities and practitioners develop their own jargon – at least some of
which is intended to act as a barrier to outsiders. For some practitioners
– those who revel in their ‘superiority’ in knowing things that the
outsiders apparently do not – if the jargon helps to make the subject
seem more technical and daunting than it really is, then so much the
better.
The combination of this jargon and the half-truths that grow up from
stories passed on from friends of business friends who have ‘done a
venture capital deal’ and the partial understandings that grow up from
half-understood precepts, all combine to make the process of winning
venture capital for developing businesses seem more daunting than it
need be.
The purpose of this book is, first, to clear some of the fog that exists
about how venture capital works; second, to illuminate some of the
background processes that exist in venture capital businesses (taking
the term to mean both the funds themselves and those businesses that
are funded by venture capital); and third, to puncture some of the
myths that have grown up about venture capital.
In keeping with those three aims, what the book will try to do is
illuminate some of the following areas:
n
what sort of businesses will be attractive to the different types of
venture capitalist;
n
the processes of investment, so that businesses that do want to raise
funding can then make a case for investment which will have a
better chance of success than one made in ignorance of the subtleties of the venture capital process;
n
the particular targets of venture funds; and
n
the pressures on the venture capitalists themselves as individual
investors.
The intention in doing this is to make it easier for those businesses
which want to, to secure venture capital by understanding what
venture capitalists want; and what they are willing to invest in; and on
what terms.
It is best to be clear from the outset that this is not a guide that simply
says, ‘Do this, this and this and you will get venture capital funding’.
Apart from the fact that it would be dishonest to write a book that
claimed to be able to guarantee success in securing funding, in truth
2
Introduction
some businesses quite simply do not deserve to be funded by venture
capital. And there are some businesses that would be better off not even
seeking venture capital and searching out other types of funding
instead. The dot.com boom of the late 1990s and first couple of years
of this century should have indicated this to many people on both sides
of the funding fence.
As far as the first objective of the book goes, we need to arrive at a
definition of what we are talking about fairly quickly to make sure that
we minimize confusion. What makes the job of description slightly
complicated is that there is no one animal called venture capital: the
term is really a conflation of several different things, hiding under a
catch-all name. Briefly (because we will return to them in greater detail
later) the usual categories (in ascending order of likely investment and
descending order of risk) are: seed capital; venture money; private
equity; and mezzanine finance.
Properly, seed capital is the money that is used to start a business
off – perhaps to provide the first set of premises or to patent a piece of
intellectual property or develop a prototype. You can think of it like
the term describing the process of ‘seeding’ clouds to make them
disgorge rain; or perhaps more closely, to the process a gardener goes
through when he puts lots of seeds in the ground knowing that only a
few will make it to maturity. It is often the financial contribution of the
entrepreneur or his family or friends to getting the enterprise off the
ground. Or it can also come from very specialized funds (frequently
affiliated to a university or a government ‘enterprise’ initiative) or from
private individuals or philanthropic trusts. It will usually require
continuing equity participation in the business, but on vastly diluted
terms; if it doesn’t, because for instance it comes in the form of a
government grant, then in consequence the term ‘capital’ is sometimes
misleading.
Venture money is the original term that was used to describe the
funding that got businesses started in the United States in the 1960s and
1970s, when individuals put money behind bright ideas – that later
grew into businesses like Apple Computers, Cisco Systems, Netscape,
– without any certainty of return. It is closer to seed capital than other
forms of funding and is an area of the market in the UK that is
increasingly becoming the province of ‘business angels’ and specialized
investment firms. Larger investors find it difficult to invest in this area
for reasons that will be discussed later. Venture money is the supposed
plug for the so-called equity gap that has been around since that term
was first invented in the 1930s.
3
Venture capital funding
People talk increasingly about ‘private equity’ instead of venture
capital and this is generally taken to imply the money that comes from
large institutional investors – money which is usually invested in wellestablished businesses often well beyond the stage of product or
process development. These businesses are often very large and the
opportunity for outside funds to invest comes when an even larger
business is broken up (perhaps after a takeover) or when a division of
a large business is sold off or perhaps when expansion money is needed
to take a developing business to the next level just before flotation. The
share capital of such businesses often has the characteristics that are
associated with listed companies.
Mezzanine capital is a very specialized branch of lending which has
most of the attributes of a loan coupled with a few characteristics of
equity: it attracts principally a rate of interest (like a loan) but may also
have the right to convert into equity on a sale or flotation; or it may
have a guaranteed (modest) equity element. The origin of the term
could be from one of two sources: either as sort of financiers’ little joke,
since it stands halfway between the ceiling of equity and the floor of
lending (or perhaps, vice versa); or perhaps from those swaggering,
padded-shoulder days when ‘financial engineering’ was in vogue and
being a vaguely architectural term in origin it seemed to be appropriate. It is often short-lived in nature – a sort of bridging finance that
plugs the gap between what bankers are willing to lend on an assetbacked basis and what private equity suppliers will put up, with a high
rate of return compensating the lender for a brief period of high risk.
Consequently, as a hybrid, although it fulfils a purpose, it is often
slightly disliked by both sides – by both bankers and equity providers
on the one hand who, while grateful for the gap-plugging, resent the
terms imposed; and by management on the other, who – also grateful
for the gap-plugging – don’t like the rates of interest and dilution of
their own holdings that mezzanine finance brings.
Since the late 1970s there has been a general gravitation of investment towards larger and larger deals – and consequently away from
small and developing businesses. This is not an absolute, of course.
Many thousands of small and medium-sized businesses have found
venture funding. In the UK in 2003, nearly 1,300 businesses were
funded by private equity funds – a figure which excludes investment
by business angels. The size of the average deal fluctuates but generally
increases suggesting that although the market goes through periodic
changes when activity swells and subsides, it is a fair bet that the
‘equity gap’ will not go away. It will always be difficult for a small and
4
Introduction
developing business to persuade a financier to part with his money. The
sting of ‘risk’ is not an intellectual concept investors or bankers are
happy with unless it is followed very quickly – in speech, in writing
and in the course of real world events – by the balm of ‘reward’.
Unfortunately, the investment world goes temporarily mad every so
often – and indulges in changes of fashion even more frequently. Gold,
jewels, land and oil have been the favoured obsessions throughout
history but foreign trading rights and even tulips were the objects of
the speculators’ attentions in the 17th century. And at the end of the
20th century we had the dot.com boom. The worst excesses of that
frenzy saw ‘investors’ making deals based on the flimsiest of suppositions about marketplace robustness, managerial ability and likely
returns. The consequences should have been obvious but only the
steeliest-nerved funds decided to ignore the race to the bottom. The
conclusion of all this was the same as in very speculative frenzy:
investors who filled their boots with the then latest fad (because they
had no real grounding in experience and still less in common sense)
now find it hard to make sensible investments as they survey the
wreckage of their portfolios – if they still hold their jobs, that is.
Unfortunately the tendency of the lemmings was so strong that it
caught not only the gullible, newly minted MBA investment neophytes
but also the experienced managers of established funds, who should
have known better.
So now no one among the survivors wants to be caught with his
pants down a second time – and consequently, gimlet-eyed toughness
is now even more in vogue as an investment/managerial stance. This
is sad for potential investee companies and although it is understandable for individual funds it makes no collective sense for either.
In truth most venture capital investment is more akin to riverboat
gambling than anything else: knowing something about the psychology of the players, about risk and reward and about the environment
in which you are playing will help to move the odds in your favour
but it’s still a gamble; there is no certainty. And in this lies the key to
understanding what venture capital is and how it is conducted.
The simple fact at the heart of every venture capital deal is that the
venture capitalist is always trying to reduce his risk. There are three
ways of doing this: first, knowing the marketplace as well as possible
(through due diligence and industry or deal-type specialization);
second, trying to gather together the best possible management team
for the opportunity (more due diligence and selection/rejection of
deals); and third, making sure that if things do go wrong then the
5
Venture capital funding
maximum amount of manoeuvring room is available to the venture
capitalist (making sure the legals – the legal terms of the deal between
the business and the venture capitalist – favour the investor rather than
the management). These three activities condition all venture capitalist
behaviour, as we shall see. But first we need to consider the seller’s part
of the bargain – the business that is seeking to raise venture capital.
6
Background issues
1
Background issues
Plan, v.i: to bother about the best method of accomplishing an
accidental result.
Ambrose Bierce, The Devil’s Dictionary
n
A brief definition
n
The availability of funding and the ‘myth’ of the ‘funding gap’
n
Some statistics
n
A brief review of the history of venture capital in the UK – an insight
into the current market’s provenance
n
The mantra of three Ms – mathematics; market; management
n
What can and what is unlikely to be invested in
Despite the run of conventional wisdom to the contrary, it is now
probably easier to obtain some form of external funding to grow your
business in the UK than it has ever been. Yet this runs against the
common belief that somehow the market has failed in providing
7
Venture capital funding
resources to fund developing businesses and that it is difficult to get
money for all but large and sophisticated deals.
The mistake that is commonly made in complaining about the
availability of money for direct investment into unquoted companies
is in confusing the amount of money that is available with effective access
to that money. The latter of these is a complicated combination of
understanding how to make the argument for funding; knowing to
whom to make it and – most significantly – appreciating how to clinch
the deal. It is with these factors that this book will seek to deal in large
measure by explaining how venture capitalists (VCs) go about making
investments and the processes that lie behind the doing of a deal.
This availability of resources is down principally to the strong
growth of the venture capital business in the UK, which has grown
steadily so that it is now without doubt the largest in Europe and
second only to the United States in terms of size and experience of
the people who manage funds. In 2003, UK venture funds had over
£8,889 million under management. That is big money by anybody’s
reckoning.
Ironically, much of the money that is used by British fund managers
to make their investments comes from the United States, with a
declining proportion of the total funds available originating from
British investors. In 2003 (the latest year for which figures existed at
the time of writing) 68 per cent of the funds raised by UK venture funds
came from the United States. In the same year, UK banks, pension
funds and corporate investors all reduced the amount that they
allocated to venture capital. Insurance companies scaled down the
amount that they were prepared to put into the sector by the huge
proportion of 72 per cent, putting in only £208 million and causing
concern among VCs as to the future source of their investment money
– especially the smaller funds.
Throughout this book, the term venture capital will be used in the
sense that it has been commonly used in the UK – to describe all forms
of equity funding in unquoted businesses made by parties external to
the original business. This may run against the more recent fashion to
distinguish between specific types of funding by type. In recent years
there has been a tendency among practitioners to distinguish between
the terms ‘venture capital’ and ‘private equity’ – with the former
following the US usage and meaning early-stage funding, and the latter
referring to development capital and buy-out money.
The trouble with that distinction, though, is first, that it makes for
cumbersome titles; and second, that VCs in the US sense can often go
8
Background issues
on to become private equity investors in the same (invested) business.
Venture capital seems to be easier and cleaner as a title, since everybody
in the business world is likely to be broadly familiar with the concept
even though it may not satisfy an academic distinction between the two
in terms of terminology.
THE FUNDING GAP – MYTH OR REALITY?
Entrepreneurs in this country grumble about the lack of available
funding – arguing from the particular circumstances of how their ideas
were spurned by the professional investors, to the general theorem of
a funding gap that afflicts all businesses below a certain size. There also
appears to be a general belief among business men and women,
officials and government ministers, that it is impossible to get funding
for a deal unless it is a management buy-out worth many millions of
pounds. Yet the evidence runs to the contrary – at least partially.
Figures produced by the BVCA (the venture capitalists’ trade association) show that businesses of all sizes do attract funding every year.
In 2003, UK venture funds invested over £4,074 million in 1,274
companies in the UK (down 9 per cent from the previous year, admittedly). However, the detail of the numbers is very interesting, and gives
a snapshot of Britain’s industrial and commercial structure:
n
Investment in start-ups increased in 2003 by 12 per cent (to 185
investments) with about £400,000 invested in each opportunity.
n
Other early-stage funding fell by about 3 per cent in value terms
(to £190 million) while the numbers of businesses funded rose
fractionally.
n
Roughly half of all the businesses that were backed (582) were
requesting expansion or development capital of some sort.
n
The amount of money invested in MBOs (management buy-outs)
or MBIs (management buy-ins) decreased by about 10 per cent (to
£2,395 million) but the number of companies backed rose by about
15 per cent, with the average amount invested at around £14
million.
The information is even more interesting sectorally and regionally:
9
Venture capital funding
n
Communications businesses took the largest share of funding (32
per cent) in the high tech sector (£260m), with computer businesses
not far behind at 31 per cent; but this sub-sector was the most
numerous, accounting for 45 per cent of all companies in the hightech category, by number.
n
Software businesses accounted for 19 per cent of high-tech investment, well down from the previous year.
n
Internet-based businesses took £14 million (against £15 million in
the year before) with the number of companies reaching only 75 per
cent of the previous year’s total: more money went into expansion
finance for this sub-sector.
n
Biotech experienced tremendous growth with early stage finance
accounting for 75 per cent of the £84 million invested (against £58
million in the previous year).
n
E-commerce saw a strong rise too, up by nearly seven times to £399
million in 168 companies, against £60 million in 119 companies in
the trough of 2002 after the dot.com collapse. But 80 per cent of this
was MBO/MBI activity rather than ‘fresh’ money.
n
Leisure and hotels took £1,039 million.
n
General retail accounted for £698 million.
n
Information technology took in £580 million.
n
Support services absorbed £434 million.
n
Engineering and machinery swallowed £302 million in 68 companies against £125 million in 34 companies the previous year.
n
London is the leading region for investment (by company domicile).
n
The South East’s total fell by 68 per cent in 2003 although it still
stood second in the pecking order.
n
The East Midlands, the West Midlands and the South West
followed in places three, four and five respectively.
For the future, little change is expected in the disposition of funding:
over 90 per cent will go to funding MBOs and MBIs, 3 per cent of funds
will be devoted to expansion and development and 4 per cent will go
to early-stage funding.
10
Background issues
Significantly, although there has been a continual migration of
funding to the higher-value deals over the past 20 years, early-stage
funding is still a valuable area of business for many VCs (if you define
the term broadly, and beyond what is commonly and mistakenly
thought of as venture capital). However, the poverty of returns experienced overall from this category have been particularly badly skewed
by the dot.com experience of 1999–2001.
With all this money moving around, and nearly 1,500 companies
taking a chunk of it, why is there such a prevalent belief that there is a
funding gap? The probable truth is that there are two reasons. It is easy
to see from the figures that the vast majority of private equity money
(using the academic distinction) goes to fund changes in ownership of
existing businesses – MBOs and MBIs. Existing businesses are proven
to work (at least they did at some point). So the numbers of successful
applications for funding coming from the ranks of these types of
business will probably be greater than from those from start-up and
early stage. That means that rejection rates will be fewer giving rise to
the obvious (and probably partially correct) belief that VCs are more
attracted to MBOs and MBIs than to early-stage deals.
But that still leaves a powerful amount of money (nearly £650
million) available for expansion and development purposes and for
funding early-stage opportunities. With this amount of money available, is there really a funding gap?
The answer to that is probably two-fold as well. First, some businesses just don’t deserve to be funded: that statement deserves further
explanation and will be explored in the concluding chapter. Second, a
good many worthwhile proposals miss being funded because the
entrepreneurs behind them have no idea what it is investors are looking
for and have no appreciation of how investors think about doing deals.
By the same token, if basic thought had been applied about what it is
that investors are looking for, many inappropriate deals would never
even get beyond the back-of-the-envelope stage, saving the expenditure of much time, effort, money and heartache. It is the failure of these
inappropriate deals, just as much as potentially good but badly
explained deals being turned away, around which the myth of market
failure has been built.
Many potentially good deals get thrown out for poor communication
of the key elements, for inadvertently missing a crucial selling point
or for some other presentational quirk. These could probably achieve
successful funding if the entrepreneurs presenting them knew which
buttons have to be pressed to attract investors. While this applies most
11
Venture capital funding
of all to the small investment opportunity where entrepreneurs are less
likely to have access to sophisticated help, it is almost certainly applicable (in diminishing volume) to all sizes of business from all sectors.
What disappointed entrepreneurs miss in constructing their general
arguments based on individual experience, is that unless a proposal
hits a potential investor as being worth pursuing very quickly, then it
is likely to get discarded. The reality of the marketplace is that, like the
princess in the fairy tale, VCs have to kiss a good many commercial
frogs before they find the business equivalent of Prince Charming. And
in consequence they are probably not willing to waste much time on
trying to understand individual deals.
Those that demand a lot of active involvement in ‘sweetening’ will
be passed over if there is a chance of a better return by spending the
same amount of time looking at five other possibly more profitable
(and possibly more easily malleable) proposals. Hence many disappointed entrepreneurs – and the persistence of the ‘funding gap’ theory.
The existence of a funding gap or ‘equity gap’ has been argued about
probably since the first Phoenician galley-owner failed to get backing
for a speculative trading voyage further up the coast. Almost certainly
Christopher Columbus grumbled for many hours in Genoese taverns
about the shortsightedness of investors before he managed to sell his
business plan to King John and Queen Isabella and convince them
about the potential of America (which he had yet to discover, of course).
In the UK, it is usual to date the existence of the discovery of the
funding gap phenomenon from 1931 when the then Government
commissioned a committee chaired by Harold Macmillan to investigate
sources of funding to stimulate an economic revival. Economic policy
was reeling from the effects of the Great Crash and, under pressure
from industry, the government was seeking ways to kick-start economic activity. The committee included, among others, the luminary
economists John Maynard Keynes and Lord Bevin – and was the first
of many reports into the problem.
Over 70 years later, the problem of the funding gap – or maybe now
the mythology of the funding gap – persists. Government officials and
(disappointed) entrepreneurs still argue that there is a failure of the
market to provide funding for new and developing businesses:
The equity gap was originally defined in the Macmillan Committee on
Finance and Industry report in 1931. Since then, the defined amount of
the gap has varied according to subsequent reports. Currently the figures
used to define where the gap can be encountered are investments of
12
Background issues
between £250,000 to £1 million. (Source: www.businesslink.gov.uk at
October 2004)
Of course, for a disappointed entrepreneur the funding gap is where
he – or she – pitched the failed proposal. But the VCs would say
differently and claim that there is, in fact, a dearth of good funding
opportunities rather than an absence of cash. If anything, the VCs are
probably right given their record of making their investments work.
Table 1.1 Rates of return for 2003 and longer term (per cent pa)
Number of
funds
Early-stage
Development
Medium MBO
Large MBO
Generalist
Total/average
Technical funds
Non-technical
funds
82
54
77
54
54
321
96
225
2003
3 years
5 years
10 years
–18.1
–3.4
12.2
15.3
19.5
12.3
–18.0
15.3
–25.1
–8.2
2.9
9.1
–3.7
2.6
–24.4
5.7
–12.5
2.7
6.7
13.6
12.5
10.2
–10.3
11.8
–10.6
16.9
8.4
17.7
17.4
14.2
–6.5
15.6
Source: PWC/BVCA Performance Measurement Survey, 2003.
Table 1.2 Rates of return since inception (per cent pa)
Early-stage
Development
Medium MBO
Large MBO
Generalist
Total/average
Technical funds
Non-technical
funds
Number
of funds
to
12/2003
to
12/2002
to
12/2001
to
12/2000
44
46
55
45
46
236
60
176
4.7
9.8
9.7
16.4
13.8
13.6
7.4
14.5
11.5
10.1
11.0
16.8
15.4
14.6
10.7
15.3
14.1
9.7
14.2
18.8
16.2
16.2
12.1
17.0
15.0
10.0
16.3
18.7
16.4
16.4
12.8
17.3
Source: PWC/BVCA: Performance Measurement Survey, 2003.
13
Venture capital funding
Rates of return had obviously been affected by the dot.com debacle but
still remained comfortable for generalist funds and those concentrating
on larger deals, even after this depressive effect.
Venture capital funding in the UK is now a phenomenally large
business – definitely the largest in Europe and with a significant place
in national economic and industrial policy. The British venture capital
business has a substantial record of achievement, over something like
30 years, in developing ideas with commercial potential into highly
successful growing companies and embryonic businesses, and from
these into large thriving concerns (although not without the occasional
spectacular failure). This suggests that either VCs in aggregate do know
something about what they are doing, or that they are having a
phenomenal run of good luck. On balance, the former is more likely.
As you can see from the tables on page 13, a very large number of
businesses find their funding from venture capital investors every year
– even though individual years may show some variation because of
economic conditions. What distinguishes the businesses and proposals
which do achieve funding from those that don’t – aside from the cases
which are inherently ‘unfundable’ – is that they have hit the right
buttons in a number of areas that investors consider to be sensitive.
Whether this is by accident or design is difficult to generalize about –
some entrepreneurs will know naturally what it is that attracts an
investor; others will have been supported by previous experience,
either of their own or of others.
However, what can be distilled and communicated is that these
‘buttons’ centre principally on the question of risk and how to mitigate
it in the inherently uncertain area of the business world. As such, they
are dependent at any one time upon the evaluation of what is risky and
less risky, and what is desirable, according to the prevailing fashions
and beliefs of operators in the venture/unquoted/private investment
arena.
These things can change: at the turn of the millennium, any investment fund that wasn’t pushing dot.com investment proposals through
its investment committee was, according to the market gurus, out of
touch with the reality of the changing marketplace. It should have been
evident, according to those self-same gurus, that everybody was
abandoning the out-of-town shopping centres just as they had abandoned the High Street, and buying their daily groceries and consumer
goods by staring at a computer screen and clicking on a mouse.
Investors who didn’t understand this, in one of the more inane clichés
of the time, should ‘wake up and smell the coffee’.
14
Background issues
Unfortunately, no one had told all those people who still trawled the
shopping centres and the corner shop rather than the internet, that they
were buying from the wrong place. So the pet supplies companies, the
grocery businesses and the clothing companies who spent millions in
venture fund money on devising elaborate websites that took minutes
to download and complicated logistics systems that could deliver
single cans of baked beans to individual customers with perfect
accuracy, lost those same millions almost overnight.
It would be difficult now to find an investor who claims not to have
seen the crash coming and stayed out of the frenzy or sold out just
before everything in the market started to melt. Few people – especially
those with collective egos as sensitive as those of VCs – like to admit
to being taken in by both the emperor and his new clothes.
Even if market fashions do rule temporarily, the basics of putting
together an investment proposal and seeing it through will remain the
same. The basic factors are largely unchanging: clarity of purpose in
seeking funding; clarity of exposition in describing an opportunity; and
ability to see the opportunity brought to fruition. This is reducible to a
mantra of three Ms – mathematics; market; management.
Mathematics
The business plan is the distillation of the business set out on a few
pages. An experienced venture capitalist (VC) will know what is likely
to prove to be a good business plan from its shape, structure and size.
The business plan, since it is probably the first document that the VC
will receive from most businesses, is the document that lays the
foundation stone for the future of the relationship between the
company and the investor. What this means is that the business plan
has to stack up.
‘Stacking up’ in venture capital terms means that the business has
to be capable of a growth rate around 25 per cent per annum – meaning
that it can double in size as a minimum every five years. This level of
potential is required in the business plan since aiming at a return of
anything less will doom the money invested if the business plan is not
completely achieved.
Numbers are crucial, but too many business plans, especially those
prepared mostly by accountants, neglect the equally valuable explanatory aspect. ‘Stacking up’ does not simply mean that the numbers side
of the business plan – the profit and loss account, the balance sheet and
15
Venture capital funding
the cash flow – has to be accurate and without mistakes. The explanation of the opportunity must also enhance the information that the
numbers show. The narrative adds to the whole package, not simply
in mirroring the information provided by the numbers, but also by
persuading the reader of the credibility of the opportunity. Writing a
good business plan is more than a mechanical process of being a whiz
with spreadsheets.
Market
In many ways, market opportunities are as much defined by the
characteristics that they do not have as much as by those that they do.
In general the market opportunity has to have both breadth and depth
for it to be truly attractive to a VC. Ideally it should not be limited to a
very short window in time or restricted to a very narrow range of
customers. It should probably be capable of replication as a concept
into other sectors, product areas or geographical areas if there are such
limits.
The size of the opportunity has to be both accessible to the individual
business that is seeking the funding, and realistically open to penetration by that business. In other words while, say, the world market for
oil is huge and represents a massive potential market for any one
player, it is not possible to consider taking a substantial chunk of it by
merely replicating another oil prospecting/developing/refining
company with only limited venture funds.
Last, there should be some characteristic unique to the company that
is seeking the investment, which marks it out from other offerings to
the marketplace. This is what marketeers call the USP – the ‘unique
selling proposition’. That USP might be a positioning of some form:
technological, geographical, organizational or even financial.
Without some of these characteristics it is unlikely that the opportunity offered to the investor will be attractive as an investment. There
are, however, exceptions to every rule. James Dyson was turned down
flat by lots of venture funds that refused to see the opening for a
different kind of vacuum cleaner. And I remember turning down a film
investment opportunity from someone who went on to be one of the
biggest and most respected of the late 20th-century British film
producers. If I am truthful that was mostly because he kept me waiting
for an hour before he turned up for an appointment but, in my defence,
also because the plan he produced was almost incoherent.
16
Background issues
Management
The last and the most potent of the three Ms is management. Good
managers will rescue a poor proposal from ‘oblivion’ to ‘average’ and
promote an average one to ‘attractive’. Good managers combined with
attractive market propositions and mathematics that make sense are
what make propositions readily ‘do-able’.
Management ability is demonstrated in three ways as far as a VC is
concerned: through a record of achievement; through the way that the
business plan explains and persuades and through observation of
current business operations. The record of management is demonstrated through both individual records of competence – a good CV –
and through the record of the business in terms of turnover growth,
profitability and a good record of returns to shareholders. Being able
to explain the opportunity to an outsider demonstrates that it has been
thought through by the author(s) and also gives some insight into the
ability of the management to explain commercial strategies to others.
The quality of the business plan will also give an insight into management’s ability to motivate staff and dispose of the business’s resources
in an efficient way. The VC will then calibrate the inferences he draws
from reading the business plan with observations about the business
and interviews with key staff.
Mission impossible
There are some businesses which VCs will be reluctant to invest in no
matter how outstanding the prospective returns indicated in the
business plan. The wider ramifications of this statement are, again,
developed further in the final chapter but it is appropriate at this stage
to categorize some of the problem cases.
VCs will only be able to invest in incorporated businesses – that
means investments in limited companies or, since they were introduced
in 2002, in limited partnerships. Sole traders are impossible prospects
– since it is impossible to derive a saleable return purely from an
individual. No shares can be sold in an individual, and so a VC cannot
develop such a prospect. The only way to overcome this obstacle is for
an individual to choose to turn himself into a limited company for the
exploitation of his managerial abilities or his inventiveness, or to grant
the exploitation rights of his intellectual property to a company. In the
1980s, this is what the investors who backed Sir Clive Sinclair were
17
Venture capital funding
taking on. Generally speaking, such investment vehicles – like the
Sinclair C5 – go nowhere.
Inventors who are able to constrain themselves to the disciplines of
an organizational format are best advised to form a limited company,
properly staffed with some commercially-experienced managers, and
to seek the assistance of business angels for the cash required to exploit
their ideas. Only when the ideas get big enough to support substantial
amounts of venture money will the time be right to approach venture
funds rather than individual investors. Until that time few professionally managed funds will have any idea how to deal with a lone
inventor.
The only exception to dealing with lone individuals for most VCs
will be when they ‘follow’ an entrepreneur from one successful
investment to another. In such cases the entrepreneur will be expected
to build managerial teams around his own strengths and then to
develop conventionally structured businesses that the investors can
support. ‘Serial investors’ or ‘serial entrepreneurs’ like Mike Southon,
co-author of The Beermat Entrepreneur or individual VCs like Jon
Moulton or Sir Ron Cohen who develop fan clubs around their own
investments, provide examples of this. This sort of arrangement has
yielded good returns for some of the larger funds in the past.
But there is no guarantee that previous successes can be repeated:
Ernst Malmsten thought that he could replicate the phenomenal
success he had had in building a publishing business in Sweden from
scratch, with trendy fashions sold on the internet. He started up the
web-based fashion-house Boo.com with his business partner and
girlfriend. He ended up blowing over £9 million of investors’ funds
with little to show for it except some very fancy hotel and restaurant
bills, a lot of professional advisers who got fat on advisory fees and a
website that took eight minutes to download. That was in the middle
of the internet boom.
Malmsten and his girlfriend are examples of another area where
many VCs are reluctant to get involved – husband-and-wife or familybased businesses. Family businesses are renowned for two things in
particular – the kitchen-table nature of strategic development and the
intensity with which internal feuds are conducted. Kitchen-table
strategy is not necessarily a derogatory name for the exercise. What
frightens VCs about family businesses is that the strategizing takes
place behind closed doors. VCs expect that the businesses in which they
invest will conduct themselves in a certain way – essentially as miniplcs. The family network is a place where they cannot be involved as
18
Background issues
equals either in the initial discussion or the subsequent development
of ideas and strategies. Bitter experiences have led many to conclude
that no matter how rigorously and apparently impartial the administration of a family business is conducted, blood will always be thicker
than the ink signed on the bottom of an investment agreement. And if
it is not, then the chances are that the resulting family feud will destroy
any value generated in the business. Investments where one family
holds a substantial shareholding are very difficult to manage both for
external investors and their representatives on the board.
The advent of limited liability partnerships (LLPs) in 2002 meant
that VCs could enter into investments with members of professions and
mixed professional practices without compromising the professions’
regulations. Previously the law on the division of responsibility for
debts incurred by the partnership meant that this was an area they
could not enter. However, while an interest in an LLP can be bought
out by another party, it is still not possible to arrange a listing for one
on a stock exchange. That cuts off one exit route for the deal, effectively
condemning any deal with an LLP either to a restricted size or to the
company converting itself into a limited company in due course. VCs
mostly still prefer to enter ground they know rather than blaze new
trails.
Limited life deals – where investments have to be liquidated within
a specific period of time for tax reasons – will be of no interest to VCs
since they will want the manoeuvring room permitted by unlimited
time to rescue or maximize the value of an investment.
Investments in subsidiaries of holding companies will be of no
interest since VCs will always want their investments to be where the
power lies – in other words in ‘topco’. This minimizes the amount of
jiggery-pokery that they are subject to – anything from the movement
of money from subsidiaries to holding companies, to shifts in costs and
accounting policies that favour the ultimate owner of a business.
With the increasing stringency of money laundering regulations,
venture capital funds now have to conduct very detailed checks on the
backgrounds of those they do business with, and aside from minor
infractions of minor laws, few will be willing to invest in businesses
where there is anyone in a senior management position with any form
of criminal record. There is a hard practical reason for this. Not only
would such a disclosure probably alarm an investment committee too
much to proceed, it would certainly make the subsequent sale or
flotation of the business difficult to accomplish.
19
Venture capital funding
Certain markets may also be out of bounds to some funds. The
words ‘ethical’ and ‘venture capital’ are rarely found in the same
sentence but there are markets that probably disqualify themselves
from venture capital investment for reasons of reputation. I have yet
to come across a business set up specifically to manufacture pornographic films receiving venture capital funding, for instance. And a
business that deals exclusively with tobacco products probably
wouldn’t get very far in its discussions with investors, either.
Companies that are domiciled overseas but are in the UK for operational purposes will probably also be difficult to sell as investment
opportunities to most VCs. This is for much the same reasons as they
don’t want to invest in anything but topco: essentially, the investor
wants to be able to control what goes on in the investment and a distant
domicile makes this difficult. However, some of the very large venture
and pension funds are now operating internationally – in Europe at
least – and will arrange to conduct investments with corresponding
partners based in the jurisdiction where the company has its main operating base. The development of the Societas Europaea – the European
public company – may well encourage more of such ventures.
20
Why do you want funding?
2
Why do you want funding?
Opportunity, n: a favourable occasion for grasping a disappointment.
Ambrose Bierce, The Devil’s Dictionary
n
What venture capital is and is not
n
The basic question
n
Types of VCs
n
Timing of approaches
n
Post-investment consideration
n
Exit routes
n
The four main purposes of venture money
The last chapter laid out some of the factors that form the background
to embarking on a quest for venture capital for a business. This chapter
tries to illuminate what venture capital is and what it is not; and to
define some of the basic characteristics of the marketplace.
21
Venture capital funding
DEFINING WHAT VENTURE CAPITAL IS –
AND IS NOT
Both the marketplace for funds and the venture capital business tend
to define themselves by what they are rather than by any dictionary
definition. The actors know what they do and how they do it. Essentially, and as far as this book is concerned, venture capital can be
defined as an investment in an unquoted company for one or a
combination of purposes. These purposes usually fall into three major
categories:
n
initiation of trading (start-up);
n
change of market position (development capital); or
n
change of ownership (buy-out).
The purpose of the investment is to make a substantial rate of return
to both the investor and the entrepreneur(s) within a reasonably closely
defined period of time, typically three to five years, by enhancing the
capital value of the business in which the investment is made.
Stating some of the things that venture capital is not, will also help
to define it. Venture capital is not:
n
secured – there is no guarantee of recovery of the investment in the
event of failure of the business;
n
time limited – while there is a horizon (typically three to five years)
for the calculation of the rate of return available to the investor,
there is considerable uncertainty as to that being achieved;
n
certain – the investment is always at the risk of market forces and
managerial capability;
n
liquid – once in it is very difficult to get the money out again
readily;
n
suitable for a ‘core’ investment policy – venture money is capable
of high rewards but is not intended for the provision of basic and
safe returns.
22
Why do you want funding?
The factor linking all these last five characteristics is that venture capital
is risky. As we shall see this means that the investors adopt certain
strategies in making investments. Knowing what the root of these
strategies is will help to shape the approach that the entrepreneur
should adopt.
The basic question
Simple though it may seem, there is one very basic question, which if
answered properly gives the key to the whole exercise of raising money
for a business. It may at first seem like something of a redundant
question to ask, ‘Why do you want outside funding for your business?’
– because the answer is, fairly obviously, ‘Because I haven’t got the
money myself’. But if you go on to think a little more about the
reasoning behind the question, then a slightly more elaborate answer
will help in the search for funding. The real intention behind the
question is to elicit the purpose to which the investment money is going
to be put. If you can provide a cogent answer to this for your business
then you are a long way down the road of achieving a satisfactory
reason for an investor to make an investment.
The four reasons for this are simple and powerful. Knowing the
purpose for which you want the money will control:
n
the type of VC that you should approach;
n
the timing of your approach and the timing of the entry of the cash;
n
the way that you will run your business after the injection; and
n
the exit route that you expect to achieve.
These four factors are really at the heart of any excursion into raising
venture capital. We will go on to look at them in greater detail in just a
while when we consider the types of business that can normally
achieve funding. But before you embark on the (possibly long and
probably arduous) quest for outside finance you should ask yourself
an even simpler question: ‘Do I really want outside cash at all?’
This is not so stupid as it may seem. And, before you answer the
question, consider some advice from someone who has been through
the process. Mike Southon1 started a consultancy that he sold to one of
the very biggest worldwide computer/accountancy consultancies only
23
Venture capital funding
five years later, and has been involved in several start-ups since. His
advice is to use the following sources of finance to develop your
business and he lists them in priority order as:
1. your own money;
2. grants/soft loans;
3. revenue from the business;
4. a mentor;
5. a friend;
6. your bank;
7. revenue with the enticement of future equity;
8. business angels;
9. VCs;
10. gentlemen in dark glasses.
He regards inviting VCs into one’s business as equivalent to agreeing
to a Faustian pact – in other words, selling one’s soul to the devil. We
shall see why he thinks this in Chapter 10 when we deal with the legal
stages of a venture capital investment. However, since Mike Southon
also lists his services as helping to secure venture funding for young
businesses on the same website where you can buy his book, he
is obviously exaggerating to make a point when he lists VCs as one
notch above loan sharks as a source of finance. But like all good
exaggerations, there is a kernel of truth at the bottom of what he
suggests.
Enticing venture capital into a business is not a one-off process that,
when completed, can be sidelined to the main purpose of the business.
Once in, VCs are likely to be more than a little intrusive in a considerable number of ways – determining business strategy; vetting the
appointment and dismissal of senior employees; controlling capital
expenditure; controlling salary levels; being picky about corporate and
statutory regulation details, and so on. The list will be extensive – as
Chapter 11 will show – and there will be more than a marginal element
of corporate adjustment in accommodating their requirements. And
24
Why do you want funding?
that goes without any consideration of the rate of growth that they will
expect for their investment to turn out satisfactorily.
In order for a business to be of definite interest to a VC it is probably
going to have to exhibit a potential growth rate of about 25 per cent
per annum compound. In other words, at that rate of growth, a
business is going to have to double in size by the end of the fourth year.
Can you manage that – in both senses of the word?
First, can you actually physically cope with that degree of extension
of your management abilities and, second, is your business capable of
that sort of speed of growth? There are comparatively few businesses
that have the market potential to do that – and of those, still fewer with
the managerial capacity to cope with such change. No wonder Southon
says that taking a VC on board may be a Faustian pact.
But there are two counterpoints to the Southon view. First, venture
capital has helped to make a very large number of what were otherwise
pedestrian or even stumbling businesses into worthwhile industrial
and commercial concerns; and second, a large number of the owners
of those businesses have become very wealthy in the process.
So if the prospect of having to cope with this culture shock doesn’t
put you off, then keep reading (and I hope you will).
The four main purposes
Going back to the question which was posed at the very outset of this
chapter – ‘Why do you want outside finance?’ – there are essentially
four main purposes for raising venture capital. Any reason other than
these is simply a variation on the main theme. The principal purposes
are:
n
to start a new business:
n
to develop an existing business;
n
to change the shareholding structure of an existing business;
n
to rescue a business.
These four purposes equate roughly to the life cycle of a typical
business: birth, growth, maturity and some form of exit – although
hopefully not a corporate death. Consequently they encompass most
of the opportunities that will present themselves to most entrepreneurs.
25
Venture capital funding
But what is also important to recognize is that they all represent stepchanges of some form in the life of a business. In other words, they are
not simple changes in the pre-existing strategy that the business has
been working to, but that they are fundamental changes in the organization of the business that will bring about fundamentally different outcomes
to what previously existed. Such fundamental changes in expectation
can be expected to bring about greatly enhanced returns to the
business, if they are properly executed.
The corollary of this is that you don’t pursue venture capital unless
you are contemplating a step-change. If your business needs some form
of transient funding to accommodate changes in trading volume, then
go and get yourself a bigger overdraft or talk to an invoice discounter
or factoring business. If you need to fund a large piece of machinery
then get a term loan. If you need to move premises then get a mortgage.
None of those purposes is suitable for venture capital funding
(although I ought to qualify that by saying that if the size of the expansion of premises you are contemplating is very large and brought about
by a merger, then venture funding might just be appropriate). And it
will probably not be worth your while trying to find a VC who will
put in less than £250,000; you may find a business angel (or business
angel syndicate) who might do that for you if your case is good enough
but most of the large funds won’t stir themselves for opportunities of
less than half a million. Even some of the managers of the regional
venture capital funds (see Chapter 3) – specifically set up to plug the
perceived ‘equity gap’ regionally – are beginning to mutter that, with
caps on the size of investment they can make, their supposed turf offers
thin returns and they would be better able to make returns on their
(public) money if they moved upstream to where the larger opportunities exist. The equity gap, like the poor, is always going to be with
us apparently (even if it doesn’t exist!).
But back to our analogy of the life cycle of a business. Just as each of
the different stages in the business life cycle brings about different
problems and opportunities, so each is of a very different nature from
the others in terms of the risks, problems, rewards and outcomes that
accompany them. And, not least, the issues that surround each of the
purposes need to be carefully considered by the entrepreneur before
embarking on the pursuit of venture capital. The effect on the business
cannot be considered in isolation but has also to be viewed in the light
of the changes that will occur as a consequence of financial development.
26
Why do you want funding?
To throw into contrast the different approaches that are demanded
of both the entrepreneur and his or her potential backers in bringing
these changes about, we need to look at them in a little more detail and
consider the funding characteristics of each in terms of the four
consequential categories we introduced. To recap, those are:
n
the type of funder who will be interested;
n
the timing of approach;
n
post-investment consequences;
n
likely exit route.
Start-up
This is the area from which true venture capital sprang – and from
where most VCs are now migrating (see statistics from the British
Venture Capital Association (BVCA)). Some very large start-ups might
still attract some specialist funds in specialized industrial areas
(pharmaceuticals; computer chip manufacture; specialist computer or
communications hardware, perhaps) but by-and-large this area is now
principally the hunting ground of business angels, specialist universitybased funds or technology-fund specialists. Funding will almost
certainly be ‘staged’ – predicated on the achievement of ‘milestones’
established in the business plan – and the amount of equity that the
entrepreneurs can be expected to retain is likely to be on the low side,
in order to protect the funders from the heavy element of risk in taking
on – presumably – largely untried management or unproven markets
or risky technology.
It will also have to protect them against the impact of the almost
inevitable second-round funding where their holdings will be severely
diluted by new participants. Prospective rates of return (RoRs) will
have to be high, in consequence.
Type of venture capitalist to be approached
From what has just been described it should be plain that if you are
contemplating a start-up then you have two choices. You are either
going to have to use your own money (or that of the three Fs – friends,
family and fools) or probably more likely you are going to have to
approach a specialist. And all of the following is also dependent on the
27
Venture capital funding
assumption that when the term ‘you’ is used it is being used in the
plural and, further, to a multiple of persons – in other words not just
two people. Very, very few professional investments are ever made in
lone inventors. Investors want to see a team of managers that will be
able to cope with the growth of the business that they are hoping for.
So if you are going it alone then you will have to recognize that your
choice condemns you to a perpetual small size in the eyes of most
investors and that you will likely have to rely on the three Fs for your
development money.
The main market for investment funds has moved on from the startup area, leaving it to specific types of VC to trawl. These types of funder
fall into three main groups.
If you are involved in venture capital in a university environment
then there is probably a specialist in your university whose task it is to
liaise with industry-specialized VCs to develop funding relationships
and alert them to potential opportunities within university departments. Each university, if it does operate this system, will have specific
rules about whether the university will hold a stake in ventures started
up by academic researchers and what size that stake should be. These
need to be considered carefully before an approach to a VC is made
through such a route (although if you have made the discovery or built
the venture in university time using university materials and funding
then you may not have much choice). Most universities now have an
enlightened view about this, recognizing that some portion of a large
cake is better than none at all. Their expertise in helping to develop
such ventures is not to be dismissed lightly. The rules about stakes and
assistance are usually published or well known by senior researchers.
If you are operating outside a university then you are probably going
to find the most attentive audience among the several specialist
investment fora which have set up either commercially or through
business links. (You can find addresses for some of these in Appendix
2.) These specialize in introducing potential businesses to potential
funders – in the shape of business angels – and will give some technical
assistance to the businesses or proto-businesses that approach them in
return for a fee. The businesses are the clients of the investment forum
managers – not of the business angels (who may also have to pay some
form of fee to be associated with the forum) and so there is usually
some scrutiny done by the staff of the forum to improve the presentations of the best client companies and advice about how to develop and
present a cogent case to potential investors.
28
Why do you want funding?
The usual format for these investment clubs is that there is a monthly
meeting of investors at a local hotel where four or five potential
investments are given 10 or 15 minutes (at most) to present to the
assembled funders who then might choose to approach the presenters
either individually or in syndicates. (These mini-presentations are
called ‘elevator-pitches’ because they supposedly first took place in a
lift where the entrepreneur had trapped the investor and used the time
it took a lift to go up and down the entire height of the building to make
his case.)
You can see that the forum is effectively a sort of financial dating
agency, where opportunity meets angel (rather than boy meets girl).
The outcome is hopefully the same – a consummated relationship.
Another similarity with the dating agency is that in each case, the
introducing party retires immediately after making the introduction so
as to avoid being a gooseberry and cramping the style of the two main
parties.
Equally you might try to approach one of the regional venture funds
(RVCFs) that have been specially set up by the government, for the
purpose of joining commercial money and investment skill with public
funds. These funds are fairly catholic in their investment tastes and are
usually obliged to look carefully at the opportunities that they are
presented with, under the terms of their operational charters. They are,
as their name suggests, strictly regional in their residency requirements
but have been known to entice potential opportunities across regional
boundaries if they find them particularly attractive – so if you are a
start-up as yet without a home then you may be able to play this
particular card. They may also have special requirements to look at
female-led proposals/ethnic minority ventures or rural or urban
situated proposals. But whatever the requirement to look their judgements about whether to invest will be based on the pivot of commercial
viability.
Timing of approach
Usually for a start-up, the sooner approaches are made to VCs, the
better. But beware talking to investors before you have properly
protected any intellectual property on which your business is going to
depend. You cannot approach an investor with an investment proposal
and maintain your credibility if you are going to tell him that your idea
will revolutionize industry X but that you are unable to reveal precisely
how.
29
Venture capital funding
If you are working in a university then this problem should not pose
too many difficulties since the liaison officer will already have taken
this into account and undertaken the necessary steps to protect
patentable processes and ideas. In a commercial environment this is
less easy – patent protection costs money. Defending patents costs lots
of money.
In either case, university or non-university, it is necessary to have
some basic ideas about the next two factors.
Running the business post-investment
The one overriding trouble with start-ups for most investors is that they
do not contain a full suit of management skills in the hand that is being
dealt. Most VCs will want to add commercial skills to a start-up
opportunity to make up any managerial deficit they feel they have
identified. This may be hard for some teams to swallow – not least
because it may involve some further erosion of the stake that they
collectively hold or impinge on the way that they want to exploit the
market commercially.
Business angels get over this problem by combining their money
with a requirement that they take an active role in the business –
combining cash with so-called ‘sweat-equity’. Most sensible entrepreneurs will readily embrace this offer if they find a compatible
partner.
Knowing how to get out – the expected exit
Only one thing causes more trouble than getting money into a business
– and that is getting it out. Start-ups pose particular problems because
there are so many unknowns about how the business will develop. The
professional investor assumes that one of his possible exits will be to
see his holding heavily diluted by further injections of cash required
from other investors to see the business plan brought to fruition.
This supposition is borne out of hard experience. You can count startups that have got to a successful exit on the initial injection of cash on
the fingers of one hand. Business angels must operate on this assumption – on the near-certainty that their pockets will not be deep enough
to fund the level of expansion that a small start-up requires to make it
a decent business. If this is going to be the case, it helps explain the high
levels of equity that start-ups often have to concede to incoming
investors.
30
Why do you want funding?
Business development
‘Development capital’, as this part of the market has come to be known,
is an area where venture capital funders probably begin to feel fairly
comfortable: there is a market that they can analyse, management that
they can scrutinize and a company with a record of profitability that
can be assessed. The ‘hurdle rate’ is probably much lower because some
of the uncertainties about the business will have been mapped out and
the likelihood of second-round funding can be better judged. Ratchets
may well be employed in the structure of the funding to allow some
flexibility for equity drift to one party or the other.
There are many funds that compete in this marketplace and that
means that the price of capital is likely to be driven down to what can
probably be viewed by the entrepreneur as more reasonable levels. In
terms of stakes that have to be conceded to the incoming investor, this
translates directly into more equity for the management team.
Type of investor
Business angels are still active in this part of the market but probably
as syndicates rather than as individuals, mobilizing collectively larger
amounts of cash. They will thus take on many of the characteristics of
‘normal’ funders, probably nominating one of their number to act as
non-executive director or rapporteur – but still perhaps with a greater
degree of participation than might be expected from a fund-based nonexecutive.
RVCFs like this area very much but also find it frustrating since there
are ceilings on the amount that they can place in any one investment.
This means that they tend to go for opportunities where a commercial
sale can be seen as a realistic possibility in a fairly close time-horizon.
If they see a good future for the business, but one which requires more
money than they can supply, then they may have to place high equity
requirements on their involvement.
Development capital is such a popular area with venture fund
managers that many even incorporate it into their fund names. But not
all will have the same risk-appetite for development deals and there is
undoubtedly some segregation of the market by size and by industry
type. Most funds will indicate in their literature and on their websites
the areas in which they feel most comfortable, and, generally speaking,
the larger the fund the more sectors it will look at.
31
Venture capital funding
Timing of approach
Speed is of less absolute significance for the development capital deal.
Operating probably in a more mature market, in many ways managerial calibre is of greater significance than pure market considerations.
The coherency of the business plan will also count highly – and the
quality of the management of the company will be strongly evident in
this.
Running the business post-investment
Well-rounded management teams will include subject and functional
specialists to whom the VC will be able to introduce little of additional
value. The one area where there might be some managerial lightness
will be in the area of what might be called ‘corporate wisdom’ and it
is often here that VCs will seek to make some changes. This is usually
done by selecting a new chairman for the business (from the stable of
individuals who circulate among the venture capital community) to
complement the seat on the board that will come with the ‘monitoring
rights’ for their investment. The right to appoint the chairman will
probably be put forward as a stipulation in the offer letter.
Development capital businesses are being prepared for sale from the
moment that the VC’s investment hits the bank account – often before.
Good development capital opportunities are, in fact, businesses that
happen to be currently private but are being run like public ones. This
applies not simply to the range of skills and the capabilities of the
senior staff but also the regulatory standards that are employed in the
company. The idea is that a public flotation of the shares or a private
sale to another business will be made that much easier if such standards are adhered to – and of course that the resulting price will be that
much higher, since a ‘control premium’ will be fully justified by the
company’s financial and operational history.
The expected exit
Well-run development capital businesses leave investor options open
for either flotation or sale but it is unusual for these options to be
equally likely outcomes. Since the exit is much higher in the chronological list of priorities than for the start-up business (not surprisingly,
since the hard early work of growing has largely been done) the
preferred outcome will usually form a concrete part of the management’s plans. For the potential investor not to be able to recognize it
32
Why do you want funding?
as being in place as the investigation of the proposal becomes more
detailed, may well be an obstacle to investment. The need for management to give an unambiguous signal that they are clear about the
commercial strategy for the business is of critical importance in
trapping the interest of the potential investor. The VC can be persuaded
(or not) about the case and either pursue the investment (or not) but
to leave the case unmade will not encourage any pursuit at all.
The area where problems often arise, though, is where development
capital is sought by one company to enable a purchase of another.
Buying into one company is difficult enough for the VC to convince
himself to do but buying into one as a route to buying into a second is
probably a step too far for most. The problems of integrating the
different cultures of two apparently similar businesses are often a
mouthful even for experienced management teams, never mind when
they are also coping with the strangeness of taking on board an
investor. Consequently such deals offer the type of problems that are
usually met in the next category as well as the problems that are
normally associated with assessing development capital deals.
SHAREHOLDER CHANGE
If ‘shareholder change’ means the sale of a subsidiary to management
then this is probably now the area where most VCs feel at home. If it
means simply buying out a recalcitrant problem to make life easier for
the incumbent management then there are going to be fewer takers. But
in each case, the larger the numbers being talked about – paradoxically
– the larger the likely number of interested funds.
Management buy-outs (MBOs) have become the favoured variant of
venture capital for many of the larger funds. In the larger buy-outs, the
management levels of these businesses are often populated with
executives who have been selected according to the rigours of big
company criteria. The senior staff of major subsidiaries (prime candidate companies for buy-outs) will be at or just below board level calibre
for plcs; seasoned, qualified and experienced managers. They will be
used to operating in major markets and with big company disciplines.
The businesses that they run will have long financial records that
can be disentangled from head office overheads to demonstrate
commercial attractiveness. There will be nice clean audit reports
coming from long audit records.
33
Venture capital funding
Most MBO opportunities also come with the blessing of the selling
company so there is a willingness to do a deal from the outset. And
critically, the interests of the VC and the managers are almost completely allied while the bulk of the deal is being done: both want to
flush out the lowest possible price for the deal. This is in marked
contrast to the normal situation in a development capital opportunity,
where managers are trying to bid up the price of their company while
the VCs are trying to push it down. Not surprisingly, MBOs are juicy
plums for most VCs.
By contrast, using money to winkle out a recalcitrant shareholder
looks a bit of a thin reason for investing. Only if the business is capable
of some spectacular growth under a rejuvenation of management is this
likely to be an enticing opportunity for most investors.
Type of investor
The biggest funds devote much effort and much cash to cultivating this
sector of the market. The amounts of money that can be mobilized by
any one of the largest funds are now tens of times larger than the
biggest deals that were being done by syndicates of investors only 15
years ago. If a big buy-out is what you are pursuing then you will find
no shortage of potential takers for the right type of deal.
Timing of approach
It is less easy to be specific about this area: some funds like to work
very closely with potential management teams. Others like to get
started only when the bulk of the permissions to try to arrange a buyout have been granted to managers by the parent company. Clandestine arrangements are probably not very attractive to most funds –
although it happens even with the largest deals. I can remember, when
I worked for the Coal Board Pension fund, being escorted from the
premises by security staff (together with a large number of other
potential investors) when the first buy-out of Land Rover was proposed by the incumbent managers, without having checked with the
board first.
The big benefit of this type of opportunity is that there is usually no
shortage of good advisers to help managers put a deal together. But it
is also necessary to point out that good advice can be costly – and if
the deal falls over at the last minute, it can be very embarrassing for
the managers who may find themselves in the unenviable position of
being without jobs and with big professional bills to cover.
34
Why do you want funding?
Likely exit
Only a few years ago there would have been no doubt that the most
likely exit route for a big MBO would be another flotation. Now there
is a tendency for large companies to think twice about the administrative and regulatory burdens of listing on a public exchange. Consequently private sales and cash-flow deals have become more popular
as the longer-term prospect for buy-outs rather than entry to a public
stock market.
This has deep implications for structuring deals and the relative
attractiveness of various types of management investment. The choice
of investment vehicle, the use of off-shore and discretionary trusts and
whether to use loans, equity or preference shares and so on, is much
more complicated than it used to be and depends very much on good
professional advice. Many such deals are now tax-driven in terms of
their structure, rather than being commercially transparent as they
would have been for flotation purposes.
Rescue
You have to have fairly strong nerves to do this kind of deal either as a
manager or as an investor. There are specialist fund managers in
recovery situations – and they often follow one or two talented
individual managers who specialize in doing recovery work. A good
generalist fund manager will not turn down any potential opportunity
without studying it thoroughly. But if you are contemplating taking
this sort of opportunity to a VC then you have to put yourself in his
place and ask yourself why should someone invest in a proven difficult
case when they can probably experience less grief in a much simpler
proposal for the prospects of a similar rate of return – at least at face
value. The only possible correct answer is because there is a prospect
of a stupendous return for some otherwise unrecognized technical
reason.
People, and particularly investors, being what they are, will remain
sceptical about these technical reasons. Because of this, recovery deals
are just about the hardest to sell to investors. Even most business
angels, often more adventurous both by disposition and by reason of
practical experience than most VCs, tend to fight shy of recoveries.
The problem of credibility is not only concerned with the commercial
history of the business but also means an almost guaranteed requirement will be that the management should suffer wholesale replacement,
35
Venture capital funding
since they were the ones who got the business into trouble in the first
place. From the investors’ point of view, there is the double bind that
anyone associated with the previous regime will be tainted, and fresh
incomers may not understand what really caused the problems that
brought about the demise of the previous management group.
Type of investor
This will almost certainly be a specialist – therefore both easy and
difficult to find in consequence. Easy because they stand out; difficult
because there aren’t many of them. Specialist associations like the
Turnround Management Association will know of likely investors in
these areas.
Timing of approach
This is critically important. Get in too early and not all the commercial
problems will have become apparent. Get in too late and you may well
be flogging a dead horse. VCs are very well aware of this and also that,
as their industry folklore has it, ‘lemons ripen before plums’. The due
diligence requirements for these sort of opportunities will be severe –
costly and probably extended. Even to get to that stage at all you are
going to have to present a very good case.
Likely exit
If the corporate undertakers can be avoided – corporate failure is
statistically the likeliest outcome – then probably a trade sale will be
the preferred route. Most venture investors will be unwilling to tempt
fate with a long involvement with a company with a dicey history –
and a poor record of profitability will not contribute much towards a
sturdy initial recommendation in a public stock market.
So that’s completed our brief Cook’s Tour of the investment landscape.
In summary, start-ups aren’t flavour of the month – this month or any
other month; development capital is a better bet for funding; buy-outs
are the likeliest to get capital; rescue situations have to be potentially
very, very profitable to get a hearing because of the risks involved. Are
there any other general points we need to introduce to thoroughly
flatten any residual interest in raising capital? Well, yes. Just a few.
36
Why do you want funding?
NOTE
1
Mike Southon and Chris West (2003) The Beermat Experience,
Prentice Hall, London
37
Venture capital funding
3
Know your enemy: the venture
capitalists considered
Freebooter, n: A conqueror in a small way of businesses, whose
annexations lack the sanctifying merit of magnitude.
Ambrose Bierce, The Devil’s Dictionary
n
The background factors
n
The myth of patient money
n
Pressures on the VC
n
Types of venture capital fund – fund size and structure
n
How these factors affect fund behaviour
n
From fund to individual: who are the VCs?
n
How VCs make their money
38
Know your enemy
While the previous chapter started off by posing the question, ‘Why
do you want the money?’ this chapter takes a look at the problem from
the other side, and asks, ‘Why should they want to give it to you?’
The simple answer to that question is profit. VCs can make a lot of
money out of buying into young or developing businesses and helping
them to grow, then selling out. The statistics in Chapter 1 compiled
from information released by the British Venture Capital Association,
showed where VCs have been placing their money in recent years.
VCs provide the wherewithal for the company to grow, possibly
adding some managerial help and some administrative discipline. But
their overriding intention is to leave just before the peak of the
company’s growth parabola – at the point where a little more growth
can be anticipated, but in truth, where the fastest rate of growth has
already been experienced.
So don’t ever forget that critical clause – they want to sell out. They
don’t want to stay with you forever. Venture capital funding is a
marriage of commercial minds, with a built-in divorce about halfway
before the seven-year itch starts to set in.
This should be appreciated from the outset. VCs are not long-term
investors. This is in direct contradiction of what they try to emphasize
as part of their sales pitch to the businesses that they deal with. They
are better described as serial medium-term investors.
In fact, unlike many pension funds who are genuinely long-term
holders, the three to five years for which venture funds typically hold
their investments are barely two-thirds of one economic cycle.
THE MYTH OF PATIENT MONEY
A myth that has grown up is that money put into a business by way of
equity is ‘patient money’. The myth appears to have grown up through
a misapprehension, like most myths, and appears to rest on a mistaken
contrast with loans. Because loans are repayable on demand and need
constant attention in the form of interest payments, they are felt to be
demanding and undesirable as a means of stimulating business
growth. The implication is, as I understand it, that equity is patient
because it is ready to wait for its return. That, unfortunately, is not true.
And it is certainly not the case where venture capital is concerned.
39
Venture capital funding
Successful venture capital investment is built on three things and
patience is not included. The three factors that I perceive to be
important are risk minimization, opportunism and a good dollop of
luck. None of those things are particularly well acquainted with ‘the
long term’.
To explain those characteristics further, we shall see throughout this
book that one of the key factors to any venture capital deal is the
minimization of risk. This is what VCs strive after in arranging the
structures of their deals – and also in the duration for which they are
willing to stick with a deal.
It is a reasonable supposition that any investment that is longer in
duration than any comparable investment is exposed to greater risk.
This is simply because the passage of time conveys with it the development of risks unknown and inexperienced in the shorter investment.
Hence VCs will stay with a company up to the point where the top of
the growth parabola can be seen and no longer. Of course, they might
be mistaken about where the top of the curve is exactly but where they
perceive it to be is the operative factor in their decisions.
The second characteristic I have identified – opportunism – has
received a bad press in recent years and is now often associated with
some sort of reprehensible behaviour or lack of morals. This is unfortunate since in its pure form, shorn of connotations, all it means is taking
advantage of opportunities that are offered. To my mind every good
business manager should be an opportunist – seeing and exploiting
opportunities is what business is all about.
VCs are certainly opportunists and ought to wear the badge of
opportunism with pride. It is one of the methods by which they
seek to minimize the risks to which they are exposed – taking advantage of opportunities to release investments at the points where the
potential risks become greater than they are happy with for the rewards
that they are likely to reap. Or conversely, where the rewards become
less than they are satisfied with for the risks that they are currently
running.
The third characteristic – luck – is implicit in all business ventures.
While it is reasonably easy to distinguish the good business from the
bad or the good manager from the mediocre, in both businesses and
managers it is only shades of luck that separate the good from the
outstanding. No business can claim to get the exploitation of every
opportunity right every time and the record of venture capital funds
and individual investors shows that they certainly do not. Given the
amount of effort and intellectual energy expended in investigating and
40
Know your enemy
doing deals the only reason that can explain such failures, overall, is
bad luck.
PRESSURES ON THE VENTURE CAPITALIST
These three factors explain why venture capital investors are highly
impatient people (as a class). Individually, of course VCs are sophisticated individuals who behave as befits normal commercial behaviour.
We are not talking about barging to the front of queues in post offices
or the use of the briefcase as an instrument of violence in a Tube crush.
Individually, perhaps the most frequent clue to impatience that I have
seen is the tapping of fingers noisily during very long meetings.
But collectively, as far as their professional existence is concerned
VCs are anxious to see returns on their investments, eager to move on
to the next deal and have a short fuse for extended explanations when
things do not turn out as anticipated. In short, they want their money
to perform and are prepared to act in such a way that they reduce the
risk of that not happening.
While they are unable to ask for their investments back in the same
way that bankers can demand repayment of loans, we shall see VCs
are quite capable of effecting changes in a business. This is done purely
to try to bring about a turn of events that will favour the outcome they
were anticipating when they went into the deal. Far from exhibiting
the characteristics of patient investors, who are willing to let events
transpire and sort themselves out (often because they have no option
to do anything else over the short run), venture capital equity is highly
impatient money. And furthermore, venture capital money will
carry with it the right to take managerial action over the short run,
because VCs deal in the immediacy of business in real time and taking
action to rectify problems is part of the process of attempting to
minimize risk.
Nearly all the actions that venture capital investors take resolve
eventually to an obsession with risk and its minimization. It is not too
far from the truth to say that most businesses are like unexploded
bombs – something is ticking away inside the structure of the business
just waiting to go off and wreck the whole thing. If you hold on to an
unexploded bomb for long enough then you are going to be around
when it does go off. That explains why VCs like to make their investments, develop the company fairly fast and then get out while the
41
Venture capital funding
growth path is still pointing upwards. They want to get out well before
that ticking stops.
But the pressures are not all the same for all VCs. Different types of
VC will be affected by different influences, depending on where they
stand in the capital marketplace. We need to look at them not as a
homogeneous indistinguishable group but as a heterogeneous set of
individuals in order to make sense of their behaviour.
FACTORS AND ISSUES AFFECTING VENTURE
CAPITAL FUND POLICIES
The root of the pressure to which venture capital fund managers are
subject, though, is that all the money with which they are dealing is
someone’s savings. And savings, if they are to be of any use, require that
a return be made on them. Money that isn’t working is just idle paper.
It can be made to work in a variety of ways and in our economy works
mostly by being invested in companies – either directly or through the
medium of the stock market.
The big players in the stock markets are the pension funds and
banks. The managers of these funds are constantly seeking out opportunities to invest the funds placed with them to achieve returns that
will exceed those of their competitors and therefore attract more
customers’ funds from which they will derive more profit themselves.
The problem for the pension fund managers is that with betterregulated markets and faster transmission of information to all parts
of the market, it is becoming increasingly difficult for large pension
funds to make consistently better returns than their competitors.
Venture capital funds can help them do this. The VCs’ aim is to
achieve a much better than average rate of return on the savings that
they are entrusted with by using their judgement and operating in a
marketplace where direct action on the investment is possible.
The benefit for the investors is, of course, that if the VC does his job
well then they make a very fancy return, with luck, on the money that
they have entrusted to the venture capital funds. And this rate of return
will be far better than they make on their normal investments. Even
though the proportion of total funds that the big investors place in the
venture capital market is small, the rate of return that can be achieved
is very good. This makes it attractive – particularly when achieving
42
Know your enemy
above average returns in the large markets becomes increasingly
difficult.
FUND SIZE AND STRUCTURE
We have looked at some of the main forms of venture capital fund in
the previous chapter, identifying the sectoral interests that they might
have. There is no need to rehearse those features here. We are now
going to examine:
n
the structure of funds and how it affects investment stances;
n
how the size of the funds under management affects the way that
they are managed; and
n
the consequences for the investee company of the position that
individual funds occupy in the life cycle of their portfolios.
As far as the outsider seeking funds is concerned, there are really no
visible differences between the funds – no external distinguishing
features. However, the characteristics of the funds may alter the
way that fund managers are able to or wish to behave in respect of
investments.
Structure 1: individuals
Individuals operating in the venture capital business are almost
always one of three types – deal brokers, consultants or business angels.
Only the last of these is of any real interest from a funding point of view.
Deal brokers have now almost disappeared from the market with the
increasing sophistication and growing maturity of funds (British
Business Angels Association (BBAA), for instance, used to operate a
marriage-brokerage ‘Bestmatch’ service, but turned it off in 2003
because of decreasing interest); and consultants generally offer expensive services which are often paid for with equity in order to get a foot
in the door of developing business. Their value is limited to any wellmanaged business. In short, if you are well managed you don’t need
43
Venture capital funding
them and if you do need them, then you should probably not be
applying for venture capital – yet (or at least not until you have
digested the information in this book).
The interesting ones from the funding point of view are the business
angels. These are individuals who are (or are supposed to be) ‘sophisticated investors’ – that is they are able to understand and evaluate
investment opportunities by themselves, without relying upon the
expert guidance of an intermediary. There is no exam for being a
sophisticated investor – you just have to get your accountant to agree
that you are one (in writing) for the purposes of the investment that
you are going to make. (As you can guess the title is probably designed
principally to protect intermediaries from comebacks rather than the
investors from their own ignorance.)
They are also individuals of ‘high net worth’ – that is, they can afford
to lose the value of their investments, if the worst comes to the worst,
without being financially crippled in consequence. Again, the individual’s accountant has to sign a certificate – this time saying that the
potential investor earns more than £100,000 a year or has disposable
net assets (excluding their primary residence and certain other assets)
of more than £250,000. (An employer’s letter will also do for the income
certification.) The amounts that investors will want to invest are
therefore heavily dependent on individual circumstances: some
investors may have a pot that they want to spread around and may
limit themselves to, say, a couple of investments of £50,000 each. Others
may be willing to go nap on one investment if it looks good enough.
In situations where one investor can’t – or is unwilling for reasons of
prudence – to put all the cash into an opportunity then they can
‘syndicate’ the deal (see below).
The rather acid description that I have given does not do most angels
justice. While there are dilettantes among their ranks, in general,
business angels are individuals who have gathered their resources the
hard way, through building up businesses themselves, and are now
willing to speculate with them in order to accumulate more. Unlike
venture capital fund managers it is their money that they are risking
and not somebody else’s. If things go wrong they are the ones to suffer
directly – and in the pocket. A loss in any one investment may be
regretted by a fund manager but it is not likely to make his eyes water.
He will have adopted a portfolio approach to investing his funds so
that the expectation of some loss is covered by the expectation of very
high profits in other deals. Business angels are in the front line of losses
when things go wrong, for each and every loss.
44
Know your enemy
One of the most significant primary characteristics of business angels
for very young businesses is that, first, they will apply not only their
cash but also ‘sweat equity’ to a business – they will probably require
as part of the investment some form of quasi-executive post and will
want to work in the business for a couple of days a week – and, second,
that they may (but only may) require a lower rate of return from their
investments than a professional venture fund manager. (This qualified
‘may’ depends very much upon the intention of the business – going
for rapid growth is perhaps riskier and might require a higher rate of
return or going for gentler growth might mean that it is unattractive
to a traditional VC and better suited to an angel.) The invaluable
quality that the good ones bring with them is commercial experience.
Business angels (the name is borrowed from the theatre – ‘angels’ is
the collective term given to backers of a show) should be the first port
of call for raising funds for all but the mature business. Raising business
angel finance will usually set future fundraising on a firm platform, if
the investment is successful for the angels.
Finding an angel is best accomplished through one of the investment
fora that are now established across the entire country. Two of the most
active are Beer and Partners and the Great Eastern Investment Forum.
The BBAA has details of other groups which can be obtained from their
website.
The BBAA is an umbrella organization – operating on a not-for-profit
basis and backed by all the major UK clearing banks, the London Stock
Exchange and the Department of Trade and Industry – which, among
its other services, operates a website where businesses seeking finance
can be put in touch with potential backers. While individuals may
invest somewhere between £10,000 and £250,000 in any one investment, businesses requiring larger sums may also raise money using
syndicates of angel investors (often behind one lead investor or
‘archangel’). See the section below for more information specific to the
way syndicates operate. Contact details of BBAA can be found in
Appendix 2.
Business angels are also able to set off the value of their investments
against income and capital gains taxes under the Enterprise Investment
Scheme, provided certain conditions are met. This effectively reduces
the cost of the investment, which may allow them, again, to accept
slightly lower rates of return than those at which managed venture
capital funds find the deal acceptable.
45
Venture capital funding
Structure 2: partnerships
Many venture capital funds – of all types and sizes – are organized on
the basis of a limited partnership (since the Limited Liability Partnerships Act of 2002) or some other form of limited duration trust.
Few partnership funds run for more than 10 years. That means that
VCs will want to see the money they have under management, ‘in’
(invested) and ‘out’ (realized) within about a five-year (maximum)
horizon so that they can report good results to their backers, have funds
to re-invest and follow through on promising cases and still have some
funds left to invest while they raise another fund. This life cycle of
fund-raising, duration of investment and further fund-raising conditions the style of investment, and the readiness to make investments
and to embrace risk. It also means that the venture funds and the
people who run them – just like the management of their investments
– are under continual scrutiny.
The consequence of this is that stakes are high for them too, since
poor returns on the funds will mean that they are not entrusted with
more money when the time comes for the next fund-raising ‘round’ and
consequently, with no fresh funds to manage, the fund managers will
lose their jobs.
Because of this, many fund managers raise funds on an ‘overlapping’
basis if they can, so that they are continually able to draw down cash
to fund new investments. This will be evident if the fund documentation talks about funds with different names or with different calendar
designations. It is worth asking about this in discussions with the fund
managers since it is possible to conceive of a situation where they may
no longer have cash to follow through on existing investments (which
were originally funded out of what is now a mature fund) even though
the total amount of money under management may not change
dramatically. New funds may have replaced ones that are due to wind
up and release profits (or losses) to the investors, so keeping overall
levels of money managed high even though individual funds may be
winding down.
All funds have the same basic investment processes but the details
may slightly alter depending on the particular structure of the fund.
Appreciating the steps in this process is a necessary prerequisite of
looking at how the individual fund structures can affect investment
styles. Chapter 8 deals with what happens in each of the detailed stages
of the investment process but in essence it follows a path like this:
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Know your enemy
1. approach by the company;
2. initial appraisal by fund managers;
3. meetings with management;
4. detailed examination of proposal through interviews and visits;
5. offer letter;
6. accountants’ investigation;
7. submission of proposal to investment committee and approval;
8. legal stages;
9. closing.
Variations to these steps are largely around the margin: some funds
may put preliminary details of proposals to their investment committees before issuing an offer letter; others may have a fixed operational
requirement concerning which issues have to be covered before an offer
letter is issued.
Most funds have ‘Monday morning meetings’ where new investment proposals are discussed and progress with existing cases is
reported on. These meetings, which are deceptively casually run to the
outsider’s eye, are where much of the tone of the investment policies
is set. By a filtering process of discussion and sharing experiences, the
operational participants – the people who actually do the deals –
absorb what can and cannot be done in investment terms.
The investment committees, which are much more formally run, are
probably much less significant for most funds in setting the priorities
of investment policies – they are more concerned with making sure that
the details of the priorities have been observed. Most investment
committees meet regularly – some may even meet on demand – to
approve investment proposals submitted by the investment managers
for both new and follow-on financings. The operation of investment
committees will be considered in Chapter 8.
The dynamics of the internal structures of the larger partnerships
mean that there are usually a few partners who control the investment
policy of the funds that they manage and a larger number of associates
or investment managers (who are employees and not partners) who do
the detailed work of the investments. The partners will probably sit on
the investment committee, which decides whether investments should
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Venture capital funding
be done or not, along with a few independent non-executives with
business and/or financial backgrounds.
If you get a partner interested in your proposal then it should not
fail at the investment committee stage (or there is something seriously
wrong with the partnership). It shouldn’t fail either if handled by an
experienced manager – because there should be discussion about deals
all along the way as they proceed through the stages of a deal – but
the terms may be modified after the proposal has been through the
investment committee’s hands.
Because the investment partners are the ones running the fund there
should be very clear understanding between them, and between the
partners as a group and the managers, about what will be acceptable
in terms of investment strategy. Established funds will have recognized
areas that they have to consider when thinking of completing an
investment, so unless your proposal is very unusual then it shouldn’t
prove too problematic for investigating and structuring purposes.
In general, the larger the fund, the more likely it is that the range of
businesses that the fund is willing to invest in will be broad. Funds that
specialize in specific sectors tend to be smaller – principally because
of the limited amount of money that investors in the fund are willing
to risk in any one sector. The portfolio approach to investment –
limiting the prospect of overall failure through spreading risk over a
number of sectors – promotes the existence of large funds with only
modest sectoral limitations. Functional specialists – like buy-out funds
and development funds – are large for the same reason.
Larger funds are also less likely to be affected by fund termination
problems because of their generally higher rates of success. Large funds
– to paraphrase David Nobb’s archetypal senior industrialist, CJ –
‘didn’t get where they are today’ by being timid and unsuccessful. The
chances are that, consequently, they will have fewer problems in
attracting money for subsequent funds and so they can keep up a good
flow of deal completions.
By contrast, the smaller funds sometimes suffer from the partners’
attention being drawn away to raising funds from their investors and
also from rationing of funds for new investments once they invest
something close to half of the total amount that they have under
management. Beyond that halfway point, the managers are often as
much concerned with nurturing their existing portfolio to produce the
best possible returns as they are in making new investments.
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Know your enemy
Structure 3: captive and semi-captive funds
Captive funds are those owned by banks or pension funds that use
their own money without the need for raising money from other
investors. Their supply of money is effectively limitless as far as the
outside world is concerned and they do not suffer from many of the
problems of phasing of new investments against follow-on funding and
fundraising that other funds do. They are usually free to enter any
sector and undertake any type of deal – although given their size they
probably tend to specialize in big development or buy-out deals where
the sums required are large.
Most of the large funds used to be like this, but over the past 15 years
or so the large industrial pension fund subsidiaries have developed as
managers of other people’s money too – Hermes (BT), CinVen (the old
Coal Board fund) and Electra (out of Cable and Wireless). The large
banks are still interested in this area.
Basic processes for investigating and then approving an investment
are the same as in any other fund – although subject to local idiosyncrasies of style. By and large, banks do not require investments to bank
with their high street counterparts – both because the fund managers
have fought internal battles for their independence to be free of such
requirements and also for the very good reason that the banks want to
spread the risk if big deals do go down. However, where there are large
syndicated deals where a banking captive takes the lead, then there
may be some pressure for clearing bank services to be provided by the
sister bank.
Semi-captive funds are captives that also manager other funds’
money on the basis of a pooled fund arrangement. From the outsider’s
point of view, they are identical to captives with no distinction being
made by the manager about the origin of the funds.
Structure 4: independent funds: 3i and ECI; VCTs;
funds of funds
A whole book could be written about 3i – in fact one was some years
ago to celebrate 3i’s fiftieth birthday – and for many years the company
was the British venture capital business in its entirety. As a consequence
of this, many of the individuals who now run the larger funds are
graduates of the 3i way of doing things. Overall, 3i has been very
successful and is an unsung major contributor to reshaping the British
49
Venture capital funding
economy from metal-bending to predominantly a knowledge economy.
The procedures that other venture capital businesses use are largely a
result of the procedures developed inside 3i, leavened with a sprinkling
of transatlantic jargon.
Originally called Industrial and Commercial Finance Corporation
(ICFC) and then Investors in Industry (after it amalgamated with its
sister organization Finance for Industry), before assuming its current
rubric, 3i stands ready to supply funds for suitable investments in
every section of the market, and although it abandoned a specialist
high-tech start-up unit some years ago, it is still very active in the field
of technology exploitation. It was and remains a powerful participant
in the so-called Cambridge Phenomenon, for instance.
Most of the limiting considerations about fund life, partnership
issues, subordinate managers and disposal/follow-through concerns
that affect other funds do not apply to 3i. However, as a quoted
company since 1994 it now has to follow the disciplines of raising
money through the stock market and some treasury-matching of dealsbeing-done against deals-being-realized is now obvious in its strategy.
Although they were never related by direct parentage, Equity
Capital for Industry (ECI) was often seen as the sibling of 3i. The two
businesses had a similar ethos, and were staffed by individuals of
similar background and investment style. Similar sorts of consideration
about the characteristics of one apply to the other – there is no problem
about availability of funds; they are both extremely catholic in their
investment tastes; their internal processes are similar. Like 3i, ECI has
seeded much of the present British venture capital business with
former members of its staff.
Equity Capital for Industry was originally established by the clearing
banks as their answer to 3i (when 3i was still ICFC) and the two businesses carried much of the responsibility for venture capital in Britain
through the 1970s and 1980s, together with the Coal Industry Nominees’ Industrial Investment (CINII) – which became CinVen – and big
funds like Candover and Electra. Equity Capital for Industry transmogrified in due course into ECI Ventures and then into ECI Partners.
Venture capital trusts (VCTs) are funds that have a publicly quoted
price. They are managed funds which private investors can buy into
just like a unit trust or a capital bond. They make investments in exactly
the same way as any other venture investor but their trust vehicle
prices are based on the value of the assets that they control (through
their investments) as declared by the fund managers at regular
intervals.
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With the growth of the venture capital business, another type of
vehicle – the fund of funds – has grown up. This enables pension fund
managers to invest indirectly into funds by placing their money with
another fund that then allocates that money to separate investment
managers. By the nature of the vehicle, the fund of funds never comes
into contact with investments directly and proposals to invest cannot
be made to the fund of funds by companies.
Structure 5: public–private partnerships
The perception that a funding gap exists and that the geographic basis
of much of venture capital was too metropolitan in its bias led to the
creation of the regional venture capital funds (the RVCFs) in 2001/
2002. These funds use the skills of managers developed in the private
sector to control funds of about £20 million each, spread through all of
the nine English and Welsh economic planning regions. Public money
contributed by the Treasury was pledged to each fund provided the
managers could raise at least matching amounts from the private
sector. Public money also comes out last in any realization of assets
from an investment. The types of opportunity they can pursue are set
out below.
Size of business
The business has to comply with the European Union’s definition of a
small and medium-sized enterprise (SME). Currently, this is defined
as a business with less than 250 employees and has either a turnover
less than 40 million euros (approximately £24 million) or a balance
sheet total less than 27 million euros (approximately £16 million).
Ownership
It must not be owned:
n
wholly by another company;
n
25 per cent or more by another enterprise;
n
jointly by several enterprises not meeting the above SME definition.
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Venture capital funding
Some of its equity can be owned by business angels, or other individuals not connected with the directors or other shareholders. It can
already have had venture capital funding either from seed-corn funds
or from other VCs: however, if this is the case, the amount the RVCF
can invest will be restricted.
Sectors
There are a number of sectors in which the RVCFs cannot invest. The
key ones (at the time of publication) are listed below:
n
land and property development, dealing and investment;
n
provision of debt and equity finance and financial services in
general;
n
accountancy and legal services;
n
hotels;
n
nursing and residential care homes;
n
international motor transport;
n
agriculture;
n
forestry and timber production;
n
horticulture.
The birth of the funds was not easy, with funding often proving hard
to attract. Serious controversy surrounded the selection of managers
for one fund. The funds are now all up and running with various rates
of investment achieved. While £20 million (the rough average raised)
seems like a lot of money it does not go very far when it has to be
spread around investments to be made by a fund with a projected 10year life and has also to support a management fee for the fund
managers for that time. A regional breakdown of the RVCF funds is as
follows:
n
North West: £35.5 million (the fund reached £35 million at first
closing in April 2002 and £35.5 million at final closing in September
2002).
n
North East: £15 million (at first and final closing in January 2002).
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Know your enemy
n
Yorkshire and the Humber: £25 million (the fund reached £25
million maximum fund size at first closing in July 2002).
n
East of England: £20 million (at first closing in July 2003. The
maximum fund size target is £30 million).
n
West Midlands: £20 million (at first closing in January 2003. The
maximum fund size target is £30 million).
n
East Midlands: £30 million (the fund reached £30 million maximum fund size target at first and final closing in January 2002).
n
South West: £25 million (the fund reached £25 million maximum
fund size target at first and final closing in October 2002).
n
South East: £30 million (the fund reached £22.56 million at first
closing in October 2002 and £30 million maximum fund size target
at final closing in January 2003).
n
London: £50 million (the fund reached £50 million maximum fund
size target at first and final closing in July 2002).
Investment styles are quite different between the funds – although one
firm of managers runs three of the funds. At least one fund is pioneering a form of initial business plan appraisal that might be called
‘Venture Capital Lite’, using online techniques of business plan
presentation to help them to sift through the 60 or so proposals that it
receives every month – and that from a very tight geographical area.
The amounts that the RVCFs can invest in any one opportunity are
limited to what the Government, when it set up the funds, regarded
as a prudent proportion of the total amount of money managed. The
details are set out above. Consequently there are only limited possibilities of follow-on funding from the RVCFs for businesses that
develop strongly. The funds are limited to an investment of £250,000
with a follow-on maximum of £250,000. If two or more funds collaborate on an investment they still have to abide by the £250,000 ceilings
collectively. Syndicates of RVCFs with other funds do not have to stick
by this ceiling provided that the RVCFs do not invest more than the
£250,000 maximum – either individually or collectively at any stage.
While this should prove no real bar to the future funding of those
businesses – larger funds will come in from elsewhere – it may make
the achievement of follow-on funding more protracted and therefore
more painful for the businesses involved. Certainly some of the
managers of the RVCFs foresee that they will be disadvantaged when
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Venture capital funding
it comes to striking the price of a second-round funding of one of their
investments, as the incoming financiers exploit their inability to
participate in follow-on rounds. The danger they perceive is that for
the RVCFs it may well be that every follow-on is a blow-out (see
Chapter 5).
Some managers are also beginning to grumble about the constraints
that have been placed upon the funds in terms of financial targets to
be achieved, the relatively modest size of each fund, the practical proscription about certain deal types (because of funding limits) and so on.
The management companies of the RVCFs are largely partnershipbased and will exhibit the characteristics, good and bad, of small fund
management partnerships. Management preoccupation with securing
subsequent funding to support their initial funds is likely to be a major
feature of their early years.
The Phoenix Fund
The Phoenix Fund is a sum of money, first allocated in 1999, that is
spread among specialist providers in the English regions. It is available
for the support of disadvantaged groups and communities who are
under-represented in terms of business ownership. Individuals and
firms cannot make direct applications to the fund which channels its
funding through intermediaries (principally Business Links). In 2004
an additional £22 million was awarded to the fund from central
government resources for the period 2006 to 2008.
Structure 6: syndicates and consortia
Syndicates of investors get together when a deal is too big for one
investor to take on by himself. Sometimes this means not simply that
the cash amount is too large for one investor, but that the investor is
unwilling to take all the risks of the deal for himself and wants to
spread the load. Professional investors frequently arrange syndicates
among like-minded partners because they have a feel for what their
investment committees will be happy with in terms of the amount of
risk that any one deal should represent.
Business angels combine into syndicates for both these reasons:
individually, they cannot raise sufficient cash to do the deal alone; and
it would not be prudent for them to do so even if the cash was available.
Sometimes, among business angels particularly, complicated deals are
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Know your enemy
syndicated so that the burden of investigation can also be shared and
judgements about commercial viability pooled.
Syndicates usually appoint a lead investor who will act as single
point of contact for the company in order to minimize the administration of both the necessary commercial and financial investigations
and legal negotiations. Completion meetings are often attended by all
the members of the syndicate – and, what is worse, by all their lawyers
too.
The problems syndicates face are obviously those of trying to get
individuals to agree on matters that will be of concern when things start
to go wrong. This means that the legal stages of any syndicated deal
are likely to be more difficult than they would be under a single
investor as particular and individual problems about legal wording
have to be overcome to produce agreement.
The problems shift in emphasis when more cash is required for a
business. If the cash is required for rescue then they can become quite
shrill, as some investors may not be willing to risk sending good money
after what has turned out to be bad. In situations where further cash is
required to fund beneficial growth, the problems centre around the
differing capacities of investors to find the cash – this is usually a
problem of angel syndicates rather than professionally managed funds,
where cash resources are usually deeper. However, the RVCFs may
suffer from this problem at times.
The chances are that the lead investor will also act as a rapporteur
for the syndicate once the deal is completed, taking the normal board
monitoring position and reporting back to the group as and when
appropriate. Normally the legal agreements will also give syndicate
members the right to attend board meetings and possibly even to
appoint their own nominees to the board if things start to go wrong –
such as forecasts not being met; additional cash required and so on.
Although there is no strict distinction between syndicates and
consortia as far as funding is concerned, a consortium is a more
permanent arrangement between investors acting in collaboration;
syndicates tend to come together on an ad hoc basis, although in large
deals the members will probably all have done deals together before.
So consortia are beginning to spring up to handle the international
deals that are now being seen across European boundaries on a regular
basis. Such transnational deals require the presence of a supervisory
leader amongst the funders who can control the deal locally and then
act as lead monitor after the deal is completed. In such a situation it
pays greatly to work with someone whose style and strengths you can
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Venture capital funding
appreciate through having done collaborative work with him or her
before. Consortia suffer from exactly the same problems as syndicates,
with the added problem of cultural and legal differences in those
formed around partners from different countries.
Size of funds
In general, two things happen as funds get larger: first, they gravitate
towards larger deals; and second, their readiness to assume risk may
alter.
As funds get larger the economics of running them changes. It
becomes impractical to chase after lots of little deals of £250,000 a throw
when you are running a fund with hundreds of millions of pounds
under management. Monitoring the investments would be impractical,
inappropriate amounts of time would be spent in completing deals and
little time would be spent in stewarding them.
The principal problem in running a very large fund is to get lots of
money out of the door and into companies where it is going to make a
good return. This leads directly to the conclusion that large deals have
to be done by large funds – in other words large funds arise because
of the increasing size of deals that the market throws up, and once the
large funds are in place to deal with them they have to continue doing
large deals.
The time it takes to do a deal is largely independent of the size of
investment – small deals take as long to do as big ones. It is obviously
in the interest of the manager of the large fund to concentrate on large
deals – especially since large deals tend to be in large management buyouts or substantial development capital opportunities where the risks
are potentially lower.
This reduction of risk by movement up-market tends to condition
the attitudes of both the investment managers and the investment
committees when the time comes to review investment policies. The
fact that they have moved into a region of the market where there is
less risk of individual deals going wrong, may well mean that they
become unwilling to accept the risks that are present in doing smaller,
more volatile deals – even though an objective calculation of the risks
that they could afford to take across the whole population (if it was still
calibrated to what they were doing when they tackled smaller deals)
might suggest that the occasional smaller deal (higher risk but perhaps
higher return) would be acceptable.
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Conversely, some managers might say that the cushion of large deals
allows them the ability to speculate in smaller businesses where
rewards can sometimes be exceptional. Some funds actively pursue
such a policy, setting up a specialist division to deal with deals under
a certain size that have exceptional promise or actively monitoring
certain sectors that seem to be good bets for a future presence but
cannot support large deals at the moment. This might be a concise
description of the strategy that 3i has adopted, for instance.
In general terms, though, it is fair to say that the larger the fund the
larger the deal that the managers will want to do, and the less will be
their appetite for high-risk small businesses. This tendency has of
course reinforced the belief in the existence of a funding gap.
Life cycle
The influence that the life cycle of a fund has on individual fund
behaviour has already been touched on. Managers will probably want
their deals to ‘realize’ in a timely fashion as the fund nears the end of
its life and may become less willing to pump money into investments
that are under-performing as the money that they have under management reduces.
The larger funds, with their substantial investment records, are less
subject to this effect than the small and middling funds, which have to
proceed in completing individual investments with one eye always on
the perspective of the shareholders in their funds.
All funds, regardless of size, often perceive their own interest to lie
in a quick realization of a deal even though that may not be identical
to the entrepreneur’s ambitions. The investment manager will always
be trying to gauge the point in the life cycle of the investment where
he will be best served by realizing his investment. Although selling
earlier than anticipated to a third party may not produce the rate of
return that was originally predicted, investment managers are very
sensitive about their reputations among their peers, and will be far
more anxious to avoid the opprobrium of a failed deal than the
(unprovable) criticism that they realized a deal slightly too early.
Funds, being opportunist in their attitude to the investment world,
work on the principle that a bird in the hand is worth two in the bush.
Their overriding concern is to work always to reduce their risks in any
one deal. At some point that may mean accepting a realistic price for
its purchase from a third party, even if the price is not quite as much
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Venture capital funding
as was anticipated at the outset of the investment. From the VC’s point
of view, many entrepreneurs – despite their ambitions to the contrary
at the time they initiate a deal with a VC – become attached to the
business they run and continually see better and better prospects for
it, blinding them to the need to assess realistically the likely benefits
of continuing.
However, all funds are subject, to some extent, to fashions (read
‘manias’) in investing. Individual funds may not go so far as to restrict
funds to any one investment purely on the grounds of redirecting them
to in-vogue sectors but, certainly as a group overall, funds will ‘weight’
their investment stance towards what they perceive as developing
areas of the economy.
The dot.com boom was a prime instance of this. The daftest of ideas
stood a chance of being funded if it based itself on the precepts of the
‘new economy’. This sudden preoccupation with funding opportunities based on internet trading proposals had the effect of crowding
out, collectively, sturdier (but temporarily less exciting) prospects from
the old economy. Undoubtedly, some good investment opportunities
emanating from the old economy were discarded in favour of flashier
deals that fitted better with the prevailing tendency that regarded
anything connected with the web as being a sure thing.
Less sudden changes can also affect a fund during its life cycle. If
quoted stock markets make a fundamental movement in the value of
a particular market sector, perhaps over a period of two or so years,
then this will also affect the type of investments venture funds are
willing to do over their lives. Over 10 years or so – the life of the
average fund based on a partnership arrangement – these changes
could be substantial. Trends in the composition of UK listed companies
in the leisure sector are a case in point. The large groups in this sector
having nothing like the same structural composition among their
subsidiaries as they had five years ago.
This tendency also goes some way to explaining the difficulty that
venture funds have in completing successful and prolonged investment
forays into the high-tech field. The typescript for this book is being
written on a computer that no longer accepts (directly, at least) two of
the forms of recordable mass-storage media that were most popular
only three years ago. In a fund of normal duration, any investment in
a start-up that had sought funds to build a factory to supply the strong
demand that existed at the time for those forms of recordable media
would have been an absolute loss by now.
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VCs have as much difficulty as anyone else in keeping up to date
with changes in technology, despite the advice that they can draw on
from all sorts of sources and which they tap into during the period of
investigating proposals. You do not have to look very far into the public
record to find details of some of the problems with high-tech investments – the dot.com boom provides plenty of examples not only of
market misapprehension but also of technological ignorance.
Above all, in operating a fund with a limited cycle of life managers
have to be careful not to be caught flat-footed at a crucial period – say,
for instance, when they are about to enter a period of raising further
funds – by the well-publicized failure of an investment that formed a
cornerstone of their investment strategy. Consequently the appetite for
risks that the fund may have displayed at a point two or three years
into its existence may have been only very brief and may not be
repeated.
HORSES FOR COURSES
The implications of these factors for businesses putting forward
proposals for investment is that they should seek to find out as much
as possible about the funds that they would like to approach before
committing effort to preparing a detailed presentation. Horses have to
be chosen for courses.
This means that it is no use, for instance, approaching funds that are
aimed at areas distant from the proposal. These areas, as should have
been discernible from the details of the factors that affect funds’
strategies dealt with above, are as follows:
n
the size of the deal;
n
the market sector; and
n
the uniqueness of the opportunity.
It would be futile, for instance, to approach a very large fund used to
doing multi-million pound buy-outs and cross-border deals – like
CinVen or Apax Partners to name two – with a proposal to invest
£250,000 for the modernization and development of a clothing manufacturing business based in the Midlands.
59
Venture capital funding
Three factors would be against anything happening: first, the size
of the deal would be too small; second, the sector would probably be
of only limited interest; and third, the opportunity would probably be
insufficiently distinctive for the fund’s interest to be engaged. There are
lots of clothing businesses in the Midlands and for a fund to become
interested the proposal has to suggest something pretty radical is going
to arise as a consequence of the investment. Simple modernization and
development of a business is unlikely to offer the calibre of return a
big fund would expect to see.
The natural first port of call for such a proposal would be a locallybased source – perhaps a business angel whose local or specialist
market knowledge about the possibilities that such a deal might bring
about would make it an attractive proposition.
Perhaps for a slightly different proposal – involving the rationalization of a local sub-sector of productive capacity through the modernization of one business, which would result in the eventual acquisition of
others, then an RVCF might be an appropriate first call. If a requirement
for considerable follow-on funding could be foreseen then a larger
development capital fund might be a suitable fund to approach.
The progression of types of fund that might be suitable funding
partners becomes clearer as the purpose to which the funding will be
put is better defined.
FROM THE FUND TO THE INDIVIDUAL –
BACKGROUND AND EXPERIENCE
Venture capital fund managers mostly fall into one of four or five types,
in no particular order of priority:
n
ex-3i staff;
n
ex-bankers;
n
MBAs;
n
those qualified by experience (QBE).
There are four categories there – the fifth is that all the types listed
above can also be accountants, who as individuals are the largest single
population of venture fund managers.
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The last category of managers, those qualified by experience –
experienced business executives who have found themselves involved
in the running of funds almost by accident rather than as a planned
career move – is increasingly thin on the ground as the old guard of
pension fund managers, who led the British venture capital business
in its infancy, comes to retire. Also comparatively rarely sprinkled
through the ranks of venture fund executives you will find a few
scientists, some engineers and possibly some lawyers. Increasingly,
funds will only recruit from the ranks of individuals who have some
business experience – both to cut their own ‘educational bills’ as they
support staff until they have the experience to evaluate an opportunity
or complete a deal, and to ensure that the people that they entrust with
doing deals are seasoned and mature individuals.
Business angels are a separate bunch – mostly successful entrepreneurs, sometimes well paid and retired or semi-retired corporate
people – who are now able to indulge their craving for adrenaline
rushes by investing directly into businesses.
Among the larger funds, the partners and senior managers will have
many years of experience, have attended many completion meetings
and will be very able board members. Moving down the pecking order
in large funds there will be progressively less experience in all these
areas. However, in the smaller funds there is probably likely to be a
more even distribution of experience among the staff as everyone takes
a hand in performing all the tasks required – initial appraisal, investigation, negotiation, completion and monitoring.
Some funds – 3i in particular – have a policy of farming out nonexecutive directorships to third parties. This is done to allow the fund
managers to concentrate on doing deals. Other funds take the view that
everyone’s interests are better served if the executive doing the deal
stays with it throughout its time in the venture funds portfolio – the
company has a face familiar to it at board meetings and the investment
executive gets valuable experience in monitoring, which feeds back
into the next deal. Smaller funds may also find the non-executive fees
a valuable source of income, which will support the beneficial experiential effects of having one individual look after the investment from
appraisal to disposal.
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Venture capital funding
FUND REMUNERATION
Venture capital fund managers running a limited life fund take their
pay by appropriating a small percentage of the total assets under
management as a management fee. They also usually receive an
incentive payment by sharing in the profits that the funds make.
Sometimes this occurs as individual investments are realized; sometimes at the conclusion of the fund when the overall return can be totted
up.
The former case favours the managers substantially as they get to
keep part of the profits of each deal (assuming that profits are made)
both earlier and without netting off losses on some investments against
profits on others. This participative return may or may not require the
managers to invest their own money into the fund or to ‘co-invest’ as
part of the cash received by the individual.
INVESTMENT BY FUND MANAGERS
When UK venture funds were in their comparative infancy in the earlyto mid-1980s, opinions about whether to effect this practice of allowing
managers to participate were very varied. One school of thought said
that by investing their own cash, managers’ minds are concentrated
and investment returns are likely to be better. Another school of
thought suggested that co-investment produces inescapable conflicts
of interest which may result in good money being thrown after bad as
the manager uses the greater resources of the funds’ money to rescue
deals that he would kill if he had nothing of his own invested. A third
school said that to give the manager a free ride is wrong and that there
ought to be some cash outlay on the manager’s part.
Still others tried to get over the conflict of interest problem by
requiring the managers’ money to be invested blind in all the deals that
the fund undertook while some allowed managers to cherry-pick
according to their ability to invest. ‘Carried interest’, as the practice is
known, became something of a nightmare to sort out and caused quite
a few problems between fund mangers and investors and occasionally
some resentment among invested companies who often thought that
they were being forced into deal structures principally for the benefit
of the managers’ ‘carry’. The regular haemorrhage of staff from 3i (who
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Know your enemy
did not initially have a carried interest scheme and then ran one in only
a small part of the business – which caused some internal resentment)
was partly brought about by the business taking the decision to shed
staff who did not fit, and partly by an exodus of ambitious staff seeking
the crock of gold represented by the ‘carried interest’ available to
partners in the many private funds that were starting up.
Now, while the precise impact of the rules for each fund will vary,
the arrangements that were most ostentatiously generous to managers
have been smoothed out. The managers of most venture funds will
benefit to some extent from the increase in value that they achieve for
investors, but not to the levels that once existed for some funds.
Business angels of course have no such side benefits – unless you
count the tax breaks that they get. All the money that they are putting
in is theirs from the outset – real and at risk.
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Venture capital funding
4
The mechanics of doing
the deal
Debt, n: an ingenious substitute for the chain and the whip of the
slave-driver.
Ambrose Bierce, The Devil’s Dictionary
n
The process step-by-step
n
The business plan
n
Attracting a funder
n
The 3Ms
n
Employing professional advisers
n
Selecting an investor
n
Deal negotiation and evaluation
n
The negotiation in detail
n
The preliminary offer
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The mechanics of doing the deal
Investment funds all have slightly different ‘house styles’ – particular
ways of doing things which they regard as the correct way. There will
be slightly different processes and procedures for each stage of the
investment, according to which investment house does the deal. But
some features are going to be broadly similar and this chapter sets out
the way that a typical investment process will probably run. It will also,
first, give some insight into the things that the investor wants to see;
second, what actually constitutes the process of the investment as
conducted by the investor; and last, an indication of the timescales
involved. But whatever happens, taking on an outside investor is going
to be a bit like being in bed with an elephant – whatever happens he is
going to take most of the bedclothes.
In broad terms, the critical path for the deal will be as set out below.
STAGES OF THE PROCESS
1. Determination by the potential investee that cash is required for
expansion; development; buying out existing shareholders or
whatever;
2. preparation of a business plan and funding proposal;
3. initial approach to an investor;
4. investors’ preliminary (probably desk-based) consideration followed by investigation (meetings and visits);
5. preliminary (indicative) offer letter;
6. discussion of terms internally by applicant;
7. acceptance of indicative offer;
8. ‘due diligence’;
9. results of due diligence studied – indicative offer confirmed or
modified;
10. investment committee proposal (VC) – indicative terms approved
or modified or rejected;
11.
full offer letter issued (subject to legal stages) by VC;
12. formal acceptance of terms (subject to legal stages) by investee;
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Venture capital funding
13. legal stages – which are meetings first, between the VC and his
lawyer to draft the legal agreement; and then, meetings between
the company and its lawyers to consider their reply and finally a
series of meetings between both parties to hammer out the differences between what has been offered and what will be accepted
and agreed;
14. completion meeting – held at the offices of the VC’s lawyers;
15. new investor joins company (and probably the board);
16. everyone lives happily ever after.
The time taken to complete the deal could be anywhere between three
weeks (which is about the fastest I have known a relatively straightforward competitive deal take) to well over six months. The principal
choke points in terms of the time taken are:
1. finding an investor who will take on the deal;
2. the due diligence stage; and
3. legal stages – which can be as long as the bloody-minded choose
to make them.
Entrepreneurs will have to take into account the variability of timing
when they prepare their business plans. There is no point in preparing
a business plan that requires its crucial component to be executed in
three weeks’ time if the investors cannot be galvanized to complete the
deal for at least three months.
The business plan
The business plan is the primary tool by which investors are attracted
to a business.
As such it is more than simply a cash flow, balance sheet or profitability statement; it also has to describe the business and the management philosophy behind the business. It must also indicate to the
investor how he is likely to obtain an exit. (Some venture capital funds
are now using ‘electronic filing’ of preliminary business plans, and
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The mechanics of doing the deal
these are skeletal in comparison with traditional submissions. This
practice is not yet widely used, but may become more prevalent.)
The usual headings for a complete business plan would be as
follows, although the exact structure is a matter of style rather than
substance:
n
short description of the business – including the purpose of the
investment and the likely exit route for the investor – in summary;
n
brief history of the business;
n
current marketplace and trading conditions;
n
competitor analysis;
n
prospects and plans for the future – descriptive analysis crossreferenced with figures as an appendix, including how the investors
(all of them) can expect to realize the value of their investment;
n
funds utilization (in detail);
n
senior/key personnel (including brief biographies as an appendix);
n
figures (best confined to an appendix) – three years’ past performance summarized and against budget; current year’s performance
and budget; expectations for the next three years broken down by
budget, cash flow; profit and loss; balance sheet.
All this should be disaggregated into reasonable detail – for instance
by operating company or division if the company has them, or even
subsidiary company if the business has a group structure. The plans
should also give a range of likely outcomes depending on variability
of key market conditions – these are sometimes called sensitivity
scenarios.
The maximum length for a business plan intended to secure an
investment negotiation should be about 20 pages, excluding appendices. One thing that entrepreneurs should not be tempted into doing is
writing reams of description. It is far better just to pick out the salient
points – making sure that all of them are covered – and leave some
more information to be communicated during discussions and the ‘due
diligence’ stages. The key point here is about the psychology of doing
deals. Most investors will be put off by the sheer size of the task of
absorbing huge tomes of documentation with vast spreadsheets of
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Venture capital funding
financial information; they will want to be able to know that the basics
of the business can be communicated quickly.
They cannot afford to devote the energy required to all the details
of the business at the outset. They want to be able to judge quickly if it
is worth their while to pursue the deal further. With lots of other
potential deals clamouring for attention (any one of which just might
be the deal of the century which if they do not reach fast enough
someone else will snaffle) they cannot afford to spend long hours
reading through a business plan.
The next most difficult thing to do, once you have completed the
business plan, is to find an investment house that will take it seriously
and devote time to giving it the attention that it deserves. This is not
meant as a gratuitous insult to venture capital houses – so many
proposals come in to the big houses that they have to be ruthless in
their initial sifts through what they think that they might take on. If
they behaved any differently they would be accused of taking an
inordinate amount of time in considering proposals before rejecting
them – which they sometimes do, anyway.
What this rapid sift means is that proposals that apparently do not
fit their criteria immediately will get discarded quickly. Remember also
that the chances are that in a big investment house the initial sifts are
likely to be done by the more junior members of staff who may not
have the experience to recognize a good proposal immediately when
it pops up.
So you have to make your proposal stand out in some way. Coloured
paper, jazzy covers and outrageous typefaces are unlikely to attract
even the more adventurous among the staid investment community.
You have to make sure that you plan looks interesting simply by the
way you present it.
It is probably best to send your business plan to the venture capital
house, with a covering letter, after an initial phone call so that you can
find a named individual to deal with.
Attracting a funder
The key features of the business plan that will attract a funder are:
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The mechanics of doing the deal
n
Clarity of purpose (and presentation) – knowing what you want
to do with the business and being able to describe it clearly.
n
The 3 Ms:
– Management capabilities;
– Market attractiveness;
– Mathematics – A suitable rate of return within a suitable period
of time – IRRs of less than 25 per cent are unlikely to prove very
attractive. This means that your business (and the investor’s
share of it) has to double in value every three years – a pretty
stiff test that not many businesses can meet.
n
Suitability to his portfolio requirements – some of these features
you can determine. But you cannot tell whether an investor in the
development capital field has a portfolio balance within his fund
between the food processing and plant hire sectors.
n
Reasonableness – both in terms of the likelihood of the plans being
achieved or a fallback outcome in the event that the initial targets
are not met.
n
Flexibility – the adaptability of the proposal to a range of investment instruments.
Employing professional advisers
By all means employ advisers for their technical contribution to the
proposal that you want to send to the VCs, but limit them to exactly
that – a technical contribution – at least initially, and resist all blandishments to do otherwise. Outside lawyers and accountants have their
proper place in the funding process, but be wary of employing them
too early, because:
n
costs will sky-rocket (certainly);
n
time taken to do things will extend (probably);
n
tempers will shorten and harmony between the management
team will unravel (possibly).
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Venture capital funding
The professionals will want to impose their ideas on the structure of
the deal, which may be wrong, as far as the investor is concerned: all
investors have their own ideas about how to do deals. However, that
having been said, many funds do now rely upon firms of accountants,
particularly, to pre-package deals to some extent. Venture houses with
an established relationship with accounting firms will know that the
initial assessments which they will otherwise have to perform themselves will have been completed satisfactorily and so they can proceed
on the basis that the proposal is likely to be a sensible one.
But beware of giving the deal over entirely to a packager. The
investor will want to hear you speak about your business – not a
professional mouthpiece – if he is to gain a proper appreciation of the
potential for the investment.
And there is one very important point to be observed in engaging
an accounting firm to help you with the deal. Under no circumstances
think that you can substitute an outside accountant for a finance
director. You may think that it may not be absolutely necessary to have
a finance director (although most venture capital houses will want the
comfort of one) but unless your business is very small (that is, at the
start-up stage) then it is very unlikely that you will see a completed
investment without one.
You will probably find it best to use your accountants or firm’s
lawyers to guide you to a suitable range and number of potential
investors whom you might approach. Beyond that you may find that
it is best to approach the fund after an initial introduction to the
proposal has been made: do that with them accompanying you and
then proceed by yourself until the time that you need technical advice
on tax matters or other financial implications.
You must be very careful not to lose control of the deal: don’t let the
professionals attempt to hi-jack the deal and do it for you.
Selecting a potential investor
Realistically, deals are usually done with the investor who offers the
best terms. As far as most companies are concerned this usually means
the greatest amount of money for the least amount of equity. But there
are other factors that should enter into the consideration.
By attracting outside finance to your business you are doing more
than preparing for future growth in the value of your business – you
are taking on a very powerful outside shareholder who will want to
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The mechanics of doing the deal
exercise a very substantial degree of control over your business and
will expect that it is run in a very specific way. Failure to achieve these
objectives (or agreed alterations to them) will result in sanctions being
exercised – and these will be only to your detriment. It is of great
importance that you and your fellow managers recognize this and
consequently that you select a funding agent with whom you share, in
considerable detail, both an overall objective and a similar outlook on
what might be described as the ‘character’ of the investment. This
means:
n
selecting a funder who has some experience of the sector you are
working in;
n
selecting someone who at least professes a fairly robust attitude
towards the legitimacy of business plan forecasts;
n
if you anticipate further rounds of funding, you select someone who
can either supply this or will take a constructive attitude to having
his investment diluted;
n
ensuring that there is a degree of personal empathy between you
and the investor (or his representative);
n
understanding from the outset the intentions and aspirations of the
investor – which will be different from yours;
n
understanding that there is no overall congruence of views between
you and the investor about how things might be done;
n
being clear (mutually) as to the timing of any eventual exit and the
need for an opportunistic attitude to realization before the initial
target date.
Disregard any protestations on an investor’s part that he is a long-term
player who will place no pressure on you to realize the investment
before you really want to. All such statements should be accompanied
by the disclaimer that this will only hold good if no attractive offer
comes along within five days of completion and all targets are achieved
on time, on budget and without further funding calls!
As well as all these considerations, there is another good reason for
selecting carefully the venture capital house you approach. If you do
not take your proposal to a funder who is competent to deal with it,
then he will reject it. Having your proposal turned down will be a blow
to your morale. It will also waste your time and get your deal the
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Venture capital funding
reputation of being tainted since it will have already been turned down
once by the time it gets to an investor who does want to handle it. One
of the first questions most VCs will ask is whether the deal has been
seen by any other venture capital investor: among other things they
will be trying to benchmark the degree of interest in the proposal as a
means of filtering their own workload.
The venture capital grapevine is very effective and reputations are
jealously guarded – word of what deals are being done gets around
very quickly. No one likes being thought of as a fool for taking on a
duff deal and, in addition, the herd instinct is very prevalent among
venture capital investors, as it is among all investors. Once your deal
or proposal enters the system you should act as if others will rapidly
learn about it – either locally or nationally (depending on the size of
the deal).
You will waste your time and nibble away at your standing as an
effective manager in the VCs’ eyes, by taking your proposal to the
wrong funding source. The information about who is interested in what
types of deal and industrial sectors is quite easy to find. Established
venture capital houses in the UK belong to a trade association called
the British Venture Capital Association, which publishes a handbook
of members. Specific funding interests, deal size thresholds, recent and
notable past deals and industrial specializations are all identified. By
looking through this you should be able to identify some venture
capital funds that are interested in your business area or type of deal.
If the amount of funding that you are seeking is less than the
threshold level of the BVCA members, you will have to try for business
angel funding or one of the smaller regional funds which are more
catholic in their tastes – since they cannot afford to be picky industrially
if they specialize regionally, they do not specialize. Nor do they have
the cost base that means that they have to specialize, so they are usually
very flexible in their preferences. Business angels are now increasingly
organizing themselves into networks, often affiliated to Business Links
or local universities, where they collaborate on deals. Such arrangements
offer the advantages of shifting alliances between members to cater for
different types of deal and risk profile.
One of the considerable advantages of raising money through local
deal-doers is that they are generally well known to the local business
community. Where you know someone who already has a venture
capital investor on board, then seek out their advice about the skills
that the angel has brought to bear and the process of doing the deal.
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The mechanics of doing the deal
If you have the time and the expertise you can also use local
newspaper archives to help you get some sort of feel for the investment
style and preferences of local business angel networks. Most regional
newspapers have now put their back issues on the internet so a halfday spent trawling through the archives may pay dividends when it
comes to approaching an angel.
Nor should you be coy about asking the angels about their particular
expertise and experiences – entering into venture funding is a partnership of sorts after all is said and done, and it would be a dereliction of
your duty to your business if you did not want to investigate the
provenance of a new business partner. Astute angels will be looking
for such an enquiry and will probably see the lack of such questioning
as a failure of perception and the normal shrewdness that they would
expect to see in a businessman who intends to take such a large step.
Deal negotiation and initial valuation
The investigatory process (part 1)
A good venture capital house will respond to your initial information
pack within a week but it is unlikely that you will see completion inside
two months unless the deal is very perishable or very exciting. The
corollary of this is that you must not wait until your need for the money
becomes desperate before you enter the process. A likely timetable will
go roughly like this:
1. Send in proposal (it may be wise to ask for receipt of delivery).
2. (Wait.)
3. Initial interview with investor.
4. (Wait.)
5. If successful, initial visit to business by prospective investor –
purpose: physical site inspections/‘tyre kicking’/senior staff
introductions.
6. (Wait.)
7. Second visit to explain detail further – usually to go over financials
or elaborate on areas not completely covered or understood in
preliminary interviews.
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Venture capital funding
8. (Wait.)
9. Possible third visit – picking up further detail.
10. (Wait.)
11.
Possibly an illustrative deal without prejudice to their position,
or a polite refusal.
12. You reply – but only after consulting your professional advisers
about the impact of the terms on each member of your team and
the business overall. (NB: you should employ only one set of
lawyers. NB: costs start to rack up after this point. NB: this is the
point at which very robust and flexible planning is required to
ensure that the business keeps running on track.)
13. Wait while they consider your suggestions – and probably ignore
them.
14. Possibly two or maybe even three months will have elapsed by
this time.
The negotiation process (part 1) in detail
Part of the investigation process in determining the attractiveness of
the deal will be concerned with the broad terms of the deal that you
would like to secure. You should have an idea of the structure of the
investment that you would like to see coming into your business and
you should be ready to discuss this with the VC – but only at an
appropriate opportunity: most VCs will want to be in the driving seat
as far as structuring the deal is concerned. You must go into the dealdoing process with an idea of what your business is worth and a feeling
for the amount of dilution of your own holdings you are prepared to
accept.
But you must also be prepared to be flexible. It is very unlikely that
your valuation of your business and the VC’s will meet straight away
(if ever). This is especially the case with early-stage deals or where
subsequent rounds of funding are obviously going to be required. The
VC will be thinking both ‘dilution’ and ‘realization’ with suitable
caveats for both processes and a fall-back valuation in the event that
the market does not pan out as expected and/or targets being missed.
Not surprisingly, the VC’s perception of the risk/reward profile is
probably going to be quite different from yours.
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The mechanics of doing the deal
The final point of consideration is always the amount of equity you
have to give away to get the money that you need. Individually,
investors – funds or angels – will shy away from taking majority
positions in companies since they do not want to become owners of
subsidiaries. The use of preference shares by venture funds, instead of
ordinaries, helps them do this of course. By not owning ordinaries they
avoid the accounting burdens of ownership. Collectively groups of
investors (‘syndicates’) may be happy to move over the 50 per cent
mark (on conversion for funds or in ordinary holdings for angels). If it
is a fair bet that the company will need additional funding before you
move to a realization of the investment, think very carefully about the
headroom that you may need, on top of the share of the company being
carved out now, to allow another round of funding to proceed.
The preliminary offer
Indicative offer letter – the ‘term sheet’
The terms of the preliminary offer will not be fixed: they will be subject
to the following (as a minimum) of what are called ‘conditions precedent’:
n
‘Due diligence’ – to cover, as a minimum:
–
working capital verification (at some specified future date);
–
tax computations;
–
review of accounts, both statutory and annual up-to-date;
–
review of forecasts;
–
verification of physical assets and intellectual property;
–
investigation of any outstanding legal actions/county court
judgements, records, etc.
n
A catch-all clause about the investee company having an obligation
to reveal information material to an investment decision (thereby
catching all shareholders as well as management).
n
Accountants’ investigation (see above under due diligence). NB: the
costs of this exercise will always be borne by the potential investee
and this will not be a negotiable point. You must allow for this in
preparing your budgets for the exercise.
n
Investment committee approval.
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Venture capital funding
n
Other ‘conditions precedent’ – for instance, the negotiation of
satisfactory bank finance; resolution of any property issues; confirmation of ownership of intellectual property and so on.
The final offer letter, which may be dispensed with entirely in favour
of proceeding direct to legal stages, is unlikely to be offered before the
investment committee confirms approval for the deal. It will usually
contain the following principal terms, much of which is repetition of
the first term sheet; it can therefore be regarded as a revision and reissue of the term sheet:
n
the amount of the investment;
n
the purpose of the investment;
n
the vehicle by which the investment is to be accomplished;
n
the share of the company that the investment is to command;
n
the components of the investment – the amounts to be held in
ordinary shares; convertibles; preference shares and so on;
n
the amounts to be invested collectively and separately by the
existing managers of the business;
n
whether there is any form of ratchet mechanism that will redistribute shareholdings in the case of under- or over-performance;
n
board representation matters;
n
costs to be borne by investee – this will involve both accountants’
reports and legal costs;
n
anticipated realization dates and intentions;
n
interpretation of jurisdiction – this is particularly important where
there are Scottish subsidiaries because of the differences between
Scottish and English law over matters of contract.
The offer letter/term sheet is usually in duplicate. One half is retained
and one half is signed by the addressee (or the company’s responsible
officer) and returned, signifying acceptance of the terms. There is
usually a deadline after which the terms no longer hold good. Most
VCs consider it extremely impolite for recipients of offers to exceed this
deadline.
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The mechanics of doing the deal
Some years ago, some venture capital houses used to seek to lay off
all their costs; it is still the practice for some European venture capital
houses to charge a deal fee as well. In the UK the fees that are charged
are intended to defray the cost of commercial investigations commissioned from outsiders and to cover the cost of accountants’ investigations. Since you are paying for these you should be able to negotiate a
cap for them and to be given a breakdown of how the total is built up.
If you are dealing with a BVCA affiliated member there are codes of
conduct which govern the way that they deal with potential investees
and charge fees. You can obtain these from the BVCA – see the BVCA
handbook and the website.
The amount of funding to be offered together with the proportion
of ordinary shares to become the property of the VC gives the valuation
of the business. Or it should do. But when deals involve a number of
instruments (the reasons for this have been covered earlier) calculating
the value of the company becomes more difficult. If you find it difficult
to work out how much the business is being valued at, don’t be afraid
to ask them to lay out the method valuation. You probably won’t be
able to challenge the basis of the calculation but it may help you to
understand the platform that the VCs are working from.
It will be very unlikely that you will get a renegotiation of the value
of the business at this stage from a venture capital house since the IRR
calculations will have been performed fairly rigorously before the offer
letter is sent out. Portfolio managers will have had to meet guidelines
for projected rates of return which they are probably unlikely to want
to go against, since it would jeopardize their chances of getting
approval from their investment committees. They will also be holding
back a little in anticipation of structural reversals during the detailed
legal stages of the deal, so that they can ‘give away’ some concessions
and avoid beaching otherwise commercially good deals on the rocks
of legal inflexibility.
Business angels have no such investment committees to which they
have to report and the decision to invest is probably more intuitive.
They can afford to be a little more liberal in their valuations, so you
may get further there, but don’t push so hard as to turn the deal away
if everything else fits.
If you don’t like the deal you are offered – full stop – and you really
think that you can attract a better deal, then look for another investor.
If one party thinks you are good enough then the chances are that
someone else will too. And remember the opening words of this
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Venture capital funding
section: since you are going to be in a bed with an elephant you might
as well make sure you get a friendly one.
‘Due diligence’
This phrase will crop up very quickly after you embark on the search
for venture capital. Originally occurring in a US legal judgement
describing how professional investors should act, it has now become
an (ungrammatical) shorthand for the process of checking and investigating all the details of a potential deal that has to be undertaken by
the VCs and their agents. ‘Due diligence’ investigations will therefore
encompass the following areas:
n
financial records of the target;
n
financial projections of the target;
n
market information;
n
competitor analysis;
n
physical assets – particularly where there is a heavy property
component to the deal;
n
intellectual property;
n
legal title to assets;
n
management suitability.
Not all of this will be done before a preliminary offer letter is issued.
In fact the bulk of the investigation is done after the target is on the
hook (having accepted an indicative offer) and is therefore liable for
some of the costs of the investigation. Almost all of the investigation
of legal title and intellectual property will be done during legal stages
– when the detail of the agreement is settled.
Much of the basic information on markets and management is
provided by the potential investee. The amount of further work that is
done depends largely on the size of the deal: more money at risk in
larger deals probably means more investigation. Riskier (earlier-stage)
deals will probably also require more attention to detail in order to get
them past investment committee scrutiny.
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The mechanics of doing the deal
Investors will often ask for a pending audit to be brought forward
to provide further comfort on financial information. Alternatively, a
mini audit concentrating on working capital items may be requested.
Both these actions will be undertaken at the expense of the investee
company.
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Venture capital funding
5
Seeing the finishing line –
from the starting position
Decide, v.i.: to succumb to the preponderance of one set of
influences over another set
Ambrose Bierce, The Devil’s Dictionary
n
The purpose of including the exit – at the outset
n
The major types of exit reviewed
n
Factors to avoid in presenting the reasoning about a route out
n
The dark side – exits not to be mentioned in polite company
Sticking a chapter about exiting from an investment in the middle of a
book like this may seem a strange thing to do. Logic suggests that it
surely should go at the end. But there is a sensible reason for apparently
putting the cart before the horse. In seeking outside funding, as in most
areas of business, it pays to have an idea of where you want to get to
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Seeing the finishing line
before you start. Knowing what and where your objective is, offers the
easiest way to plan out a suitable path.
For almost all investors the only objective of investing large(ish)
amounts of money directly into companies that will be run by other
people is to make a return on the deal far better than they can make in
the stock market or the building society. The whole point about venture
investing is that these deals offer very substantial rewards if you get it
right. But these rewards are only available because the attendant risks
are higher.
Investors in the stock market can usually find a buyer at some price
for the shares they have bought, even if it means taking a bit of a bath
on the original purchase price. If things appear to be going wrong in a
quoted company or even if investors just get cold feet, there is usually
a buyer somewhere who will take the shares on. Venture investors do
not have that benefit. Once they are in, they are in; the investment either
has to work pretty much according to plan or they will probably lose
their money – most if not all of it.
STARS AND BARS
To put this danger of loss into context, out of a portfolio of 10 investments, the average venture fund might see something like the following pattern in its investments:
n
one or two will collapse through bad management or bad luck;
n
three or four will underperform badly so that they just hang on by
the tips of their fingers;
n
a couple will perform just above expectations;
n
one, or perhaps two, will be real stars.
These star performers have to support the losses that are likely to be
made on the rest of the portfolio. Somebody once said that the trouble
with the job market is that companies advertise for labour but then get
people. By the same token, VCs set their caps at investing in winners –
but more often than not they take on trouble.
Chapter 9 identifies that, all other things being equal, an investor will
invest in an opportunity where he perceives there to be less likelihood
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Venture capital funding
of his money being lost. Venture investing – far from being about taking
risks – is largely about structuring deals so that risks are minimized.
While the expert investor will make his own mind up about the risks
that the investment will face, he may need some expert advice about
how the investment will be realized. That is where the entrepreneur
can exercise some leverage over the shape of the deal that is struck.
It follows from this that one of the highest-priority features of a
proposal that will commend an investment opportunity to a venture
capital funder is a statement of how the entrepreneur thinks the
business will achieve its realization. So much is this the case for some
investors, such as business angels and early-stage specialists, that
having a good idea of how the investment is going to be realized is
almost a prerequisite of entering the deal. This is especially so if more
money than is currently being negotiated will be required to see the
maximum potential of the business exploited. This often happens in
early-stage financing opportunities.
For other venture funders, like sector specialists or those who
concentrate on providing mezzanine finance, the identification of an
exit route will be a useful way of understanding the entrepreneur’s
intentions and gauging both his apparent commercial acumen and
financial sophistication.
THE MAJOR ROUTES OUT
The structure of the business plan and what it should contain will be
dealt with in Chapters 9 and 10. But for the purposes of this chapter,
we need to make it very plain that at some early point in the document,
the entrepreneur should write into the business plan what he thinks
the likely route for the investor to get his money back will be. Normally
the choice is limited to one of the following three options:
n
a sale to a third party investor;
n
a flotation on some form of stock exchange; or
n
a purchase by a trade competitor.
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Seeing the finishing line
In deals involving very large businesses, which throw off lots of cash,
it may be possible for an investor to get paid back out of cash flow if
the structure of the deal is right. This might happen through some form
of refinancing of, say, redeemable shares by a third-party bank or
another investor. But these are comparatively unusual methods in the
run of realizations. Most realizations are brought about through
market-based transactions rather than through what might be called
‘internal’ pay-offs.
The statement about the exit that is incorporated in the business plan
should be made without the tone being too evangelical or dogmatic. It
must be remembered that comments about the likely exit route are
predictions and not facts. The suggestion of what the outcome might
be is best seen as a contribution to the shaping of the deal that is to be
done. It is not a forecast of what must happen, since the purpose of
making the suggestion is not to dictate exactly how the investment is
going to be structured but to help identify what issues need to be
considered in developing a suitable format that will best serve the
likely outcome.
THE P/E TRAP
One thing that should certainly never be included in the discussion
about a realization is any prediction of the price–earnings ratio (P/E)
that the business will exit on. There are four powerful reasons for this:
n
First, it is not the job of the entrepreneur to predict P/Es that might
be applied to determining the exit value: that is the job of the
investor. The entrepreneur should concentrate on maximizing the
value of the business.
n
Second, any rubbishy old business can be predicted to make an
outstanding return if the exit P/E is high enough. This sort of
tarting up of a poor proposal won’t fool an expert investor.
n
Third, the VC will have a better idea of what P/E might be applied
anyway. If the entrepreneur has included what he thinks is a likely
P/E in the business plan, which happens to be lower than the one
that the investor would have put in by himself, then it is a brave
investor who will pitch his own estimate higher. In consequence the
investor may discard the higher P/E he would have employed (to
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Venture capital funding
the detriment of the entrepreneur’s case) in the absence of the
suggestion. If he doesn’t do that then he might have to justify to
his investment committee why he thinks a higher P/E should be
applied than that which the entrepreneur speculated. Few investment committees will be able to follow that line of reasoning.
n
Last, any such prediction, whoever makes it, will almost certainly
be wrong.
There is not a human being on Earth who can accurately predict P/Es
three years out. For the entrepreneur to try to do so will merely invite
justified ridicule. Quite simply, company managers who try to look
clever or sophisticated by predicting P/Es end up looking both stupid
and cocksure, confirming to the potential investor his suspicion that
they really don’t know what they are talking about.
In comparison to the value achieved on an exit, it is certainly more
reasonable to predict the likely route out. Aside from expert knowledge
about how the developed business will fit into the structure of the
sector – knowledge which entrepreneurs in an industry are likely to
have – the managers of a business seeking to develop itself into
something bigger and better may well know of a competitor or
complementary business which would find the acquisition of such a
company to be attractive.
There are a number of other special situations, too, where applying
a P/E ratio might be counterproductive but indicating the exit will be
helpful. Sometimes venture capital investors beat an industrial investor
to the punch in buying a business – so that there is a disappointed
bidder waiting in the wings for a deal to be off-loaded in due course.
Once the hard work of growing the business further has been accomplished with the venture money the previous suitor still finds the target
attractive.
Sometimes a venture capital deal can outbid the potential attractiveness of a flotation (the Saga business was secured in mid-2004 by a
consortium of venture investors in this way). The large VC funds can
offer a quick cash-on-the-nail deal instead of the protracted managerial
agony of a flotation with its endless verification meetings and protracted legal and accounting investigations. Purchases like that are
usually taken with a view to a later and even bigger flotation, of course.
But outside either of these possibilities there is usually little concrete
reason to believe that any of the outcomes listed at the start of the
chapter are anything more than aspirations. Business is a game of
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Seeing the finishing line
chance. Sometimes the odds can be lessened but it is not a game of
certainties. So it is best not to be too dogmatic about the likely exit
route. The most likely should be identified as exactly that – the most
likely, not a certainty.
REASONS TO BE HELPFUL – PART 1
Only three exit routes were listed above because, generally speaking,
they are the only ways that a (successful) realization can be obtained.
But there are a few others that might crop up. Aside from the cash
buyback, which was dealt with as a structured possibility, there are two
or three possible ‘sub-classes’ of sale.
First, perhaps a management buy-out of the first investor might be
possible in a deal of limited size. Or, second, a sale to another professional investor at a profit for all concerned is sometimes a possibility
for deals from modest to medium size. Last, a share exchange in an
acquisition by another company is a possibility for companies of all
ranges of size.
But these outcomes are likely to be too detailed to speculate upon at
the stage that the first investment is being solicited. As a result of that
they should be discounted as deal-structuring possibilities towards
which to work. The three broad categories first listed are likely to be
the safest to incorporate in making suggestions about how the investment might be realized.
Protestations of undying love aside, such as those that are made in
completion meetings, the professional investor is looking for an
opportunity to effect an early exit almost as soon as the investment has
been made. This will be the case, particularly, with a development
capital deal, where it is the imminent maturity of the business that
makes the deal attractive to the VC in the first place. This fast track to
a developing market will also make it attractive to someone else. Think
of it this way – fast cars get lots of admiring glances, old clunkers do
not.
If the price is right, the professional investor will take the money and
bail out – completely unsentimentally and perhaps almost as soon as
the ink is dry on the completion cheque. Therefore for the investor to
know that an entrepreneur has recognized that the business is only a
way of creating wealth is a plus point when sifting through which deals
are worth pursuing. Quite bluntly, as far as the VC is concerned, it
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Venture capital funding
means that there will be so much less education to be done in encouraging an entrepreneur to think of the business as a means to an end
rather than an end in itself – as must sometimes be done with entrepreneurs who have nurtured a pet business idea through thick and
thin.
The second good reason is that for the entrepreneur to point out the
way that the deal might end, using the specialist industrial sector
knowledge that he might have, will place some of the initiative for the
forthcoming detailed negotiations about deal-structuring on his side.
This credit balance may be short-lived – perhaps only very temporary
– but if used properly it can be a useful foundation stone on which to
consolidate further gains that will work to the benefit of the management team, as opposed to leaving all the initiative to the investor.
REASONS TO BE HELPFUL – PART 2
There are supplementary benefits to the business itself in thinking
about the exit. First, it will help the funder concentrate his ‘due
diligence’ research on the likely exit areas. By knowing what the key
commercial or technological points of a deal are, the potential investor
will know where to concentrate his investigative resources (necessarily
limited by time, at the very least) in order to get the best payback in
information.
In making his mind up about what to look at, he will be probing the
potential weak spots of the proposal. Pointing out where these are (and
there are bound to be some) will help the investor to eliminate
uncertainties from his list of concerns thereby helping to reduce the
perceived risk in the deal and making the chances of a successful
investment stronger.
Second, it will mean that the time spent in investigating the deal is
shorter and the cost will be reduced. As the company or the entrepreneur will have to pay for the investigation, this is a worthwhile
consideration.
Last, it may also help determine to shift the structure of the deal
towards simplicity – perhaps for ease of unwinding at an early
opportunity. Deals that may be anticipated to end in one particular way
– a simple trade sale, say at some reasonably well-defined point – may
well be formulated in a way that is less complicated to unravel than
those where the long haul has to be provided for, with performance
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Seeing the finishing line
ratchets (of which more later) or fall-back provisions for further
funding and so on. Simpler deals are less difficult to negotiate and
mean smaller legal fees. Simpler structures also reduce the investor’s
perception of the risk attached to the deal.
At the very least, the entrepreneur will do himself no harm by
indicating that the thought processes for an end game have been
started early on in the process. I have already suggested that a
completed game plan indicates to the potential investor a degree of
commercial savviness on the part of the entrepreneur. It shows that
there is a strategic bent to the management’s thinking and that they are
aware of the skills required to manage a business that will grow beyond
its current size.
THE DARK SIDE
It was pointed out at the beginning of this chapter that the average
venture capital investor’s portfolio contains far more casualties than it
does stars. And the exit routes that have been reviewed so far have all
applied to situations where the investment has probably met with
reasonable success.
For completeness’s sake we ought to mention that other but very
unattractive exit routes do exist, of course. So-called ‘blow-out financing’ or liquidation (voluntary or forced) are the two main possibilities.
But these are such highly unpalatable prospects that no one in their
right minds would advocate them as even remote – still less likely –
outcomes. So it hardly needs pointing out that it would not be appropriate to offer liquidation or receivership as acceptable exit routes to
an investor who is in the throes of agonizing over whether to lay out
his money on an unproven speculation!
And blow-out financing – or more accurately refinancing – (which
we shall consider later in Chapter 12) is hardly more attractive. It
implies commercial failure on the part of the company, involving as it
does, by definition, the virtual elimination of all the existing shareholders’ stakes. To incorporate it as a possible exit route indicates a
mindset of failure on the part of the entrepreneurial team. Suggesting
at the outset that the management have the intention to raise further
funds to take out the investor now being courted, on highly unfavourable terms if things go wrong, will lead at the very least to suspicions
of multiple agendas (and possibly multiple accounting!). Being taken
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Venture capital funding
out of the deal at a low price (even if not quite at blow-out levels) is a
highly unattractive proposal as an outcome for an investor and in
tactical terms, advancing it as an exit would be pretty much equivalent
to grabbing the starting pistol and shooting yourself in the foot at the
start of an Olympic hundred metres.
Put it this way: ‘Don’t move or the business plan gets it’, is not a
rational negotiating strategy.
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Dealing with existing shareholders
6
Dealing with existing
shareholders (and
stakeholders)
Money, n: A blessing that is of no advantage to us excepting when
we part with it.
Ambrose Bierce, The Devil’s Dictionary
n
The effects of change
n
The best structure
n
Shareholders
n
Workers
n
Suppliers
n
Creditors
n
The bank
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Venture capital funding
The vast majority of opportunities that are presented to VCs involve
existing businesses. Existing businesses have existing shareholders.
And the chances are that the introduction of a new investor – in the
form of a VC – will have fairly profound effects on the relationships
that previously held between the shareholders.
In the most extreme case of course – the management buy-out – the
previous shareholders disappear entirely and are replaced by an
entirely new set. Other forms of investment may involve some shareholders leaving; some shareholders having their rights curtailed; some
shareholders being offered terms that they consider disadvantageous
– or any combination of those. In general, it will always be best to do a
deal that involves the smallest number of shareholders participating
in the deal as possible.
Much of this chapter will be devoted to explaining some of the
problems with minority or ‘residual’ shareholders. The idea is to
explain some of the pitfalls of doing deals with ragged shareholding
structures, in the hope that prospective management teams will be
persuaded to clean up those structures (or at least develop strategies
to clean them up) before embarking on trying to raise external capital.
The effort will almost certainly be worth it in terms of reduced complexity of negotiations and expenditure of energy during the deal itself.
THE EFFECTS OF CHANGE
What shouldn’t be forgotten is that a change of ownership can often
have considerable effects on others connected with the business –
stakeholders in the jargon – who have some form of interest in how the
business is run and owned. So we shall also need to review some of
the effects of those parties, too, to see how they might affect – and be
affected by – a deal.
The management of a rearrangement of share stakes will not usually
be undertaken by the incoming VC; it is regarded as the province of
the management shareholder(s) to sort out.
There are, of course, variations to this rule – in a management buyout, the purchasing VC may well take a strong position in developing
the structure of the new investment vehicle and join with the prospective management in negotiating the change with the prospective sellers.
Or where there is a residual stake being held in a business, it is also
often the case that the VC can assist the negotiating position (since his
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Dealing with existing shareholders
own interests will be affected by the outcome) by making an injection
conditional on the acceptance of certain shareholding structures.
But even in cases where the management side’s collective shareholding is left to them to sort out, the VC will exercise a veto position
over the arrangements that are agreed between the members of the
‘other side’ to make sure that his own interests are not prejudiced by
anything that they enter into or any side agreements that they conclude
between themselves. So dealing with ‘residual’ shareholders usually
has to be taken head-on by entrepreneurs or management teams.
There are a number of ways for such changes in shareholdings to be
perceived by those affected by them. For instance, some existing
shareholders might be pleased that new resources are being injected
into the business (as in a development deal) and will be happy to see
their shareholdings benefit from the effects of the cash that is being
raised. Others may be dismayed at the draconian changes (as they see
it) in the relative balance of power within the company that occurs
when the VCs take a stake. Some may try to resist the changes that the
management team want to effect in the expectation that if they are
sufficiently obstreperous then it will be worth the new investors talking
them out at an enhanced price to get rid of potential aggravation.
As for stakeholders, the workforce may regard the change in
ownership as an unmitigated blessing – or fear it as the precursor of
investor-enforced ‘rationalization’ that will cost them their jobs. Key
suppliers will need to be informed of the change at an appropriate
point – although their reactions are likely to be more dispassionate
provided that credit limits are still observed. Bankers may have a
variety of reactions depending on the exact nature of the changes that
are taking place.
THE BEST STRUCTURE
Without a doubt the cleanest form of arrangement will be where it is
only members of the management team who will own shares in the
company (other than the VC) once the injection has gone in, since then
there are no extraneous influences on how the deal is negotiated.
Because of this it may be sensible, if possible, to buy out straggler
minority shareholders before seeking venture capital, since this will
clean up the situation to everyone’s benefit. Sometimes if there is cash
in the business it can be used to purchase the shares of a dissident
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Venture capital funding
shareholder if the appropriate powers are contained in the company’s
articles of association. That of course begs the question that, if there is
cash in the company why is the business seeking venture capital? The
answer could be that the amount available to buy out a shareholder
and the amount required to develop the business – perhaps to take
advantage of a transient market opportunity – might be very different.
It may also not be possible for other reasons. In situations like those
where a long-established family business seeks venture capital (although
family businesses have their own special horrors for VCs: see Chapters
1 and 8), because the shareholdings may be widely spread, there may
be too many shareholders to convince that they should sell out prior
to an injection. Then, even though (perhaps because) the core group of
managers may be non-family, it will prove extremely difficult to
develop a consensus of opinion on what should be done. The exercise
will have distinct similarities to trying to herd cats, in fact.
In such situations it may be sensible to change the structure of the
deal from what was originally contemplated to one that makes more
sense from a financing point of view, in order to permit an easier
investment by the incoming investor. For instance, changing a development capital deal where there are ‘residual’ shareholders, not connected with management, to a buy-out deal where the shares are all
held by the management team, will have the effect of cleaning up the
shareholding structure at the same time as concentrating shareholdings
in far fewer hands and making the deal easier to effect from the VC’s
point of view.
This might also have the beneficial effect of bolstering both the deal
size and the prospective rate of return. More money would have to be
applied to the deal to get rid of the existing shareholders but that would
be balanced by putting more shares into the pot from the ‘old’ shareholder and therefore making more potentially available for the new
shareholder. In a deal where the rate of return might have been only
marginally attractive previously, only a small additional slug of equity
can have quite impressive beneficial effects on the rate of return if the
rate of growth of the company is sturdy.
We need to look at the potential reactions of shareholders and
stakeholders in greater detail.
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Dealing with existing shareholders
SHAREHOLDERS
As outlined above, remaining or ‘residual’ shareholders’ reactions
usually fall into one of three categories once the prospect of venture
capital injections are raised – support for the change; resigned hostility
to the loss of rights; or active opposition.
In a case where there are going to be minority shareholders left in
the business, their support has to be enlisted for the approach to VCs
before it is made. If it is not forthcoming, then there is no point in
proceeding. It would be a fatal error for an investment proposal for a
management team to try to induce a VC to enter a business without
squaring existing shareholders to the changes that will occur. Once a
VC found out that there was dissent about proceeding with an investment it would be very unlikely that the proposal would get much
further. VCs are not in the business of trying to persuade people to take
their money.
Supportive minority shareholders should be kept informed of the
progress of the discussions and negotiations with VCs, and should be
introduced into the discussions at some (early) convenient point. The
reason for this is that there is always a danger that trying to accommodate the preferences of one minority shareholder may well bring the
deal crashing down. If that initially supportive shareholder is kept too
remote from the deal then there will be lack of realism about what can
be negotiated. The VC is very unlikely to adjust the terms offered to
accommodate a proposal put by a minority shareholder. In terms of the
future development of the company, that shareholder is going to be a
very passive free rider as far as the deal is concerned. Consequently if
someone holds out for better terms that suit their particular circumstances, this may well cripple the deal since it will meet with intransigence. Everyone has to be ‘on side’ during the negotiating process and
there have to be only two voices in dialogue – the VCs and the management side. Extra voices will just be so much noise that will eventually
confuse the signal.
Unfortunately, even though there may be initial support for the
principle of an injection from minority shareholders this may be
supplanted by hostility when the terms offered by the VCs are received.
There is probably going to be a disparity between the expectations of
the management team proposing the deal and the concrete terms
offered by the VC and this disparity will probably seem even wider to
a residual shareholder.
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Venture capital funding
It is at this point that the deal gets placed in greatest jeopardy. VCs
usually place time limits for their terms to be accepted and if it takes a
long time for a residual shareholder to be won round then the deadline
may be breached.
Worse still is the situation where the residual shareholders appear
to accept the terms of the offer – however reluctantly – only to start to
raise problems when the deal enters legal stages. The surest sign that
this is going to happen is when residual shareholders appoint separate
legal representatives to look after their interests during the legal stages.
The only way to get round this (apart from buying out minority
shareholdings at or before this stage) is for the management team to
achieve an irrevocable undertaking that there will be no separate
representation or a legally binding agreement that the terms that have
been offered are acceptable. This means that the residual will abide by
subsequent negotiations as a passive rider in the agreement. That may
be a very difficult thing to do since at some point in the future of the
deal process, warranties and disclosures are going to have to be made
(see Chapter 10).
The legal stage of the deal always produces a lot of heat between
management shareholders, so they will be even more difficult for a
minority shareholder not connected with the day-to-day running of the
business to swallow. In fact the management’s legal representative may
well have to advise that there be separate representation for a minority
just to deal with this point, notwithstanding ‘no separate negotiation’.
But, even if it can be arranged, agreement on the terms of the deal
at entry does not get rid of the problem. Exactly the same problems will
reappear when there is the need for more cash (and consequently the
prospect of dilution arises) or when the terms and timing of an exit are
discussed. In short, the residual shareholder is a bit of a time bomb in
a venture-backed business, sitting in the corner and waiting to blow
up in everyone’s face. If a deal can be arranged that eliminates the
residual shareholder, it will be a better deal than one which has a
ragged shareholding structure.
OTHER STAKEHOLDERS
The four parties that are going to be most affected by a change in the
ownership of a business outside the shareholding group are the
workforce, the suppliers, the creditors and the bank.
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Dealing with existing shareholders
Workforce
The workers’ rights are protected under Transfer of Undertakings,
Protection of Employment (TUPE) regulations – in the event of there
being a complete change in the ownership of the business. This occurs
in a management buy-out where the previous employing company
disappears to be replaced by Newco Ltd. The TUPE regulations protect
the terms of contracts of employment for workers whose jobs are
transferred with the business. Business plans for a buy-out that include
rapid and substantial cost savings through making changes in the
employment cost-base are based on a complete misunderstanding of
the legal situation.
Other types of deal are less legally sensitive to changes in the
structure of the business but, needless to say, good practice would
require that the workforce be appraised of the situation as soon as is
possible. The timing of this will be different for every business
depending on circumstances: size, number of locations, numbers of key
employees and so on. But it is worth bearing in mind that the rumour
mill will be working full-time in any business where there are lots of
meetings between the management and strangers; where accountants
conduct detailed reviews of the business and where the management’s
attention is suddenly occupied by an entirely different range of
problems from the normal preoccupations. In the end, not many
workers are likely to object to their employer being better funded, but
VCs will probably be viewing the way that the funding situation is
handled and communicated internally as one of the gauges of managerial ability on which they make their investment decisions.
Suppliers
Like the workers, an increase in the funds available to the company
should be of benefit to suppliers in most cases. However, it is very
important to keep suppliers reasonably up to date as to what is
happening inside the business because part of the due diligence process
undertaken by the incoming investor will be to talk to suppliers to
understand key relationships – especially if there are a few critical
suppliers. If these people find out about the imminence of a funding
deal from the VCs or their agents suddenly ringing up to ask about
the customer, then harm will probably follow to the commercial
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Venture capital funding
relationship – not least through misunderstandings about the purpose
of the VCs’ enquiries.
There is balance to be struck here, though. If for some reason the
funding exercise does not come to fruition, then the supplier may well
need to be reassured about the future. So a judicious sense of timing is
required as is the degree to which the plans are revealed to outsiders.
Suppliers are also usually creditors at some time and the particular
needs of creditors are dealt with below.
When the due diligence process starts it is important for the management to liaise closely with the people conducting the investigations to
make sure that all suppliers who are going to be contacted have been
told enough about the reasons for the enquiries (see also Chapter 8).
Creditors
Another area for investigation in the due diligence process will be the
creditors’ list and so much the same considerations as were dealt with
in the section above for suppliers apply to creditors. Due diligence
processes and considerations are dealt with in Chapter 8 but it is
important to point out here that although (perhaps because) creditors
– like suppliers – should be beneficiaries from a cash injection into a
business they need to be treated as an important factor in the process
of raising funds.
Creditors are a bit like shareholders in that they own a chunk of the
company’s assets in the shape of its working capital (although by
contrast with shareholders this ownership is only on a temporary basis)
and so they cannot be relegated to an outside role of no importance.
They are, if you like, only minor players in the drama but have an
important walk-on part that is crucial to the way that the plot ends.
Although one of the purposes of raising development capital may
be to clean up the creditors’ lists and put the company on a better
footing with its creditors, it would be a foolhardy management that did
not make strenuous efforts to push cash towards creditors to ensure
that the lists are ‘clean’ before embarking on a fundraising exercise.
This should not be done in a sudden surge that looks – and is – artificial
but, ideally, should be part of a controlled process extending over
several months before the fundraising process begins. The purpose is
to bring the creditors’ list into line with the average for the industry of
which the business is a part. There are a number of reasons for this.
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Dealing with existing shareholders
The first is that long-term suppliers (long-term suppliers are going
to be long-term creditors) whose accounts have been properly handled
are much likelier to give favourable reports about their relationships
with the company when questioned during the due diligence investigations.
Second, during the fundraising process it is almost inevitable that
the business seeking to raise funds will suffer a drop in levels of
business activity as senior management’s eyes are taken off the ball
temporarily. This may filter back to creditors’ payments; so making
sure that the creditors are reasonably happy at the start of the process
makes good sense.
Third, taking the pressure of creditors’ lists before the process begins
provides a cushion against some deterioration during the fundraising
process so that management do not have to cope with making a deal
with the investors and battling with creditors at the same time.
Fourth, a prudent approach to the creditors’ lists will mean that the
negotiations with potential investors are conducted from a position of
equilibrium. If the creditors’ lists look ‘unnatural’ in some way then
the investor’s perception will be either that the business is on some
form of distress (‘creditor days’ are longer than the industry average)
or that there is financial fat to be trimmed by taking a more robust
attitude to suppliers, or that creditors have a strangle-hold on the
business in some way (both of which arise from creditors’ lists being
unnaturally short and below the industry average). This last might
suggest to the investor that there has been some trading hiccup in the
past that probably ought to be investigated further.
Last, by making sure that the creditors are happy when the fundraising exercise begins, the damage done by a failed search for funds
can be minimized.
The bank
Almost certainly one of the key partners with any business, the bank
needs to be kept informed of the intention to raise funds from the very
outset. In the case of an independent business (that is, one that is not
part of a group) the bank may very well have been the catalyst in
prompting the search for external finance and so will expect to be kept
informed of progress throughout.
With the frequent changes in branch banking staff that are now
commonplace, it is essential that a proper relationship is cultivated by
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Venture capital funding
the company’s management with a manager of the bank of sufficient
seniority – that is, someone at a high enough level in the bank’s own
management – to understand what is going on and to approve changes
with the minimum of referral to higher levels. At some points during
the funding process, speed of response will be of the essence.
During the process of completing a fundraising deal the banking
covenants governing any existing overdrafts may need to be revised
and future banking arrangements will almost certainly have to be
reviewed. Bankers will be concerned that any security that they
currently have over the assets of the business should not be compromised by any shareholding arrangements entered into as a consequence of the new funding. These issues will need to be dealt with by
the company’s management in consultation with the bankers. It is not
the province of the investor to make these arrangements.
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Building the management team
7
Building – and displaying –
the management team
Accomplice, n: One associated with another in a crime having
guilty knowledge and complicity, as in an attorney who defends
a criminal, knowing him guilty.
Ambrose Bierce, The Devil’s Dictionary
n
What can wreck a proposal
n
Four elements of a good management team
n
Post investment
n
Dropping directors
n
Succession
n
‘Key man’
While it cannot be said that a good management team will rescue a bad
proposal sufficiently to convince an investor to back it, it is certainly
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the case that the opposite is true. A poor management team will
certainly sink a good proposal.
Because of this, VCs spend a great deal of time in deliberating about
management structures and the suitability of the individuals presented
to them in the investment plan. The ability to place confidence in the
management of a venture-backed business is a critical part of the
process of deciding whether or not to proceed in making an investment. And the significance of being able to do this ranks, for the
potential investor, almost as highly as the attractiveness of the information about the company’s likely development contained in the rest of
the business plan.
What many entrepreneurs fail to understand is that this ability to
repose confidence in the senior members of the management has to be
evident in the chief executive of the business for it to be mirrored in
the assessment of the potential investor who will be conducting ‘due
diligence’ enquiries. And if the VC perceives that this confidence is not
there or that it is misplaced, then it will severely prejudice the likelihood of an investment being completed.
Nor does the assessment begin and end with the investigating
executive – at least not where the investment is being undertaken by a
venture fund. CVs of management form a substantial part of the pack
of information that is formally presented to investment committees –
and these are not regarded as just so much filler material to bulk up
the size of the investment folder. They are properly studied, in my
experience long and hard, by investment committees. Questions are
asked about individuals’ competences and the proposer of an investment will be expected not to present the case for investment if he has
any reservations about the collective abilities or qualities of central
members of the management.
Because of the significance attached to the senior personnel involved
in an investment, it is crucially important that entrepreneurs also
devote time to the managerial aspects of the presentation of their case.
In the end there is only one person who is in charge of a business and
potential investors assess that person’s ability partly by the shrewdness
demonstrated in picking the right people to support him or her. The
leader of the business places his own reputation ‘in play’ with investors
as soon as he holds out the business as being suitable for backing by
an outside investor and the investor’s judgement about that suitability
will be largely determined by the calibre of the management team.
It is worth remembering when fielding a management team that you
get one chance to make a first impression – you have to get it right the
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first time. Bloomfield’s Law states that as someone rises higher in an
organization it becomes more and more difficult to determine what he
or she does. The VC will need to be left with the emphatically unambiguous impression after the first meeting with the assembled senior
managers, that everyone is doing exactly what he or she is best fitted
for.
It is obviously too late to make changes to senior personnel when
the flaws in someone’s ability have been exposed during the due
diligence process. It is too late to move people around when the
discussions have started between investors and the management team.
It is even too late to start moving people around when the business plan
has been sent out and been studied by potential investors. That means
that the final management team ought to be in place before the proposal
is even considered internally in the business.
Not the least of the considerations that argue for this being done is
that it will be very difficult to get people out of a managerial position
without more than the usual acrimony when the prospect of large
capital gains have been visualized by the managers. And acrimony
costs money, aggravation and time – all things that can be ill afforded,
especially by companies that are seeking to raise funding, not to
dissipate it.
FOUR ELEMENTS OF A MANAGEMENT TEAM
There are four elements to ensuring that the right people are in place
for the business to be able to move forward and that it will be able to
cope with the vagaries of the business environment:
n
first, ensuring that all the necessary functions are covered in the
organization of the business;
n
second, ensuring that the functional positions are filled by the best
people;
n
third, striving to achieve compatibility between individual postholders so that they work together effectively;
n
last, thinking about what will happen when the business moves
from being a privately-run company.
We need to take each of these in turn to look at the problems involved.
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Functional coverage
It should be fairly obvious that for a business to run properly there
should not be any gaps in the functional matrix represented by the
skills of the core managers.
However, in a business which has grown up with a continual
shortage of resources – as do many businesses which seek venture
capital – it is often the case that the full range of functional specializations are not properly covered. People often ‘double up’ posts. The
engineering director serves as chief buyer or the operations manager
does the detailed work of the production planner; the managing
director manages the accounts with the help of an accounts clerk and
so on. This means that some posts are overlapped and some not
properly covered. Jobs get done but not necessarily very well or at least
not as well as they could be if there were proper functional specialists
in place. If the system works – however roughly – there is a tendency
to leave it alone. Custom and practice enable the business to ‘get by’.
That may be adequate for a business that has no aspirations of growth.
But ‘getting by’ will not be enough for a VC, who will be concerned
with ensuring that the money injected into the business is properly
stewarded. More particularly, as far as the VC is concerned, the process
of ‘getting by’ will not be enough to see the business capable of
developing successfully to its next stage – the whole purpose of seeking
investment.
Businesses that have been started largely by the efforts of one
individual suffer from a similar problem – the inability of the founder
to delegate responsibility to his or her colleagues. Letting go of a tight
grip of the reins while still retaining control is a skill that not all
managers can learn.
The symptoms of this are usually fairly evident during the course
of due diligence even though they may initially masquerade as tight
managerial control – collegiate decision making ignored; too little
delegation of functional responsibilities; too extensive a span of control
for the top manager; minimal delegated power of spending to functional heads; insufficient attention paid to colleagues’ professional
opinions; and too much credence given to the opinions of trusted
outsiders’ are all significant signs. These will be definite turn-offs for
potential investors who will want to see a properly functioning,
properly led team of managers.
There is also a further consideration that should not be ignored. The
process of growth will involve increased risk as new processes, or
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simply a different size of business operation, place strains on the old
ways of doing things. Growing businesses face problems that they have
not encountered before. When a new problem strikes a business, it is
very much more difficult for an under-equipped management team,
already struggling to cope with change, also to deal successfully with
all the problems that suddenly begin to pile up.
Unless there is a very disciplined approach on the part of the chief
executive then there will be even more of a tendency for some things
not to get done which should be done properly – urgently – and some
lower-priority tasks to be given more attention by more people than
they truly deserve. The success of the investment will be jeopardized.
VCs know these problems, usually through bitter experience. Poorly
managed businesses rank very high on the alarm-bell scale for venture
capital investments. Such an assessment will not be conducive to
helping the VC reduce the perceived level of risk.
Presenting the best face of management
Ideally, the people in the senior reaches of the business’s management
will be the best that can be found – full stop. But VCs are sufficiently
realistic to know that may not be the case in businesses seeking
expansion capital, where cash is probably tight by definition. Most
businesses will be staffed with people whom they can afford to attract.
With luck they will also be properly competent.
VCs will be concerned about three things. First, that the people in
place are capable of acquitting their responsibilities properly; second
that they can do this on a full-time basis; and last that they can manage
the growth of the business. A business plan that suggests that a parttime finance director will be able to be sufficient to fill the post for the
foreseeable future is unlikely to win the support of a VC; similar
considerations will almost certainly hold for the other major functional
responsibilities.
And in a development of the problem considered above – where one
founding shareholder has dominated the business – it may be more
apparent to an outsider scrutinizing the business than to those inside
the business, that the person who holds the top position may in fact be
more suited to being operations or technical director than managing
director. It is a big man or woman who can admit that their skills may
lie in another plane after having gone through all the sweat and agony
of starting and developing a business. Being prepared to relinquish
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what is seen as the top seat to someone else is a further step that some
people just cannot manage.
The core problem with both of these facets of the senior staffing of a
business, though, is one of chicken and egg. The obvious question
arises: how does a business that needs cash for development or
expansion find the wherewithal to employ people of the calibre
necessary to reassure a VC? If the cash that could be used for expansion
will only come when all the right people are in place how are those
people to be paid?
The answer to that question is, that it probably isn’t the right
question to be asked. Chapter 1 suggested that venture capital should
only be used for bringing about step-changes in a company’s fortunes.
Bluntly, it is unlikely that such a change could be brought about just
by employing a finance director or a marketing director. There needs
to be something else as well. The business should go a little bit further
in its organic growth to generate the resources to put the necessary
functional specialists in place. Then would be the time to seek out
venture capital – to add the final ingredient to enable a new market to
be tackled or a new product to be developed.
Compatibility issues
There is nothing like money for getting between the cracks in a
relationship and making those cracks wider. It is a gross error to believe
that the common desire to make an investment profitable will cement
a management team composed of people who otherwise dislike each
other. It may work during the time the investment is going to plan but
the bond will dissolve very quickly when the business hits a snag.
Bloomfield’s Second Law shows that the latitude for recriminations
and finding scapegoats will increase in direct proportion to the width
between what should be happening according to the business plan and
what is happening according to the monthly accounts.
It may be better to settle for a slightly less outstanding finance
director if by employing someone too abrasive you are going to rub
people up the wrong way. That is very definitely not a plea for
employing second-raters. It is a plea to keep on looking until you find
people that you can build into a cohesive team of managers. Very few
developing businesses can accommodate people at senior levels who
are always right in everything they do and say.
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It is usually very easy for an incoming investor to spot the symptoms
of a dysfunctional management team when detailed discussions start
as part of the process of due diligence. What is more significant is that
bad relationships between senior staff will sour the whole process of
the investment: legal stages will take longer as some members of the
team begin to think differently about their personal liabilities under the
warranties (see Chapter 10); this will cost money. The process of dayto-day working will be complicated in times of stress throughout the
life of the investment, limiting the rate of growth; and the process of
releasing the investment will be more complicated as individual managers assess their own personal positions as the prime consideration
rather than think of the greater good of the shareholders collectively.
Since many investments will also require capital to be invested by
the directors and/or managers for them to receive a shareholding –
particularly in situations where a previous dominant shareholder’s
stake is to be diluted for incentive purposes or in a management buyout – the different capacities of individuals to invest may also prompt
potential dissension between board members. It is the job of the
managing director to deal with these issues before they become
problematic for the incoming investor. That may involve limiting the
investment of some senior members of the management in order to
allow others to get a small stake.
Situations where members of the management borrow heavily to
purchase a share stake are also to be avoided if possible. In the event
of a cash crisis, far from concentrating the mind, such imprudent
behaviour acts as a distraction. It is the job of the managing director to
ascertain the capacity of each of his fellow investors to borrow and
make sure that borrowing that does occur is done within sensible
limits. Intrusive though this may seem at the time, it is a necessary
action if the harmony of the management team is to be preserved when
the going gets rough.
Development and capability
The final factor that has to be borne in mind is the extent to which
current holders of the major board positions are capable of growing
with the company after it receives the injection of cash it is seeking.
What we are talking about is step-changes in levels of activity and
subsequently dramatic changes in the level of sophistication of the
skills required to run them.
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Venture capital funding
Where sympathetic colleagues in a private business may overlook
minor failings in procedural rigour, in the harsher environment of the
venture capital-backed company, the emphasis will increasingly be
placed on professionalism of a much higher standard. Only the able
are likely to acquit themselves adequately in such conditions.
This anticipated standard of expertise does not conflict with the
point made earlier about few developing companies being staffed by
people who are always right in everything they do and say. The
standard of professional expertise that has to be expected of professionals in venture-backed businesses is not identical to the standards
and qualities of judgement which have to be exercised. Judgements are
always going to be variable and only patchily right. Everyone makes
mistakes in employing their judgement about the way something will
develop – a market, a product, interest rates. The investor will want to
know that the people who are in charge of the business have the
necessary skills and abilities to take it through to a successful conclusion without too many mishaps.
Therefore, the managing director of a business seeking funding has
to ensure that his colleagues have both the necessary professional
competence to discharge their functional obligations not only now but
in the future, too. They also have to possess the managerial capability to
grow in their jobs as the business places increasing demands on them.
Potential investors will rapidly latch on to those they think are weak
managers and this will tend to raise the risk level that they attach to
the investment opportunity as a consequence. This identification of
weakness may be right or wrong, since much of it depends on personal
empathy (or otherwise) but has to be taken into account in presenting
the case.
In the circumstances where the managing director acknowledges he
has a problem with one particular member of the managerial team it
may not be necessary to ditch that person. A more subtle strategy
would be to emphasize the blend of talents across the whole of the
managerial group. For instance, if the putative finance director is
technically excellent but possesses a diffident personality, then it might
be acceptable to emphasize the essentially technical nature of the
accounting function inside the business. But if the nature of the business is such that the finance director has to fight to control the allocation
of resources between various parts of the business then you might have
to think about finding someone tougher. It will be too late to try to
rearrange the team once presentations are being made to potential
investors. By this time there should be a rounded team capable of
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meeting most eventualities squarely and dealing with them competently as a group. Sensible investors will recognize that this quality is of
a higher significance than having paragons in each functional post.
If this case is presented properly it has great persuasive power,
trumping the value of a managerial cohort formed of individually
competent non-team players. In the eyes of most VCs, a good team that
works well together with a blend of skills will always beat a group of
perhaps separately better but less cohesive individualists.
The last factor to be considered in this process is the change that will
take place in the physical composition of the board once the injection
of cash has been received.
Few investments are made at a substantial level without there being
requirement for the investor to have a seat on the board for a nonexecutive director. Directors are not supposed to be partial – their
absolute legal duty is to the good of the company not to one investor –
but it is common practice now to appoint a representative to the board
who will act as the investor’s conduit to the board.
This person may be appointed as the chairman or may be some other
individual who is perceived to have some special competence. It may
be an employee of the venture capital fund or someone who has
worked with the fund before or possibly just someone who has special
sectoral or functional skills. Business angels of course usually take seats
themselves as a condition of putting their money into the business and
then take an active part in running the business in a sort of semiexecutive capacity.
Board members of longer standing may feel that this newly appointed
individual is in place to scrutinize their behaviour and report on it, and
they may resent this. They are right to believe the former and wrong
to indulge in the latter. Board representatives will certainly keep the
investment funds that appointed them up to date on developments in
companies – usually on a monthly basis, at least. But investee companies usually benefit from the activities of good non-executives who,
if they are doing their jobs properly, will require – diplomatically – all
the executive board members properly to justify the development of
strategy and policy, and will make their own contributions, too. The
exercise of impartial scrutiny of ideas and proposals by someone who
is not bound up in the day-to-day scrum of business activity can be a
very valuable help to a company’s progress.
In the event that the non-executive does not do his job properly or
there are serious clashes of personalities between board members, then
it is perfectly in order for the fund to be approached discreetly by the
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managing director or chair to advise them that things are not proceeding as they should and to seek a more compatible representative who
fits better with the temper of the board. But this is not a power to be
used without proper consideration and normal disagreements are not
a reasonable cause to exercise it. However, there are few investors who
would jeopardize the effective operation of a board united against a
representative non-executive director simply to stand on a point of
principle.
Dropping directors
All of which brings us neatly to one of the more difficult problems that
a management team may have to face – how to get shot of an underperforming executive director. The short answer to this problem is to
make sure that you don’t have to do so by choosing your fellowdirectors very carefully in the first place.
The problem is not simply one of getting rid of an under-performer
and paying some form of compensation. The position about dropping
members of the board is complicated in the circumstance of venturebacked companies by the fact that most legal agreements that control
venture capital deals make employment by the company a condition
for holding shares in the company.
Directors of venture-backed businesses usually own shares in those
businesses and to release someone from the company means that they
are going to suffer the loss of capital appreciation from losing their
holding of a stake in the company. The alternative of letting them hold
the shares when they are not contributing to the development of the
company puts them in an unfair position in comparison to their
remaining shareholder-directors who remain with their wealth at risk
and working hard.
To get over the obvious unfairness of both of these courses of action
– stripping someone who has made a contribution of their shareholding
or allowing them a continuing free ride – most legal agreements will
incorporate some form of compromise clause which allows directors
leaving the business to hang on to their shares after some qualifying
period. Eighteen months after the investment has taken place seems
to be a popular length of time; before that period they are required to
sell their shares back to the company. As a variant on this there may
be pre-emption rights which enable other directors to purchase the
shares or they might be held in some form of escrow account for the
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benefit of the removed director’s replacement. Whatever happens,
removal from office is likely to be accompanied by other losses, too.
The existence of such a sanction is obviously a very strong incentive
for an individual to make sure that they perform their functions as
expected. But it sometimes happens that employment has to be
terminated for the good of the company. Where there is misconduct,
the situation is very plain: bad behaviour merits the loss of the share
stake – quite rightly. In less clear-cut circumstances, the unwinding of
a shareholding by a dismissed employee can result in protracted
unpleasantness that will greatly damage the company both in terms
of distraction and in terms of legal costs.
It is worth repeating the short answer to the problem: be very careful
in whom you select as shareholder and/or director because the
consequences of a mistake can be very serious. Bad directors can
seriously jeopardize your wealth.
Succession
Something that many management teams often leave until it is too late
is the issue of managerial succession. Succession need not necessarily
be brought about by ‘death in harness’ – although that is a distressingly
frequent occurrence in venture capital-backed businesses. Businesses
have to make changes for reasons as diverse as someone in the
management team being caught fiddling expenses (you’d be surprised!); or bonking their secretaries and upsetting the rest of the staff;
or even falling under the proverbial No. 9 bus.
The experienced potential investor will want to see evidence that
some sort of succession plan has been thought of: not a detailed plan
for every eventuality but managerial strength and depth so that should
someone go, then the ranks could be quickly filled. Venture capital
deals usually involve some form of key man insurance being taken out
on the lives of the more senior members of staff so that there will be
time and cash provided to find a replacement if there is ‘a series of
unfortunate events’. But there should also be some contingency
planning, so that those whose lives have been covered also devote
some time to considering who might fill their places from within
the organization and then make this known to the investor. The whole
business should be done discreetly and as an adjunct to the management section of the business plan – not as the main feature of it.
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8
The key issues of discovery:
the ‘due diligence’ process
Finance, n: The art or science of managing revenues and resources
for the best advantage of the manager. The pronunciation of this
word with the ‘i’ long and the accent on the first syllable is one of
America’s most precious discoveries and possessions.
Ambrose Bierce, The Devil’s Dictionary
n
The overriding ‘key issue’
n
Reducing risk
n
‘House styles’ – an illustration
n
The ‘due diligence’ process
n
The basics and key points explained
n
Detail of the process
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The key issues of discovery
The issue of thoroughness of investigation has been given special
significance in venture capital investments. The assumption is that
venture investments are so risky in comparison with putting money
into a bank or with stock market investments that they need special
attention. Only by treating all the issues that are exposed by the initial
question about risk with appropriate ‘due diligence’ can the final
evaluation be properly completed.
The term ‘due diligence’ has come to be the shorthand for the process
of investigation itself. This chapter is all about the due diligence
process.
It is a common misapprehension that investors make their judgements about whether to invest or not on the basis of the business plan
they are presented with. They do not. What they make their judgements on is an evaluation of the wealth of information that they find
out about the company and its business from asking further questions
about the facts that are laid out in the business plan. In doing this they
are seeking both further information and confirmatory information
about the triple issues of management, mathematics and market.
At the end of this process, all the individual questions that have been
asked distil into one big question. The fundamental question, the key
issue for the investor, is quite simply, ‘Is this deal going to make the
rate of return that I need to achieve?’ If the answer is yes, then the deal
goes ahead; if the answer is no then, as far as the professional investor
is concerned, it’s on to the next proposal. In the end, only the right
answer to that crucial question will swing the decision one way or
another.
But that simple and fundamental question is obviously a summary
one. It is the final interrogatory in a long chain of questions that have
been designed to explore all the subsidiary information on which the
business plan was based. This chain of exploration starts with a
question that is very similar to the final question in its phrasing but,
crucially, includes one specific element. The element of risk is the prime
concern of every investor.
The first question that starts off this long process is, ‘Is the likely
reward which I am going to get if this proposal works out worth the
risk which I am going to run if I invest my money?’ It opens up a spread
of issues – all of which can be organized under one of the headings of
management, mathematics and market – and each of which has to be
explored thoroughly if the final question is to be given the weight it
deserves.
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Some deals are so obviously good that the investor has to look for
negatives to persuade himself not to do them but these are – unsurprisingly – in a very small minority. Most deals involve a complex
series of trade-offs of time against cash, and reward against exposure,
that have to be resolved, ultimately, by the arbitration of rate-of-return
calculations.
But behind that bald and brutal process, there are lots of subsidiary
factors concerning perceptions, personal ambitions and preferences (on
both sides of the investment divide, those with the money and those
seeking it); timing issues; risk profiles; sectoral expertise; past investment experiences and current portfolio dispositions. Some of the
concerns of the potential investor will be apparent to the entrepreneur,
some will remain hidden. A later section of this chapter expands on
some of them in detail.
‘House style’
The way that the investor goes about evaluating an opportunity,
devising an investment structure and then completing and monitoring
the investment all get packaged into a particular way of doing things
that gradually assumes the trappings of a routine – a ‘house style’ in
terms of investment funds.
Some of these factors will be determined almost unconsciously as the
result of past investment experience. The outcome of these events –
good and bad – form the background against which the investment
opportunity is measured. Poor experiences in several investments in
leisure businesses for instance might make funds reluctant to consider
proposals from that sector in the future. Some funds might have a rule
that they never invest in financial service businesses or, perhaps,
businesses with overseas subsidiaries. If funds are not set up with
charters that establish a specialization, then the investment fund
managers are unlikely to impose one on themselves unless they have
a very good reason for doing so. Such stances are increasingly unlikely
as more and more funds become generalist and as businesses increasingly become international. What is common is a specialization by
type of deal as we have already seen – funds commonly stratify into
early-stage specialists, development funds and management buy-out
specialists.
What is much more usual is some form of preference for a deal
structure that becomes a house style in doing deals. They might always
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The key issues of discovery
use some form of investment ratchet to ‘give away’ some of their
entitlement of equity as an incentive to high-performing managers, or,
instead, reverse ratchets which take equity away from low performers
(for greater detail on this mechanism, see Chapter 7). These oftenunelaborated operational rules will be borne out of the experience of
the individual manager and the experience of the fund or venture
house that he is working for. Sometimes they might be explained,
sometimes not. Sometimes they might result from a positive experience, sometimes from a very negative one.
Unfortunately a proposal that falls foul of a particular prejudice at
the first hurdle might never receive a full explanation as to why it was
not proceeded with, even though it might be one purely specific to that
investment house. Most rejection letters are couched in fairly broad
terms – stock phrases like ‘not in line with portfolio requirements’;
‘fully invested in this sector’; ‘did not pass our initial requirements for
investment’ – so as to prevent entrepreneurs quibbling with the detail
of the rejection.
The one area that can never be disregarded is that the primary
objective of the VC will be to reduce his risk by trying to structure the
investment in such a way that he is the last one to get burnt if things
go wrong and the first one to get out whichever way the investment
goes – good or bad. But first he will be interested in discovering as
much as he possibly can about the business. There are four principal
reasons for doing this – two basic ones (which apply to all investors)
and two administrative ones (which apply mostly to fund managers):
1. The VC wants to make sure that he fully understands the risks
involved in the business as well as the rewards and opportunities.
2. He wants to be able to understand the way that the business works
– and is likely to work once cash is put in – so that he can devise a
structure for the business which makes sense given the risk profile
he perceives.
The two reasons above fall into the category of investment risk
minimization.
3. He wants to know sufficient about the business that he can brief
the professionals who will be working on his behalf – the
reporting accountants about what particularly to investigate;
and the lawyers about how to prepare the draft agreements.
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4. He wants to make sure that if there are any questions at the point
where an investment committee considers the proposal, he is
able to answer them authoritatively.
The last two reasons fall into the category of personal risk avoidance –
the technical term for which, not only in venture capital circles, is ‘bum
covering’.
The due diligence process
The house style that results from particular ways of looking at investment opportunities will result in particular ways of investigating
proposals depending on what each individual thinks are the most
important factors that contribute to a successful investment. A little
personal history may help illuminate this.
During the time that I worked at the Coal Board Pension Fund’s
CINII subsidiary (which later became CinVen), I tended to regard
possible investments in manufacturing as highly attractive – both
because that was where my personal interests lay and because the
fund’s policy was to pursue such opportunities.
If it was possible, after a quick read-through of the business plan
(usually starting with the CVs of the senior managers) I would try to
find out a bit about the industry by looking at some economic statistics
and maybe some stockbrokers’ sector reports. If after doing that there
was nothing that definitely turned me off the sector, and the business
plan looked reasonable, then the next step would be to visit the
company to look at the manufacturing plant.
By doing this I could gain an impression of the way that the business
was run so that I could then talk at greater length to the management
about the detail of the business plan. That would let me ask informed
questions – although I was usually careful not to seem too informed
since I wanted the management to tell me what they wanted to tell me,
not to try to impose my own prejudices on the story that they could tell.
Apart from everything else, if what they told me contradicted what I
had already found out through my background reading and my tour,
then I most definitely wanted to know that too.
If all this added up over a series of meetings – each one of which
might last an hour and a half to two hours and would cover a different
aspect of the business plan: first the market; then the cash flow and
profit forecasts, then the personnel and management team – and I felt
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that there was the prospect of a good investment, then I would make a
preliminary report to the investment committee. The assumption at
CINII was that we wanted to do deals (finding cash to invest was not
a problem; finding good deals was) and so this was usually forthcoming.
It was at this point that we would discuss a deal structure informally
with the management – based on preliminary calculations about
profitability and projected price–earnings (P/E) ratios – and if these
went well we would appoint investigating accountants to review the
business.
I am not sure if my approach in going to this next step mirrored that
of my colleagues but in my commissioning brief I used to ask the
investigating accountants to concern themselves with only three things.
The first was the working capital requirements of the business as
identified in the current year, the second was the projections for
working capital as contained in the business plan and the third was the
tax calculations that the company had made in its business plan. I
reckoned that a detailed examination of these three aspects of the
company’s plan by outsiders who possessed technical skills that I did
not, would reveal all that I needed to know about the business that I
could not find out by myself.
In particular, I did not want the accountants to waste time and
money reciting the details of the business’s history and structure to me
– that was easily investigated and usually contained in the business
plan. I reckoned I could ferret out any inconsistencies. Similarly, my
own background meant that I was as least as well qualified to make a
judgement about the management’s individual and collective strengths
and weaknesses as the accountants. Lastly, I could evaluate the
business plan against the market background – again as a consequence
of my own experience and professional skills.
What I wanted the specialists to concentrate on was whether the
plans that the business had presented were:
n
sound, coherent and complete;
n
flawed by some fundamental initial problem that pre-dated the
business plan; or
n
full of gaping holes.
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Venture capital funding
all in terms of the working capital of the business – the cash needed to fund
suppliers, stock and customers.
The reason that I chose to concentrate on this was that I always felt
that what we were really trying to do was to provide businesses with
working capital with which to develop. The cash we injected in
development capital plays, in return for a stake in the business, would
be used at root to fund changes in stock, debtors and creditors. So my
own particular way of thinking about investment conditioned my
approach to investigation and evaluation.
I wanted to minimize my risk of having to be asked to put in more
cash at some later date because the cash needs of one of the three legs
of working capital – stock, customers or creditors – had been underestimated initially. The later problems that I had with investments
usually revolved around one of those aspects and so my accumulating
experience developed and modified my approach to investing – in
other words, the approach I adopted to reducing my risks.
The strategy I had devised for minimizing the risk in assessing
investment opportunities that I was presented with was to concentrate
on a few critical aspects of the business’s operations. I had identified
some aspects which I believed to be fundamental to the success of the
investment and I concluded that I needed to understand those in depth
so that I could assess the likelihood of failure of what might otherwise
seem to be a good risk. No doubt other VCs adopt similar strategies
but may have different priorities in evaluating what makes a successful
investment.
Investment fees
One of the prickliest issues encountered in raising cash is the request
that many funds make for fees to investigate the proposal. These
can usually be negotiated and should certainly be capped by agreement
of both parties. Accountants’ reports will certainly have to be paid
for by the company seeking to raise the cash, and some firms ask for
the costs of market and technology reviews to be underwritten as
well. These requests will usually be contained in the term sheet
and, with confidentiality and exclusivity provisions, will be the only
binding clauses in that document. The timing of the investor’s presentation of the term sheet to the company is a bit chicken-and-egg. Too
early and there will have been insufficient basic investigations to give
the term sheet a sensible structure; much later, and the deal will have
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The key issues of discovery
got under way with costs already incurred and no one responsible for
them.
However, management should note the following: very early presentation of term sheets will almost certainly result in the structure of the
deal being substantially reworked – and this is always to the detriment
of the company. It often says more about the investor’s desire to trap
the proposal and to cover his costs rather than any urgent desire to do
this particular deal.
To demonstrate the range of issues that have to be dealt with during
due diligence we shall now go through an extended trip – not abbreviated as in the anecdotal example above – through the analytical
process. As such it will probably not be typical since it will aim to
identify as many as possible of the separate issues that would come up
whereas, in practice, many of these will be eliminated from any
particular investigation as individual investors place greater or lesser
weight on some aspects.
In addition, the sequence as described suggests that the process is
strictly sequential whereas some tasks will be completed concurrently,
and there will be continual interruptions – in a large fund, at least – as
completions and monitoring duties intrude into the working week.
Some investors may also take some steps out of the sequence that is
suggested here – for instance in looking at the technology before the
market or perhaps looking at detailed management issues after visiting
the factories. Some funds may commission an accountants’ review
before the final review of the business plan so as to incorporate the
findings in a summary review; others may wait until they have
discussed the financial data so as to find out what further details
they want to have examined in detail. Usually there is some basic
research done before the issuing of a term sheet (see Chapter 10) when
things start to get serious. But almost always the first step is a desk
review.
Stage 1
Desk review
Issues covered
There is no set procedure for desk reviews. In some funds, the first
review of the proposal may well be undertaken by a junior member of
the investment house – if it is a large fund that the proposal has been
sent to – or equally all proposals may be reviewed in summary form
by the senior member of the fund to ensure that good opportunities
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Venture capital funding
are not being missed. It doesn’t really matter – what is important is that
the first review will be fairly cursory and that a number of features have
to stand out if the proposal is to get any further:
1. The preliminary estimate of the rate of return has to be attractive
(this is not necessarily something within the control of the management team putting the deal up, as we have already seen); preliminar y rates of return are usually done on the backs of envelopes
using a combination of pre-tax profits and modest P/E multiples.
2. The proposal should be complete – a complete business plan (not
only the summary cash flow, estimated profit and loss and balance
sheet); complete financial information; market appreciation;
opportunity rationale; business history; complete CVs; and a good
summary that will attract further examination, are essentials.
3. The technology – if there is a proprietary edge to it – should be
robust.
4. It has to be appropriate to the requirements of the fund – it will be
no good sending a biotech investment to a software fund, for
instance.
In the case of a business angel being the targeted potential investor, the
likelihood is that the introduction will come from some sort of presentation (if the business is entering a formal fundraising process) at an
investment forum. These will (usually) be held in the evening, perhaps
at a local hotel, where five or six businesses will get the chance to
explain the basics of their proposition in a 5 to 10 or maybe 15-minute
presentation to a group of potential angels. The organizers of the event
should have given the businesses some coaching in how to make a
presentation of this brevity and how to pull out the major points to
attract investors. After these brief introductions the angels are then free
to approach the businesses individually to discuss matters further. The
investment forum will take no further part in the process leaving it up
to the parties to hammer out the terms themselves.
Commentary
Point 1
In the last chapter we introduced the concept of the hurdle rate that
venture capital opportunities have to clear before anyone is going to
be interested in investing. An investor will expect to see something
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The key issues of discovery
around a minimum potential 25 per cent per annum compound growth
when he completes his initial calculations. That means the business
doubles in size every five years. In fact, it is not too difficult to achieve
that sort of rate of growth if a market is expanding fast, if there are
plenty of efficiency gains that can be made in a business as it gets bigger
and if the market recognizes the value of the company by ascribing an
increasing multiple to the value of its earnings. Most venture investors
will want to see a sequence of accounts from three years back to see if
the projections can be derived logically from the history of the business,
but a detailed review of past years’ accounts will probably wait until
the formal due diligence process begins (after a preliminary approval
from an investment committee).
Point 2
No one will waste any time looking at a proposal if it is not immediately apparent that it is complete and answers most of the initial
questions that the investor will want to know – market opportunity;
likely rewards; who’s going to be running the business and what
experience they have.
Point 3
Larger funds will have in-house experience that they will bring to bear
on assessing technologies – but this will only be at a preliminary level,
initially. More detailed work will need the assistance of specialists
which will probably be done on a contractual detailed basis, later.
Point 4
The needs of the fund you approach will be determined by all sorts of
things – not least of which will be the type of deal that they have most
recently done. There is very little way of knowing what will attract a
generalist fund at any given point. The tastes of specialist funds are
more obviously ascertainable.
Stage 2 Management called in to discuss proposal
Issues covered
If everything appears to make sense and hits the right buttons at the
preliminary review, then the chances are that the next stage will be for
the fund manager allocated the responsibility for the deal to ask the
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Venture capital funding
management team to come into the fund’s offices to talk over the
proposal in general terms. This is not so much a truly exploratory
meeting where the details of the proposal are discussed as an opportunity for the manager to study the individuals who will form the team.
There are a number of things he will be looking for at this stage:
evidence of cohesion among the team; evidence of leadership; evidence
of knowledgeability concerning the marketplace; unanimity of purpose
in respect of the outcomes of the deal.
The fund manager will also discuss the fund’s particular approach
to deals of the type that is being presented. However, it has to be said
that relatively few proposals get turfed out at this stage. If you have
made it to the point where the fund wants to meet you then the chances
are that they are serious about proceeding. That, of course, is no
guarantee of a successful conclusion to the process. Much ground has
yet to be covered.
It is at this stage that due diligence as such really commences – after
the decision has been taken to proceed in principle. Many funds will
present companies with a term sheet at this stage (see Chapter 10) to
enable them to demand some form of exclusivity, and to provide some
form of fee underwriting for the expenses that are about to be incurred.
Fees, if they are charged, should only cover the costs of externally
provided advice – about things like technology or markets or legal
affairs. The basic investigative costs should be borne by the VC.
The specific purposes of due diligence that the investigators will
have in mind when they visit the company or review its activities can
be summarized as follows (they all follow the general objective of
reducing risk):
1. checking the financial valuation of the target by analysing the
assumptions of the business plan;
2. discovering factors that may lead to a reduction in the price of the
target;
3. identifying areas that need to be protected by specific warranties
to be given by management;
4. discovering areas that may need the consent of others for the deal
to be able to go ahead successfully (property rights or product
licences for instance);
5. identification of areas for improvement after the deal is completed.
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The key issues of discovery
Stage 3
Company visits
Issues covered
Assuming that none of your management colleagues have two heads
and/or particularly unpleasant social habits then the likelihood is that
the fund manager will want to make a visit to the company shortly after
the preliminary meeting. This visit (more likely visits in the plural) will
include the factory (or factories) and any remote sites – for instance
R&D or distribution depots if separate from the factory. It is not
very usual for approaches to be made to customers at this stage –
unless the proposal is for a start-up where there is not much else to
investigate apart from potential customers and technology. That comes
later.
The particular points that are likely to be covered at this stage will
include the following:
1. the age, state, suitability and location of the physical fabric of the
factory and offices;
2. the production plant and equipment – suitability; age; layout;
technological generation;
3. ownership of the factory and plant;
4. production capacity considerations;
5. sub-contract arrangements (if any);
6. key suppliers – location; dependency;
7. capital expenditure plans and surplus equipment (if any);
8. workforce – key workers; skill level; local availability; turnover
rate; salary levels; unionization (if any); employment policies;
payment terms (hourly/piecework/bonus details);
9. regulatory requirements – health and safety considerations;
hazardous material usage; discharge permits; records of infractions of any of these;
10. stock levels;
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Venture capital funding
11.
quality control procedures;
12. costing methods.
This list is obviously extensive (but may not be exhaustive) and it is
likely to be covered over three or four sessions of increasingly detailed
investigation of the business rather than in one big swoop. The likely
detail of the investigation is dealt with below.
Commentary
Point 1
The investor should be concerned to find out about the suitability of
the plant of the business that he is investing in. This will include an
examination of the physical state of the factory to see if it is in good
repair; its physical suitability to the production process in terms of
layout; the location of the place in terms of accessibility and ease of use;
the scope for expansion.
Point 2
A similar process of consideration will be applied to the production
equipment and plant – how old is the production equipment; is it
technologically up to date; will it need replacement to cope with the
needs of the expanding business in a short time?
Point 3
Are the factory and the plant owned outright or leased or mortgaged?
Is the plant leased or on hire purchase? What are the terms of the
property lease? Are there penalty clauses for early cessation?
Point 4
Is the current level of production at or close to capacity? Has provision
been made for expansion? Can the workforce, the plant and the factory
itself cope with the expansion that the business plan anticipates?
Point 5
Is any part of the production process sub-contracted to another
business (or another factory in the same group)? What are the risks of
this? Is there any danger of disruption to production in consequence?
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The key issues of discovery
Point 6
How far away are the key suppliers? Are they dependent on the
business for their existence? Are they replaceable in the event of
problems? How dependent on one or two key suppliers is the business
being investigated?
Point 7
What are the business’s capital expenditure plans with specific reference to the existing plant? Is there any surplus equipment available to
defray these plans? Is there a market for surplus equipment? What is
the rate of technological change of plant?
Point 8
How far do the workers travel to get to the factory? What is the rate of
turnover of staff? What is the rate of absenteeism? How many of the
workers are key to the business? How old are the key workers? What
are the key skills required and how long does training take? Is recruitment possible locally? On what basis is payment made to staff –
through piecework, hourly rates or flat salary? Are bonuses paid? Is
there a union in the factory or the group or some other form of
collective bargaining arrangement? Is the management aware of
forthcoming legislation regarding issues like pay rates/maternity leave
provisions/ staff consultation? Is there a dedicated personnel function?
Is there a pension fund and is it fully funded?
Point 9
What particular regulations govern the operation of the factory and
offices? Are appropriate insurance policies in place and are they up to
date? What is the record of infractions? Does proper staff training take
place to deal with emergencies?
Point 10
In touring the factory the alert investor will be looking at the levels of
stock that are held and making his own assessment of this slickness of
this aspect of the business. But in particular there are a number of issues
that will need to be examined, such as: What is the seasonality of stock
holding? Can the available stock-holding space cope with seasonal
changes? What are prices of raw materials doing and do they change
seasonally? What is the wastage rate of stock? How is stock control
physically effected? What is physical security like? Is stock fully
integrated into production accounting? If not, why not?
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Venture capital funding
Point 11
What are the procedures for ensuring consistent (high) quality? Does
the firm operate any formalized quality control procedures – ISO9000
(of dubious value); AQAP (better); total quality management (TQM:
better still)? Who is responsible for the enforcement of quality control?
Point 12
How is costing performed? This is a question specifically for the
operations manager – to see if he or she understands the theoretical
basis of the control system. The answer should match the one given
(later) by the finance director.
Coincident with this stage of the examination of the business, if there
is a technology aspect to the proposal then the chances are that the fund
manager or investor will be farming this out to specialists. Very few
funds have the necessary expertise held in-house to enable them to
adjudicate on matters of advanced technology. In fact, in cases where
the technology is very advanced, the management team may be asked
to suggest suitable referees who can advise on the technology from
among the ranks of academic researchers. If there is a piece of intellectual property involved at the centre of the deal, then patent agents may
also be called in to comment on the registration of the patents.
Questions will also be being asked about how the specific technology
of the business fits in with market patterns and likely future developments. The investor is always thinking of how to reduce the risk
associated with the investment and in a technology-based opportunity
this is particularly important.
Stage 4 Market review
Issues covered
The best way of trying to find out about the market is to use comparative data from competitors’ published information and market reviews.
The investor who is based in a large investment fund will probably
have plentiful access to such data; the business angel may be thrown
back on his own resources or on verifying information provided by the
company. If the deal being proposed is a development deal then the
historic sales records of the business will give a good idea of both the
likely type of customer and the pattern of trading – both annually and
seasonally.
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The key issues of discovery
Specific information that is likely to be requested or reviewed will
include the following:
1. existing order book;
2. order backlog, if any;
3. rate of growth of the market;
4. size of the customer base – both now and anticipated;
5. identification of major threats to the business’s sales strategy;
6. information about how much custom is repeat business and how
much is new;
7. sales forecast construction;
8. pricing policies;
9. competitors’ offerings;
10. profiles of major competitors – possibly with a SWOT analysis;
11.
information about the organization of the sales aim;
12. detailed information about the sales strategy – possibly broken
down by geographical area and/or market stratification;
13. warranty periods;
14. customer complaints received;
15. credit terms offered.
The reasoning behind these questions is fairly straightforward – the
investor wants to know as much as possible about the detail of how
the business is going to achieve its sales forecasts. It is absolutely crucial
for the investor to determine whether the sales forecasts have been built
up on sensible information or simply for the purpose of making the
proposal an attractive one in financial terms. This means more than
simply ensuring that the sales director was involved in the budgeting
process. Ideally, individual sales managers will be able to display
confidence in the realism of the forecasts, which may have to be broken
down for verification at the product or sales area level. This has to be
done with a degree of sensitivity since it is not helpful to future
relationships inside the company to suggest that the forecasts are acts
of pure imagination. Skilled investors will be able to elicit the opinion
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Venture capital funding
of the sales force without apparently casting doubt on the ability of the
sales director to forecast sales patterns. Whatever it takes, it has to be
done. As far as the eventual success of the business is concerned,
everything will rest on the robustness of the income line.
Stage 5
Customer review and supplier review
Issues covered
Investors are generally quite sensitive to the need to be discrete when
investigating opportunities and will hold off alerting customers and
competitors to the plans of the target company until necessary.
Sometimes, of course, the need to ask questions will have to be tackled
fairly early on – specific situations will dictate the run of events.
Competitors are rarely asked about the subject company. It would
be unethical to do so and to expect a neutral answer would be unreasonable, if the background to the questioning were known. Questions
are usually only asked of customers and suppliers when the target
company has few customers and they are significantly important in the
future plans of the company.
Suppliers may well be asked questions when the company relies
heavily on one or two for critical components or services. Credit
reviews and reports will also be utilized to gain a rounded view of the
risk that the investment runs from problems with, or in, a supplier.
Generally speaking, VCs do not ask for the proposing company to
defray the costs of such expenditure. If potential investors do intend
to ask the target to underwrite expenditure of this nature then it should
be done early on in the process so that the company can make a
decision before the investigation has gone a long way and the company
is committed to negotiating with one investor.
Stage 6 Financial and credit review
Issues covered
With the market, customer and operations reviews completed, the
process of investigation now apparently goes back to the beginning
again.
Usually after the investor has gained a greater understanding of the
business through site visits and preliminary discussions with the
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The key issues of discovery
management team, the process will revert to a detailed re-examination
of the financial data. But the purpose of the exercise this time is
different from the first time.
Initially the business plan was checked to see if it made sense in
isolation and if it offered a rate of return that was attractive – sufficiently attractive to warrant further examination but, again, in isolation
of deeper understanding of the business. The purpose of the site visits
and further discussions was to gain this further understanding and,
bluntly, to see what holes could be poked in the supposition that the
deal was a good one.
The process of financial investigation may well have begun with a
review of the last three years’ accounts (if they go back that far) to see
what the pattern of the financial years was and how the business has
progressed. Much information about present problems can be gained
by a skilled analyst by looking at a sequence of accounts.
This may well have been followed by a standard credit reference
available from any of the major credit agencies. If this is checked out
reasonably well, then the investigation will have proceeded without
interruption. At some time during the site visits the investor should
also have checked to see if the business has ever had any County Court
Judgements (CCJs) made against it for non-payment of debts. These
arise in all sorts of companies, including the big plcs, and if they show
up they should be investigated thoroughly. CCJs will be recorded on
the company’s credit reference or can be obtained from a separate
Companies House search.
With the permission of the target company, the clearing bank may
have been approached for discussions about the past history of the
accounts and the future attitude of the bank towards the company with
an additional investor on board. If additional facilities are required as
part of a package of funds it may well be that the potential investor
and the company approach the bank together, once the deal is settled.
However, in general, British banking custom does not permit the sort
of probing (read ‘impudent’, if you are on the European side of the
Atlantic) questions that US investors may well be used to asking about
the banks who supply credit to businesses in the United States.
The investor will almost certainly have discussed the company’s
affairs with the auditors to see what skeletons may have been unearthed during previous audits. The company’s permission for this is
required, of course, so it will not have been done without their
company’s knowledge. Much useful information about the robustness
or otherwise of a company’s systems can be gained during such
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Venture capital funding
conversations, and this will contribute further to the investor’s desire
to reduce the concomitant risk. Shrewd investors will certainly have
asked for access to previous management letters (completed at the
conclusion of each audit) to see what recommendations the auditors
have made about the company’s financial position and the operation
of its systems.
The purpose of the second review of the financial aspects of the
business plan will be to understand how the physical operations and
constraints of the business fit with the financial projections that have
been made. The discussions this time will probably be mostly with the
finance director of the business. The intention is not to trip anybody
up, but to progress further down the road to securing the investor’s
continual objective of minimizing risk.
The investor will want to make sure that what he has learned in
poking around in the business is reflected in the financial plans, and
that he fully understands the reasoning for changes in the structure of
the business plan. These changes should, of course, mirror changes in
the business that will take place after the investment and during the
step-change that the injection is bringing about. If it has been properly
prepared then the business plan will only be fully comprehensible in
the light of the additional knowledge that the investor will have gained
during the investigations. A sophisticated treatment of the numbers for
a business that is undergoing a serious step-change is unlikely to show
an unflinchingly upward progression of the arithmetic. And one of the
measures that the investor will rate the business plan on, is the
sophistication of the treatment of the numbers – that is, he will expect
sophistication, not unnecessary complexity.
With the better understanding that the investor will have from the
visits and detailed investigation of the business, the premises of the
business plan can now be more thoroughly explored. Specific points
that might be covered at this stage will be concerned principally with
change:
1. Is there an increased demand for working capital as a consequence
of expansion? And if so, what is the magnitude associated with
volume changes and what amount is due to product change?
2. How will the plans for the changes in the business affect existing
capacity and the mix of plant?
3. How will the cash that is being sought be used – precisely? Is there
scope for phasing the injections of cash?
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The key issues of discovery
4. What additional marketing burdens will be placed on the business
by the plans that are being contemplated?
5. Are the changes that are being contemplated reasonable in the light
of the historical information prepared by the company?
6. Will gross margin change uniformly? Are straight increases in
margin (if they appear, for instance) realistic in the face of having
to build up capacity to attack new markets?
And so on.
If the discussions with the auditors revealed weakness in the
accounting systems, then the investor will need to be reassured that
these have been remedied. This will go beyond warm words and
comforting smiles. It is likely that the investor will require a completion
audit (see below) – especially if a large fund is involved – and there
will be specific requests in the instruction letter that goes to the auditors
to ensure that the problems revealed by previous management letters
have been tackled.
Stage 7
Accountants’ investigation
Issues covered
Accountants’ investigations are almost always paid for by the proposing company – the only exception being where a parent company is
disposing of a business and offers to pay for a completion audit as part
of the deal. This is sometimes done as a gesture of goodwill to help the
departing managers, sometimes to speed up the process of disposal.
Because of the financial significance (in both senses – for the company’s
proposal and the size of the exercise) of investigations, they are rarely
taken now without a term sheet having been presented, agreed and
signed, signifying that the company raising the cash will pick up the
bill.
Some investors – particularly those leading syndicates or where the
time between the deal being proposed and completed is extended or
where a subsidiary is being bought out – will also require a completion
audit.
The completion audit and the accountants’ review are not the same
thing and it may be that both exercises will be required in any
case. However, it may be possible for the two to be combined if the
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Venture capital funding
investigation is relatively straightforward. Problems arise, of course,
when the investigation part of the exercise discloses issues which have
to be cleared before completion of the deal can take place. However,
on the plus side, you can be almost sure at this stage that this is more
or less the last of the acceptance hurdles to be jumped. If the accountants’ review is satisfactory, then the deal will almost certainly proceed
to legal stages. However, very few reviews ever come out completely
clean. This is for three very good reasons:
1. The investigators want to appear to earn their crusts by finding
something wrong in the forecasts.
2. There is usually something that can be criticized.
3. The investigating accountants will be very reluctant to pass a
completely unqualified judgement since they will always fear for
their liability if something goes wrong with the deal subsequently.
Disclaimers will abound in any investigating report and the terms
of the remit will have to be very strictly defined before it goes
ahead.
The extent of the remit given to the investigating accountants will vary
between investors and possibly even between individual managers
within the same fund, as suggested in the opening remarks of this
chapter.
As a minimum, the accountants will be asked to verify the existing
levels of working capital and to make such comments as they think fit
on the business’s plans for the future. Some potential investors may
want a review to be conducted which will approach the levels of
diligence of an audit, in addition to a completion audit. This may then
cover a good deal of historical and statutory information. The purpose
of this is presumably to verify that the past record of the company has
been as described. The content will more usually be dependent on the
nature of the proposal being put forward – a start-up has little to audit,
after all, but complicated or fast-changing business may require a beltand-braces approach.
In general, larger deals tend to require more complicated investigations and angels tend to be fairly robust in what they really want to
find out, being more amenable to paring investigations down to the
bones. Financially qualified angels may well feel comfortable with the
level of due diligence that they are able to complete themselves; there
is, after all, no law that says you have to have an investigation.
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The key issues of discovery
It is unusual for the business’s auditors to be asked to conduct the
investigation, since the incoming investor usually wants an unbiased
third-party opinion, but it is sometimes acceptable for a partner from
a different office of the same firm of accountants to conduct the review.
The investigation, if commissioned by someone who knows what they
are doing, should not be regarded as a substitute for the exercise of an
investor’s judgement but should be a support to the process of making
a judgement.
The duration of the investigation is likely to be very short – and the
amount of effort required by both the accountants and the company
being investigated is consequently intense. The purpose is not to spend
a leisurely time getting to know the company but to blitz the task and
get a report to the potential investor as quickly as possible. Investigations rarely go beyond a couple of weeks from commissioning to
reporting. The accountants want to take a snapshot, not a home movie,
and that is what the investor is also expecting.
Discriminating investors will be able to pick out the important
details of an investigating accountants’ report and concentrate on them
with a view to modifying the structure of the deal – unless, of course,
the report is so damning that it kills the proposal stone dead.
Occasionally such an adverse report may be received that the deal
does die there and then. The fallout from such a deal can be toxic – but
it is not usually without warning. I once commissioned a report that
revealed that inadequate stock checks for the annual audit had been
performed in a business (which was very highly seasonal and dealt in
very perishable stock) since the term of the current auditors began. This
meant that it would have been three years before a completely clean
record could be established for the accounts; not surprisingly, we
withdrew from the deal forthwith.
The senior partner of the auditing office landed in very hot water
for that one and the company, which knew all about the auditors’
practice of accepting their stock records without independent checking,
suffered badly in reorganizing its accounts. At one stage it was touchand-go whether it would make it, since the clearing bank (which had
a floating charge on certain fixed assets, debtors and stock) got very
windy about the whole affair. The moral of the story is not to even think
about seeking venture capital if you know there are huge clanking
skeletons in your cupboard. The irony was that the report had been
commissioned (against my better judgement) from a sister office of the
firm of accountants that had been conducting the audit.
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Checking all the planks of a business plan can go on forever and
become a substitute for actually making a decision. It is sometimes the
way that an investor who does not want to complete a deal can avoid
being brought to the sticking point – there is always something more
that needs checking. The management team cannot completely avoid
this possibility, but should ensure that they ask for a detailed discussion
about the due diligence at the outset of the process so as to establish a
common (rough) timetable for doing the deal. To paraphrase Donald
Rumsfeld, there will always be certain things that the investor will not
know he does not know until he comes across them – which will extend
a review of a proposal beyond the expected time – but an experienced
investor should have a very good idea of what the vulnerable parts of
a proposal are and how he intends to assure himself about the risk
attached.
The purpose of all this investigation – from the initial basic desk
review to the completion of the expensive accountants’ report – is to
help the investor understand the risks involved in pursuing the
opportunity. The physical end of the process is the preparation of a
report to the investment committee, leading to an approval of funds
to proceed. We now need to look briefly at the committee.
The investment committee
Business angels take decisions on their own about whether or not to
invest their own money. The deal goes from presentation to investigation to negotiation to legal stages without interruption. This is not quite
the case with investment funds: there is a break point at the stage where
formal approval for the deal has to be obtained. Investment managers
usually have to have their investments cleared by an investment
committee that will usually consist of senior executives of the fund (if
the fund is modestly sized) together with a sprinkling of outside ‘wise
men’ (and/or women) if the fund is substantial. These non-executives
will be senior financiers (perhaps retired); senior business leaders and
perhaps the odd academic (the adjective is used advisedly).
The idea of having investment committees is that the investing
executive has to convince his colleagues that the deal is a sufficiently
good one for them to want to give the go-ahead for the investment. The
committee reviews papers presented them by the fund managers that
request both the approval of the investment and the release of funds
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The key issues of discovery
to make the investment. The papers will be prepared to a set format
(‘house style’) and will contain the following information:
n
summary of the proposal;
n
history of the business;
n
CVs of the management;
n
market report;
n
major risks analysis;
n
deal structure proposal – including details of syndication partners,
if any; and details of management’s financial contribution, if any;
n
calculation of the likely internal rate of return of the deal (IRR) on
explicit assumptions;
n
detailed financial information;
n
summary of the investigating accountants’ report.
The sequence of this information and use of appendices to contain
detail will be dependent upon the individual fund. Much use will be
made of the information prepared by the company together with any
expert reports on technology that have been commissioned. The papers
are confidential and will not be disclosed to the company with which
they deal.
Investment committees usually meet at regular intervals (in large
organizations) and often consider several proposals together. In smaller
organizations the meetings may be held as and when required –
perhaps to consider individual proposals.
Whatever their frequency or composition, investment committees
are not pushovers. Their powers of dismissal are real and are exercised.
They do not automatically approve investments – few will be dismissed outright but some investment proposals will be sent back to the
manager for reworking of the investment structure to get a better return
or to minimize a perceived risk. Sometimes this will mean that the deal
that has been submitted by the investment manager will have to be
renegotiated with the management of the business; sometimes it may
mean that the committee was unhappy with some aspect of the review
and wants it to be investigated further. Once reworked the review will
then be resubmitted. If the committee’s concerns have been met then
the deal probably gets approval.
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With approval, the fund may or may not send out a formal offer
letter that repeats the terms on which the committee has approved the
deal, and this is usually counter-signed by the company to signify that
they have received and understood the structure of the deal. With both
parties having signified that they have the capacity to proceed, it’s off
to the races – or rather to the solicitors.
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The choice of investment vehicle
9
The choice of investment
vehicle: existing business
or newco?
Corporation, n: an ingenious device for obtaining individual
profit without individual responsibility.
Ambrose Bierce, The Devil’s Dictionary
n
Factors involved in determining the investment vehicle
n
Type of investment
n
Realization intentions
n
Trading record
n
Complexity
n
Tax
n
The impact of structure on the return to investors
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Venture capital funding
Following on from negotiations with the existing shareholders – and
in fact sometimes part of that discussion – will be discussions and
negotiations between the investors and the entrepreneurs over the
choice of investment vehicle. In other words, will the investment be
made in the company currently owned by the management or in
another one specially created for the purpose – a ‘newco’?
This may seem to be one of those dry-as-dust academic questions
best left to the lawyers – but in fact it can have significant impact on
what happens a little further down the line when the investment comes
to be realized, and so it is worth spending a little time considering the
pros and cons of the various options.
Not the least of the considerations about the type of investment
vehicle will be the financial structure that results from the negotiations
between the new investor and the management who are going to
run the business. The financial structure chosen for the investment
will have a significant impact on how much the investment is
worth when it is realized. Needless to say, it will result substantially
from the investors’ desire to minimize the risks that they run in the
investment.
Financial structures cannot be designed in isolation from considerations of the scale, type, purpose and likely outcome of the investment
and are almost certainly going to be tailored to the special characteristics of each individual investment. There are preferred house styles
– 3i used to have one particular style of investment which was
reasonably easy to identify because of its inclusion of redeemable
shares, which boost the value of the remaining equity – but the market
is now very homogeneous in its choice of financial instruments, and
so the differences mostly amount to variations around a theme. That
is useful for us because it means that we can describe the basic types
fairly simply.
As far as making any proposals in the business plan is concerned, it
is probably very unwise to take any pre-emptive decisions about
structure before both the quantum and the specific arrangements for
the money are agreed. But it is essential for the managers of the
business to understand how the corporate structure can influence the
financial structure.
There are (at least) four major commercial factors, and one subsidiary
one (tax), in deciding whether you are going to have a new company
to play with or use an existing one. These are:
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The choice of investment vehicle
n
The investment type that is being made – broadly, speaking
whether the investment falls into the classification of start-up or
development capital; buy-out or recovery. Considerations of the
existing shareholding structure might also impinge on this.
n
The intention of the parties in realizing the investment – again
broadly, whether there is going to be a flotation or a trade sale; or
are further acquisitions going to be made? or is there already
evidence that some form of additional financing will be required
at some point down the path?
n
The trading record of the existing business – if it is consistent then
that would argue perhaps for a different approach from one where
the record has been patchy; if it is very variable (perhaps even
because something as trivial as head office charges that have been
levied) then again that might argue for a different choice of
investment vehicle than if there had been a historically strong
(perhaps even accelerating) record of stand-alone growth.
n
The complexity of the investment – whether there are multiple
divisions; or a research and development business feeding marketing arms; whether there are now, or likely to be in the future,
manufacturing and service functions serving the same or different
customers, may all affect the choice of vehicle.
n
Taxation considerations may very occasionally dictate the choice
of vehicle in special cases. While tax efficiency for all involved is a
laudable aim in the detail of an investment, it is probably not going
to be a very good investment if the sole consideration in deciding
a commercial structure is a desire to avoid some tax statute. There
is a danger – which must be avoided – that the fiscal tail will wag
the financial dog if taxation concerns are elevated above their
rightful station.
The combination and significance of these factors will have various
influences on the way that the business is structured. Professional help
will certainly be required to sort out the tangle of influences and to
design the correct structure. Since all the turmoil of a legal agreement
is being entered into then it might be best to roll the costs of reorganization into this process at the same time.
Looking at the detail of the factors outlined above will illuminate
some of the considerations that have to be borne in mind.
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Venture capital funding
Type of investment
Development capital and start-up deals may well sit comfortably inside
an existing company but the chances are that a buy-out will require a
new company to be created that can purchase either the assets or the
business from the existing owners.
Sales of divisions of larger businesses usually require the creation of
a newco. Attempts by the seller to be helpful by shovelling the elements
to be bought out into one company – possibly a previously dormant
subsidiary – are unlikely to turn out to be so. It is far better to have the
assets for sale identified but to leave the choice of vehicle to the time
when the deal is ready to be done.
The choice of buying either assets or the business is one of those
situations where tax considerations can be pivotal in determining the
structure of the investment vehicle. And in the case of the buy-out the
whole arrangement is complicated by the vendor also having tax
interests that will probably need to be protected. It is often very much
simpler to create a new share structure, which can then be used ‘clean’.
With special consideration having to be given to the facts of each case,
it is not really possible to generalize further about what sort of structure
suits what sort of situation: the eventual choice will be decided by the
circumstances, the current tax regime and professional advice.
Realization considerations
Once you have considered what option you would like to follow in
either continuing with the existing business or substituting a new one,
you have to place the overlay of realization intentions over the decision.
If you are going to try to float a business, then it needs a substantial
trading record before it can be taken to public investors – at least three
years of trading. Thoughtless elimination of an existing record even if
it is not a terribly exciting one (such as occurs by employing a newco
as the investment vehicle) could cost you dear in terms of extra time
required to establish the record. A sale to a trade buyer does not carry
such considerations, and if that is your aim then the trading record may
not be so important. (But what happens if you and your investors
change your minds?) If you can see that there is going to be more
money required in the future to bring the business to its fully-exploitable level (such as often happens with angel-backed deals, for instance)
then you should choose a structure which will allow some ‘room’ for
shareholder expansion and does not require, at the extreme, blow-out
financing to bring about change. This probably means a straight equity
deal with no funny money tucked away into redeemable preference
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The choice of investment vehicle
shares or convertibles. Start-ups are better served by such structures
anyway – most business angels know this and shy away from structurally complicated deals.
Trading record
If the business that the incoming financiers are investing in has a patchy
trading record or is too closely associated with the business that it is
being bought from, then it might be that the investors persuade the
management of the attraction of an entirely new company through
which to make the investment. The timescale that the management
suggests for the realization of the investment will also have a bearing
on this – for instance, if the intention is to take the company to a flotation. But cutting ties with a dominating parent can also be a strategic
move to establish a new identity and make customers and the investment community at large aware that the business is under new
management with its own plans and its own operating priorities.
In the event of a purchase of a business to bring about its recovery it
might seem sensible to cut away the past history of a failing company
by creating a new trading vehicle. But it is likely to be practically
impossible to do so unless some formal insolvency arrangement is
contemplated – and even then the scope for doing so may be limited
by both the law and creditor pressure. Buying out part of a failing
business is usually best done with a newco that is set up clean and then
buys the assets that it wants from the old business.
Where there is merely a bad trading record, the options are more
flexible and will be dependent on factors such as the amount of capital
being injected; the changes being made in the management of the
business; and changes in physical and organizational structure. But
beware of jettisoning tax losses along with the old business.
Complexity
Buying a complicated business may well argue for a newco to be
utilized so that it can form the holding company of a future new group
structure. A complicated business would be one that had lots of trading
subsidiaries in different fields, owned a multitude of properties, had
trading licences or operated internationally. Buying out an existing
complicated business from a conglomerate parent and then restructuring can be a troublesome exercise; it might be better to grasp the nettle
now with a new and more commercially justifiable structure. But if
you are going to do this then you have to be careful of something
called TUPE – the Transfer of Undertakings, Protection of Employees
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Venture capital funding
regulations. You can’t buy something out with existing employee
contracts and then make unilateral changes to those contracts – the law
won’t allow you to. You also have to think carefully about the tax
implications of what you intend to do. And the battery of regulations
grows. As of March 2005, TUPE has been joined by the Information and
Consultation of Employees Regulations (2004) which provide that
employees now have to be consulted in advance about changes in the
structure or organization of the business that are likely to affect
employment. Matters covered by these regulations specifically include
mergers and acquisitions and takeovers.
Tax
Without contradicting what was stated earlier about tax considerations
not being allowed to be the main factors in determining corporate
structure, it is easy to see from the above that tax does play a significant
part in determining the structure of investments. Almost every choice
was qualified with the need to consider the tax implications of what
was being proposed. Consequently, although the commercial factors
are the ones that should be driving the deal, one of the marks of a
sophisticated management team is not to neglect entirely the issue of
tax-efficient structures. The investors will obviously have the major say
in what the structure of the deal is going to be: even a matter as
apparently straightforward as the choice between purchasing assets or
purchasing the business will have tax ramifications for the deal. But
the management team has to be aware of the tax implications of the
deal for their own interests and must be prepared to speak out in order
to have the proposed deal modified if they feel that the suggestions
being made harm their interests. It is better to have disagreements
about the structure of the deal before entering the legal stages than
during them and even better to have such disagreements out in the
open before the deal is finalized.
It may be that the current owners of the business may need to impose
a certain structure on the deal to ensure that their own liabilities are
minimized. This is often the case where the business is being purchased
from one major shareholder who is approaching retirement age, for
instance, and who wishes to take advantage of the tax provisions
offered for this contingency.
It is also at this point in the deal that managers should actively begin
to plan to minimize the impact of personal taxation on the proceeds of
the realization. Any particular arrangements that need to be made
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The choice of investment vehicle
should be introduced into the discussion about the corporate structure
at this point.
Minimizing the impact of personal tax charges in the event of a
realization can usually be achieved with some modest planning and
provided that the necessary accommodations are identified in order to
be made in the corporate structure early enough. This may not be
possible later, when less manoeuvring room is available in deciding
how the money goes in and in what form.
For instance the management may decide to use individual trust
arrangements to protect some of their likely gains, and since trusts
cannot in themselves be shareholders of a company, that prospect has
to be dealt with soon after the start of serious negotiations between
management and investors. Tax matters should not really become dealbreakers and if dealt with soon enough are unlikely to be so. They only
really become troublesome when someone neglects to warn all the
other parties about a special concern and the deal trundles along under
its own momentum with positions gradually becoming embedded and
too complicated to disentangle.
It should be obvious from this brief tour of some of the salient factors
that the decision about how to approach the choice of investment
vehicle is not one that should be taken in isolation of a review of the
circumstances of the deal. Still less should it be taken in isolation by
one party or another. Dogmatism on the part of the management team
for one preferred route without initial consultation with the investor
about the most suitable choice is a sure way of introducing angst into
the negotiations. Negotiations which start in that way are unlikely to
get very far. The deal structure that has to be settled on eventually has
to be the one that all parties can live with – not one that reflects only
one party’s preferences.
Equally if investors press for one style of investment structure
without preliminary consultation they should be challenged if the
characteristics don’t meet the aspirations of the management team. It
is usually possible for the investment to be tweaked in some way to
accommodate modest individual requirements. And lastly, professional
advisers who encourage their management clients to adopt one
particular strategy for arcane reasons of tax or personal preference will
be doing them no favours in the long run. The reason for this is that a
requirement on one particular investment structure will limit the
options available to the investor in determining the shape of the
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Venture capital funding
investment. This ambition on the part of the incoming investor to
design the investment structure is not a simple piece of ritual meddling
but an obligation to try to find the structure that best suits his overriding intention to minimize the risk he faces.
Given this biological need and aside from the implicit difficulties of
deciding on the desirability of the basic structure, it is probably
foolhardy to take any pre-emptive decisions until heads of agreement
have been settled between the parties. In fact, trying to fix a structure
that will cater for as-yet unknown developmental changes in the
business at this early stage might be taking a bridge too far. What
should be borne in mind is that whichever structure is chosen, it
should be capable of accommodating the changes that the business is
likely to experience up to the forecasting horizon. The three golden
rules are:
1. Don’t take any decisions in isolation.
2. Don’t neglect to warn other parties of any special considerations
that might apply to your plans.
3. Employ the best possible professional advice you can.
What management teams often forget in the heat of raising the cash to
do a deal (and running the business at the same time) is that they are
investors too. While the deal is likely to be imposed by the VCs in the
first instance as investors, the management are entitled to have a say
in the structure of the deal. But the management themselves will have
to make this known. If they want a certain twist to the deal incorporated into the structure, then they will have to argue it. From this it can
be appreciated that there is a fourth rule implicit from the three above:
you cannot expect anyone else to look after your interests in negotiating
the structure of the eventual investment.
The structure of the deal and the return to the
investor
Commercial considerations will affect the choice of deal structure, as
the sections above have shown. But that is only part of the story.
Internally to the deal, once the choice of vehicle has been made, the
investor will be anxious to adopt a financial structure for the business
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The choice of investment vehicle
that secures his primary objective of reducing the risk to which his
investment is exposed. There is not a lot that the investor can do about
market risk (and by entering the deal he is presumably content with
the risk/reward ratio for that element of the deal). So the investor will
then move back to the part of the deal that is controllable – the way
that the money actually goes into the business.
Venture capital deals are equity investments. Investors put their
money in as shares and become part owners of the business. There may
be some loan stock added to balance the investment (see below) but
this is usually much less than the amount of share capital. But not all
shares are equal in their rights and obligations. VCs will make maximum use of this differential to do two things: first, make sure that they
have only the minimum amount of their investment locked in as
ordinary shares; and second, make sure that they are the first to get
their money out of any deal.
But in contradiction of these limiting requirements they will also
want to control the company, too. Ordinarily, control in a limited
company is exercised through the voting weight of ordinary shares, all
of which are equal – more shares equals more votes, equals more power
to determine the company’s strategy in those matters that can be
decided by shareholders. But by limiting the amount of ordinary shares
that they wish to hold for value reasons, VCs ostensibly limit the control
that they can exercise. They get over this contradiction by employing
different types of financial instrument to make their investments.
In order to examine fully how they do this, we need to take a small
digression to describe the various species of financial animal that
inhabit the venture capital jungle.
Financial instruments
For completeness’s sake let’s start at the beginning.
The simplest of all the financial instruments is the loan. I lend you
money for a fixed period; you pay me back at the end of the period (or
‘term’), or in instalments, and pay me interest all the while. Sometimes
the loan repayments are modest and a large chunk is saved until the
end – these loans are called ‘balloon loans’. Loans can come in lots of
different guises, but essentially the principle (no pun intended) is
always the same. The banker gets his money back at the end plus some
interest.
The loan is too simple for most VCs because it does not do what they
want – it confers no rights of ownership, except perhaps in default
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Venture capital funding
(which they are not interested in) when it commands security. So VCs
don’t make loans – they leave that to the bankers (but see below in the
section dealing with convertibles). The consequence of demanding
security, against which their loans are made, always puts bankers and
VCs in opposite camps.
Next rung up on the food chain is the ordinary share. These are the
first of the financial instruments to have rights of ownership. Ordinary
shares are permanent and live as long as the business does. They can
be added to but not reduced in number – which makes them the ideal
instrument for funding young businesses. More shares are added as the
requirement for cash increases and the rights of everyone remain the
same but the incoming shareholders dilute the voting power of existing
shareholders.
Ordinary shares usually have a right to a share of the distributable
profits of the business, which are shared among equity holders. Ordinary shares also have the right to vote at meetings of shareholders – although the rights of ordinary shares in any particular circumstance will
be determined by the terms set out in the company’s articles of association. These will be dealt with in detail in Chapter 10. Most VCs don’t
like ordinary shares for their holdings, since they don’t offer enough
scope for protecting the rights that they want to impose. They prefer
to have preferred shares, next one up in the family tree.
The ordinary share’s bigger brother is the preferred ordinary, which
is entitled to a slice of the distributable profits before the ordinary
shares. It gets its name because it is preferred in the ranking of entitlement to dividend. Voting rights may, or may not, be the same as the
ordinary shares – again, depending on what the articles say.
Top of the ordinary shares pecking order is the participating
preferred ordinary share which gets a dividend equal to some identified percentage of the distributable profits – thus PPOs are usually
called 3 per cent PPOs or 5 per cent PPOs, dependent upon their
percentage entitlement. PPOs usually also have voting rights which
are, again, determined by the company’s articles. Sometimes the name
is just kept at participating ordinary.
So far, so good. These types of share are quite basic in the form of
their rights and obligations. It is beyond this level that things start to
get slightly more complicated as the VCs start to play variations on
themes.
The chief variations are to do with convertibility rights, redemption
rights and cumulative rights to dividends. ‘Convertible’ means that the
shares change into something else on some trigger event; ‘redeemable’
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The choice of investment vehicle
means that the shares can be eliminated as a class from the company’s
balance sheet (but only out of the proceeds of a new issue of shares)
and ‘cumulative’ means that the shares have the right to catch up on
any dividends that they may have missed in previous years when there
wasn’t enough profit (and/or cash) to provide a dividend.
The situation gets really quite complicated when the variations are
multiple. Either of the preferred or participating classes can have any
one or all of the additional rights of convertibility, redemption or
cumulation applied to it. So it is quite possible to have convertible
participating preferred ordinary shares (CPPOs) or redeemable convertible participating preferred ordinary shares (RCPPOs) or even
cumulative redeemable convertible participating preferred ordinary
shares (CRCPPOs).
Having explained some of the major tweaks that can be added to
simple share structures let’s now revert to seeing how they are applied.
How the variations work
The intention of these variations is always to give the VC some
advantage. In the case of cumulation, the intention is to protect the
‘running yield’ that the instrument offers so that the investment is
continually ‘performing’. This enables the investor to reap some return
from the profits that the business makes even if the capital appreciation
that was hoped for is late in coming through. A patchy profit record
will be salvaged – for the investor at least – by the fact his dividends
will be protected. Cumulative dividend shares are entitled to arrears
of dividend before any current dividends can be paid. So ordinary
shareholders have to wait before they get their dividends if cumulative
dividend shares have missed a turn.
The characteristic of participation is that it does much the same thing
– it means that the investor gets a slice of the profits before everyone
else – so if the business is appreciating only slowly in capital terms,
then the investor makes his money through a continually escalating
monetary amount provided it is generating profits and cash. The twist
here is that participation is based on the profits that the business
achieves not the value of that class of shares. So putting a comparatively
minor amount of money into this type of instrument can have massive
ramping effects on the rate of return in an investment where lots of cash
is thrown off by the business.
Convertibility is used to exchange one sort of shares for another. The
purpose of this may be to swamp the other shareholders in the event
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Venture capital funding
of some difficulty with the company so that they can take both voting
and managerial control. If the company is performing badly and the
management owns more than 25 per cent of the capital of the business,
then the investors may find it very difficult to effect changes that they
want to see in the strategic direction of the business. Swamping an
underperforming management with a flood of converted shares that
suddenly become ordinary voting shares enables control to be exercised in the bluntest way. These conversion rights will also usually be
accompanied by ‘board packing’ rights, which will give the investor
the right to appoint sufficient directors of his own choosing to outweigh
the management directors on the board. This will then ensure that not
only are matters put to shareholders capable of being won on a
shareholders’ vote but that the right matters are put to shareholders
and furthermore that they are then executed by the board.
Convertibility may also be used simply to clean up a share structure
at the moment a sale or flotation occurs, when one class of shares has
had different rights to the others – typically, participation or preference
will evaporate on conversion. So if these shares are made convertible
then their additional rights disappear and they can be sold as ordinaries.
More practically it may also be used – along with redemption – to
change the proportion of ownership either in favour of the managers
or in favour of the investors. This is done for one of two reasons. One
is for ratcheting the other for reasons of valuation.
Ratchets are employed to provide an additional incentive to the
management team. They are either positive in their effect (they give
shares back to the management for either agreed performance or overperformance) or negative (they take shares away for under-performance). Convertibility is generally used for a negative ratchet as it alters
the balance of ownership in favour of the investor while redemption
is generally used for a positive ratchet – as it has the effect of removing
shares that might constitute a proportion of ownership. However,
where a ratchet is employed for this purpose the redeemable instrument will often be a loan, since (to simplify the situation slightly) under
company law, redeemable shares can be redeemed only out of distributable reserves. In the absence of these – probably the case when the
business is young – then the redemption can only take place from the
proceeds of a fresh issue of shares. This defeats the object slightly, as
far as giving shares to the management is concerned. So a positive
ratchet will often be in the form of a convertible and redeemable loan –
if it is not redeemed on time then the investor will have the option to
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The choice of investment vehicle
convert it into shares at some agreed rate, which is usually provided
for in the investment agreement.
Redemption will usually take place at agreed windows (say, after a
year or maybe eighteen months from the date of investment and then
at intervals of every six months thereafter), which places the burden
on management to so arrange their business that they have generated
the cash to take out the required chunk of the investor’s initial injection.
Early redemption of substantial chunks of the investment also serves
the investor well. It reduces his overall risk profile by getting some of
his investment back into his hands early and it boosts the rate of return
of the investment as a whole since the value of the investment is also
calculated against time.
Convertibility and redemption can also be used for valuation
reasons. If the sum of money required by a business is large in
comparison to its current value it will be very difficult for the investor
to put all his investment in as equity. A start-up requiring £1 million,
for instance, will command an unreasonably high valuation which
cannot be sustained if all the cash is put in as equity. Putting more cash
in to sustain the growth of the business in future will also be very
difficult if the initial valuation is high; in fact initial over-valuation is
one of the prime causes for blow-out financing in subsequent financing
rounds.
To get over these problems, investors can employ positive ratchets
where they take more of the initial equity than they intend to end up
with and then release some back to the management as the company
develops according to plan. This is done by using a core of ordinary
shares (which is the amount that the investor intends to end up with).
These are bought at a comparatively modest price and using a slug of
redeemables/convertibles to balance out the remaining required cash.
The ordinary shares constitute the accounting valuation of the business
for the purposes of the investment and for calculating the likely rate
of return. The redeemables/convertibles can then be used to give back
equity and act as a control mechanism in the event of non-performance.
In this way the investor can achieve all of the following:
n
make an investment at a reasonable equity price, yet still provide
the total amount of cash required;
n
incentivize the management;
n
protect the investment against commercial reverses; and
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Venture capital funding
n
reduce the impact of second round funding at an adverse price,
since the price and value of the redeemables can be isolated, with
luck, from what happens to the price of the minimal quantity of
ordinaries.
How and why deals are structured the way they are
Given the details that have been explained above, it should begin to
be apparent why investors choose to put their money into a business
using instruments other than straight equity.
The overriding consideration is one of risk avoidance. At the macro
level, investors try to keep all their eggs out of one basket by adopting
a portfolio approach to their investment strategy. The shrewd investor
will place some of the total available investment funds into low risk/
high yield situations, some into high risk/low yield and some in the
middle.
This strategy will also be pursued at the micro level if at all possible:
in each venture investment there should ideally be a spread between
high risk (pure equity) and a type of moderate-risk interest-bearing
instrument which is more insulated than the straight equity in the event
of some commercial reversal. (Nearly all direct investments preclude
the choice of a low-risk instrument.)
If the investor places all his investment in one type of instrument
then he places it all in equal jeopardy. If anything goes wrong, everything goes wrong. By splitting the investment into different types of
instrument, although it will all be still subject to the riskiness of the
investment as a whole, it will be possible for the investor to attach
certain rights and obligations to different types of share and to protect
some of his investment. This protection may be limited but it is better
to have some protection than none.
The secondary consideration is that ordinary equity has to wait for
an event such as a sale or flotation to achieve a realizable increase in
value. If a different class of share which has participation or preferred
rights is used in the investment then it may not enjoy all the capital
appreciation of the ordinary shares but it has the potential to improve
the overall rate of return by returning cash to the investor both earlier
and faster than the ordinary shares can. Since the way that investment
returns are calculated takes into account the time value of money, then
a pound in the investor’s pocket in eighteen months’ time is worth
more than a pound in thirty-six months.
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The choice of investment vehicle
The investor can of course waive his right to a participating dividend
if the company needs more cash for an agreed reason – an acquisition
or a physical expansion, for instance. The investor will have to calculate
the cost or benefit of foregoing the interest/dividend on that part of
the investment against the prospect of a higher capital value for the
ordinary shares. It is in such cases that attaching multiple rights to
shares becomes very useful. The cost of participation rights foregone
can be ameliorated by being able to exchange some of those shares into
ordinaries that will benefit from the greater capital value of the
company occasioned by the expansion.
Lastly, by ascribing superior rights to separate classes of shares and
keeping those superior rights to himself, the investor gives himself the
power to take control of the available cash generated by the investment
in the event of a failure of the company to make its commercial targets.
There is also the sanction on the existing management to take complete
managerial control by dominating the voting rights of the ordinary
shares (via convertibility) and associated board packing provisions.
Finally, careful structuring enables different valuations to be placed
on businesses.
Preference for structuring
The business angel is probably less likely to indulge in elaborately
structured investments than the manager of an investment fund. This
is for two principal reasons.
First, he is unlikely to have the experience of having done the
complicated deals that putting successful structures in place requires.
Complicated structures require complicated legal agreements and the
lone investor may not have either the technical expertise or the legal
grounding to work these through. Syndicates of angels operating at the
development level may well include more sophisticated structured
deals in their investment arrangements. They can afford to pay the
lawyers collectively to do the groundwork; they may well be in a more
complicated deal, and the larger amount of money involved (as there
are more investors) usually means that there will be slightly different
priorities for the investment.
Second, at the start-up or early-stage levels where most angels tend
to apply their skills, complication is a threat rather than a safeguard,
so over-elaborate structures are to be avoided. Simple deals work best
at this level and the need for a complicated deal will probably indicate
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Venture capital funding
that the commercial nature of the opportunity is unsuitable for a lone
investor. The risk of blow-out financing will not be reduced by
introducing a complicated deal structure. If more money is required
than can be provided by the individual, then a complicated structure
is not going to lessen the risk.
Conversely, the larger the deal the more likely there is to be a
sophisticated structure. This will be done both in an attempt to
accommodate individual partners’ appetites for risk and to ensure that
the investment is fully funded. Syndicated deals among investment
funds where one partner has taken responsibility for the deal often
involve the use of ‘strips’ of the deal being allocated to syndicate
partners: everyone participating gets a ‘vertical’ strip of the total
structure ranked according to risk and reward– some ordinary equity;
some preferred shares; some redeemables and so on. Partners can then
buy multiples of strips according to their preference for the deal. This
arrangement also provides for fairness between the investing partners
in terms of eventual return from the various instruments that are
available in the deal.
Other reasons for structure
In general terms, simpler deals are better deals. There is a uniformity
of purpose and a greater degree of cohesion between the parties where
interests are not split by different types of shareholding. But it is very
unusual to find deals where there is no differentiation at all. And in
many cases, some form of differentiation works well for the management side – often a differential pricing mechanism is introduced into a
deal to enable managers to buy shares more cheaply than the incoming
investors, for instance.
So deals which are overly complicated are probably bad deals and a
structure that is devised solely as a means to accommodate a bad
commercial proposition is not going to make it any better.
If the deal looks like getting unwieldy then the best thing to do is to
go back to basics and try to think of a simpler method of accommodating the requirements that the parties are placing on the structure rather
than on the opportunity. One of the methods of doing this is to try to
involve another party in the deal. Though it may sound as though this
is introducing further complications, it may help to break the log-jam.
In particular, some funds specialize in providing ‘quasi-equity’ which
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The choice of investment vehicle
take a good deal more risk than simple bank loans but don’t require
all the rewards accorded to pure equity.
This is sometimes called mezzanine finance – since it fits in halfway
between the two types of funding, pure equity and pure debt. It often
takes the form of unsecured debt, which is paid off quite quickly but
leaves an equity ‘kicker’ in the business for the lender. Although the
investing and management parties will have to compromise to some
extent over their holdings, using mezzanine finance can sometimes
untwist the knots that deals otherwise get into.
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10
Legal stages: where the going
gets tough
Lawyer, n: One skilled in circumvention of the law.
Ambrose Bierce, The Devil’s Dictionary
‘The first thing we do, let’s kill all the lawyers’
Shakespeare, Dick the Butcher in Henry VI Part II
THE PROCESS STEP BY STEP
If you thought that getting a VC to invest in your business was hard
going then you may be in for something of a shock when it gets to the
legal stages of doing a deal.
This part of the process, where the governing terms are hammered
out, is usually a long hard slog. Much energy is expended in getting to
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Legal stages
the position where each side feels comfortable with the form of the
investment. I nearly wrote ‘happy with the form of the investment’ but
that would be an overly generous description. It is not unusual that the
relationship between the parties changes to something distinctly cooler
after this point and is possible that there will be irreparable knocks to
the rapport that has been built up unless care is taken by both parties
to avoid them.
This is especially the case if the lawyers are allowed to run (sometimes even rework) the deal. If this happens then there is a danger that
the process turns into a combat between professional arguers each
determined to beat his opponent instead of a codification of the rules
that will govern the conduct of each party towards the other. In these
cases the most that the entrepreneur can hope to come out with is that
some of the more egregious stipulations – those that work only in
favour of the VC – are knocked out of the deal in favour of ‘almost
reasonable’ terms. The cost of this Pyrrhic victory is that at the same
time as defeating the worst proposals a big hole will have been blasted
in his wallet by the fees – which he will almost certainly have to pick
up for both parties. It shouldn’t be that way.
Many entrepreneurs may have had to swallow hard in accepting the
financial terms that were put forward in the preliminary offer letter.
They will usually have fallen short of the hopes of the management
team, usually in terms of the disparity between the price the management think that the business should command and what the investor
is willing to pay. This may have resulted in some loss of morale and a
little less enthusiasm for doing the deal. But an offer that doesn’t quite
meet expectations is better than no offer at all. Unfortunately the deal
isn’t done yet, and the course of completing the deal is likely to get worse
before it gets better. Few people ever enjoy the legal stages of a deal.
In all probability the first reaction of the management team on
reading the first draft of the legal documents will be that this is not the
deal that they thought they had. In fact, they may think that they are
entering a different deal altogether, especially if this is the first deal that
they have done. The primary reason is this business of risk minimization again: the lawyers will be keen to extract more value out of the
deal for their clients if there is the slightest hint of a wobble in the
expected progress of the business. The lawyers reason that if the
anticipated rate of return is going to be sacrificed by management
ineptitude, then the capital value must be protected by their prowess.
This has led to more than a little inflation in the protective clauses
that the lawyers like to incorporate. Like much of the developing
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Venture capital funding
practices of the venture capital business, these provisions are mere
aping of US custom. Offer letters have become ‘term sheets’, avoiding
the unpleasant connotations of a legally binding half of a contract;
flotations have become IPOs (initial public offerings); chance and risk
have been reduced in ‘down-round protection’ and ‘liquidation
preferment’. Companies seeking venture capital might be forgiven for
thinking that the VCs’ desire to reduce risk has become extended into a
desire to eliminate risk – especially as money generally has moved
upstream to the bigger (safer) deals.
It is more than debatable whether these developments are beneficial.
Inevitably the extended legal provisions work to the disadvantage of
the management of venture-backed businesses and they also make
refinancing increasingly problematic. On the other hand, the term
sheets may work to the benefit of both sides by reducing legal costs (if
properly handled) by taking some of the contentious issues into the
pre-legal stages before costly legal bills are racked up. Generally,
though, it is difficult to see how some of the proposed changes benefit
anyone but the investors. In particular, the clauses in the original
investment agreement put in to protect previously-injected money (see
below) cannot be easily reconciled with the need to give new investors
a reasonable chance of achieving success with a sensible funding
structure. In these situations, the management is normally the loser –
both financially since their share price valuations are shot to hell, and
physically since they are forced to try to run the business on no cash
while financiers haggle over numbers. (Being mercenaries, the lawyers
will oppose these clauses just as vituperatively when they work against
their clients’ interests, if they represent the investee companies, as they
will be evangelical in promoting them for the VCs.)
The first piece of advice that should be given to management teams
in respect of the legal stages is ‘get yourself the best lawyer that you
can afford’. Under no circumstances should you anticipate that the firm
of lawyers who have always done the company’s conveyancing will
be able to cope with the grind of a venture capital negotiation. The last
thing that you want in a venture capital deal is your lawyer learning
how to do it as he goes along. Make sure you use a lawyer who learnt
at some other mug’s expense.
The lawyers preparing the documents (the investor’s lawyers) will
have reduced what appeared to be an acceptable deal into a hostile
document that places much more emphasis on the obligations of the
management than on those of the VCs. Legal language is always
daunting but the frightening thing is that this reaction is – in essence –
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Legal stages
correct. The lawyers will have been employed to protect their client’s
interest and, particularly, to reduce their client’s risk in the event that
the exercise goes pear-shaped at some point in the future. In terms of
the ever-present goal of reducing risk, the legal documents are the last
ditch. It is no wonder that they are toughly written in consequence.
As we have seen, the primary consideration of any VC is one of risk
minimization. Lawyers become paranoid about this over-riding
preoccupation, especially the very good (and therefore expensive)
lawyers employed by VCs. Nowhere is this paranoia better expressed
than in the legal documentation that surrounds a venture capital deal.
The process of agreeing terms is one of attrition. Legal point after
legal point is advanced in battalions of words and squadrons of
paragraphs, claiming why the deal has to be this particular way or
contain that particular clause. These advances are then discussed and
either repulsed or conceded. Counter-attacks are mounted as proposals
for change are suggested. These are batted back, amended and usually
incorporated in some modified from. The use of the language of armies
is deliberate: the process can seem like a small war at times. It can often
take three or more weeks to complete this process – and therefore the
deal – if it is allowed to drag on.
But there are exceptions. One of the biggest failures of the dot.com
boom was a company called ClickMango, which had pretensions to run
an online health and beauty business. (Great name, rubbish concept.)
ClickMango’s legal documents were constructed, negotiated and
signed in eight days. In other words the whole deal worth £3 million
was done, from start to finish, in less time than it usually takes for the
desk review to be completed. Unfortunately ClickMango collapsed
within three months of opening its virtual shop – despite the fact that
the terms of the legal agreement were held to be very good, coming
from a well-established and respected venture fund. All that goes to
prove is that very good, even fast-negotiated legals will not save
rubbish businesses. By contrast, bad legals can definitely damage good
businesses as the increasingly bad-tempered skirmishing between the
lawyers, the management and the VCs wears down previous reserves
of goodwill.
Legal stages are not nice for any management team that simply
wants to get on and do the job. This is the way that it works.
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Venture capital funding
The process
Like much of venture capital investment there is no consistency of
format or content to the documents that are exchanged between the
investor and the company. Just as each investment fund has its own
house style, so each fund will likely have a pet set of lawyers that looks
after its deals. And each firm of lawyers has its own particular wrinkles
that it wants to see incorporated in deals to protect its clients’ interests.
The situation has regularized to some extent with the adoption of
more consistent US-style ‘term sheets’ that have partially replaced the
offer letters that used to be issued by funds. For simplicity’s sake the
term ‘offer letter’ has been used in this book up to this point (because
I think that it more accurately describes what the document is) but from
now on ‘term sheet’ will be used for consistency with current practice.
However, the use of term sheets is still far from universal, and when
they are used they can still be very variable in content. Regardless of
individual peccadilloes, all term sheets/offer letters have the characteristics that they describe the basics of the investment that will be
completed by full legal stages and that they are not legally binding as
‘offers’ in the legal sense.
Investments of early-stage money, by angels for instance, may well
never use term sheets or offers.
Term sheets are usually issued at the point when the deal has
received the preliminary approval of the investment committee. To get
to that point, though, the deal will have been partially negotiated
already. The investment manager and the company will have discussed
the structure of a deal in principle and this will have been incorporated
in the preliminary documents that the manager submitted to the senior
fund managers or maybe even in an informal discussion with members
of the investment committee.
In recognition of the fact that many venture capital-backed companies experience more than one round of financing, the first investment round is now referred to as Series A. The layman might well
wonder why this is; doesn’t the term ‘first round funding’ serve just
as well? This terminological exactitude is useful, though, when shares
belonging to different funding rounds need to be described. Two types
of shares that have otherwise identical characteristics can be identified
by reference to the round they were created in – series A prefs (preference shares) will be immediately distinguishable from series B (secondround) prefs and so on.
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Legal stages
New term sheets and new legal agreements may be used in subsequent financing rounds, of course, to identify the particular features
of investments made after the first. However, the description of the
events and tools that follows applies to the legal stages of an investment completing funding for the first time.
Major features and documents
The major documents that are used in completing an investment (in
the UK) are:
1. the term sheet (previously known as the offer letter);
2. the subscription agreement;
3. a shareholders’ rights agreement; and
4. the Articles of Association of the company.
Sometimes the subscription agreement and the shareholders’ rights
agreement are combined into one document; sometimes some of the
provisions of the shareholders’ agreement may be repeated in the
Articles.
What the term sheet contains
The first thing that the term sheet contains will be a description of the
deal structure. This is likely to centre on the types of shares that are
the backbone of the investment.
Because of their need to exercise additional rights over the direction
of the investment, venture capital investors will normally invest in
some form of preferred shares (which we have already seen are
preferred because they have some form of preferential rights). These
shares have rights which the ordinary shares owned by the founding
management team of the business (called with startling imagination
‘founders’ shares’ or ‘management shares’) do not possess. The preferred shares will also include protections for consent for certain actions
– these will probably include, at least, bars on:
n
capital spending above a certain limit;
n
change of name;
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Venture capital funding
n
change of registered office;
n
change of directors (hiring or firing);
n
assumption of further borrowing;
n
granting of any security;
n
any form of warranty being given without consultation with the
investor;
n
anything that the investor and his lawyer can’t think of at the time
the documents are prepared but that the investor might want to
object to when it is presented for decision.
These preference shares will have a value that is computed by reference
to the ‘pre-money’ valuation of the company – ‘the money’ being the
injection that the venture capital fund is about to make. They may have
dividend rights attached (again, as we have already seen) and may be
invested in tranches – or blocks – that enable the investor to withhold
the entirety of the investment until certain ‘milestones’ are achieved
along the business plan.
As well as reducing the risk involved to the venture investor this
mechanism also is supposed to incentivize management. It should
normally only be used where the business plan suggests that the money
used by the company will diminish slowly – so that the initial injection
can be topped up by a later tranche when the need arises. Anything
else is really an abuse of the process and will probably have the effect
of goading rather than incentivizing.
Another red rag for most management shareholders is the liquidation preference that most venture capital investors will insist on. This
says that in the event of the business going belly-up during the time
that the VC is invested then the venture money has the right to come
out first if there is any surplus available for distribution to shareholders.
This right is contentious enough to throw among ordinary shareholders in the form described but it also applies to what are called
deemed liquidations – mergers, acquisitions, changes of control of the
company, consolidations or flotations (now more usually called IPOs,
initial public offerings, again following US practice). In short what this
means is that whatever happens, the VC gets back his capital (plus any
accrued but unpaid dividends which will be protected under
the preference clauses) before anyone else gets a sniff of the cash.
Where the business is sold for a sum that only equates to the venture
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Legal stages
investment this means that the VC comes out clean but no one else gets
anything. Anything below the invested amount, where a liquidation
preference is in place means that the investor gets all the pot – and,
again, everybody else has to whistle.
Even more tendentiously, this liquidation preference can be extended
to include multiples in the event of an ‘event’ – so that the VC might
stipulate a two- or three-times liquidation preference. This will ensure
that the proceeds of any cash-generating event flow first to the VC in
the required multiple of his initial investment. The problem with this
mechanism is that it potentially cuts across the rights that banks will
seek to impose in determining security for themselves on the loans they
might be willing to offer companies. That leaves the poor old management team caught between two sets of powerful financiers, without
any powers of their own. The further undesirable effect of this is to
make venture capital best suited to businesses that don’t need it
(because they have no cash requirements other than those needed to
change ownership) or where managers don’t really count as drivers of
the investment and so can be disregarded as fellow shareholders; this
is often the situation where the big independent funds now buy and
sell (large) companies between themselves.
The ratchet mechanisms that we have already looked at (Chapter
9) will be embodied in the conversion and redemption rights that are
described in the term sheet. As we have seen, redemption rights can
force companies to effectively buy out the shareholdings of VCs if the
investment is not performing as expected or if the company takes an
unexpected path instead of that outlined in the business plan. Conversion rights can be used as either positive or negative ratchets. They are
fairly readily accepted by management.
A variant of this procedure is to incorporate vesting terms into the
term sheet. These control the amount of the company that the management own at any one time: the management only get their hands on a
certain proportion of the management shares (sometimes called
founders’ shares in a start-up) over an extended period of time, growing cumulatively year by year. The vesting arrangement may be a
straight line (say 25 per cent each year) or by determination and
agreement. As is dealt with in the chapter on management issues
(Chapter 7), directors or founding employees who leave through
some form of misbehaviour or of their own volition before a crucial
commercial point, may forego their shares entirely or be forced to
sell them back either at par or at some independently determined
valuation.
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Venture capital funding
Perhaps less easy to swallow though are the anti-dilution provisions
that are often incorporated in term sheets. These are designed to protect
shareholders from the effect of blow-out financings that were described
in Chapter 5. These provisions will provide for methods to calculate
additional shares that the investor will be entitled to at the new price
that is being struck in the so-called ‘down round’ to protect the capital
that he invested.
The effect of this provision is to grant the investor additional shares
at a lower price to make up for the fact that his higher price shares have
been undercut, so that the total monetary amount of the investment is
not written down: more shares at a lower price means that the original
monetary value of the investment is preserved. Again these conditions
may well have the effect of so steadfastly protecting the original
investment, through protecting share stakes, that they make subsequent (rescue) financing very difficult.
Issuing more shares will normally be subject to pre-emption rights,
which again will be covered in the term sheet. If the company sells
more shares then the investor will have the initial right of first refusal
of such equity before they are offered to outsiders. Table A of the
Companies Act 1985 already includes such provisions (to protect
shareholders from fraud), so quite why term sheets include this
provision is open to question. Presumably there is no harm, as far as
the VCs’ lawyers are concerned, in just making sure that everyone
knows what the law of the land says.
Disposal of existing shares is the mirror of selling new shares and
will also be subject to a number of provisions. The most important of
these are rights of first refusal – also embodied, of course, in the
clauses governing the disposal of shares by founders and senior
employees. The idea is to prevent hostile parties gaining a foothold in
the company or the sale of shares at a price below the book value of
the investors’ holding – which under UK accounting regulations would
require the investor to write down the value of the investment. Not an
option that is liked, as we have already seen. Right of first refusal
imposes no obligations on the VCs to buy the shares – merely that the
seller must offer to them first. This can block sales completely unless
balanced by a clause in the final agreement saying that once refused
by the investor, after a reasonable time for deliberation, the seller is free
to sell the shares elsewhere. The addition of such a provision will
probably be resisted.
If one investor decides to sell his shares and can find a buyer, the
term sheet will also usually provide what are called tag-along rights
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Legal stages
for the VC. These may require that a similar proportion of the VC’s
holding to that being sold by the other investor also has to be bought
by the incomer – and not surprisingly it usually makes share stakes
unsaleable because of the quantum of cash that has to be found by a
buyer.
The obverse of tag-along is drag-along. This provision is roughly
equivalent to (but more robust than) that which exists in public
companies where minorities who have not sold their shares to a
predator at the conclusion of a bid can be forced to sell at the last
prevailing price. It is, in fact, a sensible provision and makes companies
more saleable rather than less. It is designed to prevent one shareholder
holding out for a better price and obstructing everyone else who wants
to sell – although it can also be used, of course, by an investor with cold
feet to bale out of an investment which appears to be wobbling or to
compel a management team to sell up against their better judgement.
However, the twist that is usually incorporated by VCs is that the dragalong provisions will not apply to them if the sale is for anything except
cash, other than at their discretion.
The term sheet will almost certainly stipulate that in the event of the
breach of any of its provisions then the investor is entitled to take
certain remedies. These will probably centre on the right to pack the
board with its nominees so that its normal rights, to have one or more
directors, are suddenly tripled or quadrupled without any countervailing increase from management nominees. Some funds refuse to appoint
directors because they are mindful of the requirement of the Companies Act that directors may not be partial in their behaviour at the
board and have to act in the interest of the company as a whole. They
will often appoint board observers who will attend meetings – but not
participate in discussions – and then report back to the fund. (The legal
position of these individuals is ambiguous: shadow directors, according to the Companies Act, are those ‘in accordance with whose wishes
other directors are accustomed to act’; such observers, when they have
the power of the investment agreements at their elbows, are roses by
another name). These reports back up the frequent management
information reports to which the term sheet will also entitle the
investor, probably specifying frequency, form and content.
The term sheet will also make reference to representations and
warranties that the management team will be expected to make about
the business. This clause provides endless problems since it seeks to
place a burden on the management that requires them to guarantee that
everything that has been said about the company – everything, either
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Venture capital funding
written or spoken – and passed on by them to the potential investor, is
accurate. Since every company is a moving target in terms of the way
that it changes day-to-day, this can provoke considerable heartburn in
the management. The warranties are actionable at law in the event that
they are found to be flawed – and as the VC will not want to take the
remedy by biting the company (that is by biting himself) he will bite
the managers instead. And needless to say the VCs’ lawyers will be
drafting this clause as widely as possible.
Management teams can console themselves with a number of
thoughts:
n
There is usually a de minimis clause, below which claims cannot be
made (although they can be aggregated and actioned once the total
breaches the threshold).
n
Actions for breach of the warranties are comparatively rare in a
going concern (it is only when things go wrong that the VCs start
to search for scapegoats).
n
The disclosure letter is there to protect them.
The disclosure letter comes a little later in the process, at the point
where the deal is nearly complete. The reason for leaving things this
late is to incorporate any last minute changes into the information that
needs to be laid on the table about the company.
The term sheet will also contain details of the conditions precedent
to the deal, which need to be completed before the deal can be signed
off. These may include some or all of the following (and other terms too):
n
satisfactory completion of legal documentation;
n
satisfactory completion of due diligence;
n
approval by the investment committee;
n
a full legal review of the company by the lawyers working for the
venture fund;
n
tax clearances if required (usually by a venture capital trust);
n
satisfactory references for the senior managers – this may now
include Criminal Records Bureau searches;
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Legal stages
n
key man insurance being taken out on named executives;
n
satisfactory fidelity bonding.
The disclosure letter
Many management teams get the wrong end of the stick initially about
the disclosure letter. This is the device by which the management shield
themselves from actions for breach of warranty – so the trick is to get
everything you possibly can into the disclosure letter, because once it
is in there the other side is deemed to have been informed about it and
cannot pursue it legally. This sometimes leads to ludicrous theological
negotiations between lawyers about what is and what is not disclosable. These arguments may be riveting for the lawyers but cost a great
deal of money. Shut them up by refusing to accept any changes to the
disclosure letter and stand on a point of principle; threaten that nonacceptance is a deal-breaker. Non-acceptance should be exactly that –
a deal-breaker. But refusing to agree to non-acceptance does not mean
that the consequence of the point of disclosure cannot be negotiated.
Other points
The term sheet is an effective halfway house in determining what the
deal will be if the due diligence reveals no unexpected problems. It
forms the briefing sheet for the lawyers who will be drafting the legal
documents. It is not the end of the process of legal documentation but
the first step. As such it can be negotiated and changed if there are
sufficiently valid arguments form the management team for so doing.
The term sheet will have a duplicate attached to it that should be
countersigned by the management team, usually within a stipulated
period of time, signifying that they have understood and agree to the
terms. After legal advice has been taken – and not before – the sheet
can be signed and returned if the terms are acceptable. If they are not,
then the sheet should not be signed but an urgent meeting should be
requested to discuss points at issue. There is no harm in doing this, and
if the points are valid only good can come of it. No investor really wants
to get into an investment where the terms of the deal are such that the
investment will not work. If the management know of a good reason
why the deal should be changed they have an obligation to the deal to
try to get it changed.
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Venture capital funding
In truth, it is the process of completing the legal documents that is
important. What results from the process – the shareholders’ agreement
– is often largely redundant as a device for controlling the conduct of
the investment. You end up with a big thick bound book of documents
which is really only useful for hitting people over the head with if they
don’t play the game. Those who have no intention to abide by the rules
really won’t care about a legal agreement and will normally put up
only token resistance to points at issue during the negotiations.
The process of discussing the legal documentation flushes out all the
points that need to be understood by both parties and reveals the
anomalies in the documentation that need to be ironed out to the
satisfaction of both sides. It is this interplay that has real value as each
side gets to know the intentions of the other and the moods and
characteristics of each other far better.
Formal legal documentation
If the due diligence and the accountants’ report reveal nothing that
substantially alters the expectations of the investor, then the details that
were contained in the term sheet will be retained into the discussion
of formal legal documentation.
The shareholders’ agreement will embody the majority of the terms
that were first displayed in the term sheet with necessary correction
and adjustments being made to the company’s articles of association.
As we have already noted, sometimes the articles will repeat terms that
occur in the shareholders agreement – mostly unnecessarily but, as the
lawyers say, for the avoidance of doubt.
If the term sheet was properly written, then there should be no
surprises for management when they receive the draft documents – in
that all the points made in the term sheet should crop up again. But
there are two things to watch out for when the draft documents arrive:
changes to the documents which reverse points that were agreed upon
– either by accident or design; and the detail of the points that were
previously only set out in summary form.
Legal stages can take a long time to hammer through.
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11
Post-investment
considerations: culture shock
Enough, pron: All there is in the world if you like it.
Ambrose Bierce, The Devil’s Dictionary
n
The failure of mutual comprehension
n
Costs
n
Additional scrutiny – and the consequences
n
Requisite skills
n
Board atmosphere
n
Increased formality
n
The false hope of synergy
n
Outside involvement
n
Personnel change
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Venture capital funding
n
Tactical actions of the investor
n
Further funding
n
The problems with angels
n
Non-problems
It may have seemed a long hard road to get to the point where the
cheque is passed over, the lawyers cap their Mont Blanc Meisterstucks
and gather their papers, the investors and the entrepreneurs lean back
contentedly in their chairs and the post-investment party celebrations
begin. In fact it is merely the start of the exercise. The true culmination
of the investment is perhaps two or three years beyond the point when
the financing is actually completed, sometimes more.
The investor knows this and now prepares to bend his efforts to
making sure that the promise of the business plan is fulfilled. This will
involve bending the management, too – sometimes willingly, sometimes not; sometimes leaving the business mostly as it came to the
venture fund and sometimes changing it to something radically
different.
The completion of the (initial) financing process should mark the
point where the interests of the financiers and the entrepreneurs begin
to run along the same path. Until this point there has probably been
something of an adversarial relationship at times – more or less
apparent, according to the natures of the participants, and the stage
through which the deal was passing, as each party sought to ensure
that the outcome of the legal negotiation favoured their position. In
some deals of course – management buy-outs for instance – the
interests of the financier and the management are both almost the same
from the outset – they both want to secure the lowest possible price for
the business they are buying and are both anxious to reveal weaknesses
(up to a point). It is only when the deal enters legal stages that the
community of interests begins to separate. For companies seeking
development capital (at any stage) a semi-adversarial relationship
exists much earlier.
But now that the deal is settled there should be a combination of
effort towards seeing the business plan brought to fruition. That’s what
should happen and what both parties – management and investor –
should expect to happen. Unfortunately it does not, in many cases. The
paragraphs below detail some of the major reasons why.
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Post-investment considerations
THE FAILURE OF MUTUAL COMPREHENSION
The truth is that it is usual at this point for the two parties’ understanding of the practical mechanics of the achievement of the targets
in the business plan to diverge. The management side often think that
they will be allowed to go away and get on with running the business;
the VCs believe that because several times during the negotiations they
have alluded to the way that they will want to get involved in the detail
of running the business, the management side have fully absorbed
what was said and have understood the implications.
Many management teams seem to fail to understand when they
complete an investment that they have taken on a nervous partner. This
anxious partner will want to know the progress of the business against
the plan he has bought into, at least on a monthly basis and probably
in real time; he will want to appoint his own director to the board of
the company to represent his interests (even though this is strictly
against company law); he might also want to appoint the chairman and
will probably have all sorts of provisions in the legal agreements
entitling him to control of (unusual) financial activity.
Still less do most management teams comprehend at the outset of
the relationship that the investor – or his appointed director – will
probably want to get deeply involved in the development of the
business’s future strategies. In short, the management team probably
won’t have completely understood that they haven’t just taken on
finance – they have married an investor. It wasn’t just a completion
meeting they went to; it was a civil ceremony.
It should be obvious from being set out like this, even though it may
have escaped some management teams, that there will need to be
changes made in the way that the business operates.
COSTS
The first and most significant change is that running the company will
cost a lot more than before the investment. One of the principal reasons
for this is that the board of the company will swell in number – and
cost. Most venture capital funds will be mindful of the current tenets
of good corporate governance and will want there to be a majority
of non-executive directors on the board of the company. (In small
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Venture capital funding
companies, where this may be impractical, they will still want at least
one.) These people have to be paid for. There are no prizes for guessing
who pays.
Where the funds do not appoint directors of their own, they may also
charge a monitoring fee that purports to defray the costs of the work
they do in checking the business remotely. This will certainly be the
case where they appoint an observer from among their own staff (and,
it has to be said as an aside, it further complicates the shadow director
conundrum).
ADDITIONAL SCRUTINY – AND THE
CONSEQUENCES
Outside directors, for those who have not been used to dealing with
them before, can be a blessing or a curse – depending on the frame of
mind in which the fundraising has been approached and the temperament of both sides. Good ones are very, very useful; bad ones. . .
Sensible companies will embrace them as both contributors (to the
brain power sitting round the board table) and conduits (back to the
investor). They have to be paid for so they might as well be made use
of.
Several other developments will come very quickly. The management teams of all businesses will now find that they are under scrutiny
in a way that they may be unaccustomed to. Subordinate staff are
usually under continuous review in a commercial environment; most
businesses recognize that the annual personnel review should merely
be the device by which the summary of the continual assessment is
communicated. At board level in a venture-backed business the annual
review effectively happens every month when the board meets to
discuss the company’s performance – and quite right that is, too.
But this may be hard to accept for the managing director of a small
to medium sized independent business, who may have been top dog
until he took on a large and powerful outside investor in the shape of
the VC. One of the consequences of this change is that managing
directors, who operated quite comfortably in the sheltered environment of the private company, with only family and friends as shareholders and no real critics of his plans or opponents to his views, now
find themselves exposed to the chill of external scrutiny on a regular
basis. They may not immediately like it. The good ones rise to the
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Post-investment considerations
challenge by making adjustments both in their own behaviour and the
support that they can derive from the way the business is run. The bad
ones – quite bluntly – get replaced (see below).
The grounds for dismissing managing directors are not limited to a
lack of professional capacity. It is surprising how many senior managers who have been used to running their own businesses cannot
distinguish between the company’s money and their own. I can think
of at least three cases, without much searching, where otherwise
competent men who should have known better have been dismissed
from very senior positions because they were unable to complete their
expenses claims properly or because they anticipated, in their domestic
spending habits, the proceeds of a flotation before it actually occurred
and got used to using the company’s money to bridge the gap. Venture
capital investors will not turn a blind eye to such misbehaviour. Nor
will many tolerate extra-marital affairs that occur between senior staff
and jeopardize the future of the business in consequence. Most nonexecutives will be briefed by the VCs to deal with such matters solely
for the benefit of the company.
REQUISITE SKILLS
Similarly, many early-stage investors find there is a need to change
personnel as the business grows. The man or woman who started the
business is not necessarily the person to run it as it expands. The skills
required at start-up are different from those required to maintain and
develop growth. A brilliant inventor or gifted technician who initiated
the business’s product range may have started off as managing director
– almost by default, since the managing director’s position is usually
seen to be that of the pivot and leader. But it may make the company
work better if that person is moved into a less managerially central
position and one more suited to their skills and talents. Encouraging
such changes is quite properly the responsibility of the outside investor
(and the non-executive director) but not many companies – and even
fewer major shareholders – will be prepared for this sort of advice
being offered. Investee company managements may ask themselves
when advice becomes interference. The answer for many is probably
the moment you have a venture capital investor on board.
The scrutiny of all the senior personnel of the business will now be
much more plain than in the past, unless the business was used to
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Venture capital funding
operating to strict managerial reporting disciplines. Taking on venture
capital is a bit like stepping on to a faster treadmill.
BOARD ATMOSPHERE
The atmosphere at the monthly board meeting will almost certainly
change, too – at least until the managerial directors get the measure of
the new non-exec(s). And on the dark side, there may be management
shareholders who feel for whatever reason that they did not come out
of the negotiations and legal agreements with all that they wanted.
Sometimes, the deal was completed too swiftly for them to put all the
necessary arrangements in place to make the deal tax efficient, or they
could not raise as much cash as they wanted to in the time they had.
These individuals may well nurture resentments against their colleagues and the VC that can deepen into significant problems when the
time comes for realization. Business angels are particular targets of
such feelings – especially since they will almost always take an active
part in the running of the business post-investment. They will be
evaluating their new colleagues in a very practical fashion, from the
moment they step across the threshold of their new investment. Their
actions and involvement in the running of the business may put the
noses of other team members out of joint. But with the background
many of them have of senior managerial positions, they are probably
better equipped to deal with these problems than the venture fund
manager or non-exec who visits once a month.
Non-executives may well want to spend some time getting to know
their new charges and this will also involve some disruption to the
business. Ideally a non-exec should spend not less than three days a
month looking after his responsibilities to each of the companies of
which he is a director: one day for preparing for the board, one day
for the meeting itself and one day afterwards clearing up any consequential business and making a report to the investor if required.
INCREASED FORMALITY
Consequently, among young businesses, there is likely to be an
increased level of formality in the way that they operate internally; in
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Post-investment considerations
established businesses, procedures and systems are likely to need
overhauling to ensure compliance with best practice; in expanding
businesses, controls are likely to be reinforced to ensure that the money
that has been raised is properly applied to the purpose for which it was
raised. The ultimate purpose of the investor being on board should
never be forgotten: the money was invested to make the business more
profitable so that it can be sold at a higher price. Everything that
happens in the business from now on should be directed towards that
goal.
One of the ways that this can be done is to run the private business
as close as possible to public company disciplines. The VC and the
fund’s appointed directors are unlikely to whip out the Combined
Code to go through it line by line at every board meeting but the major
requirements of good governance in public companies will be at the
core of the suggestions that are made for the better running of most
venture-backed businesses.
THE FALSE HOPE OF SYNERGY
At the period of the relationship when fund investors are courting good
prospects and managers of likely investments are reviewing which
fund to go with, there may be some loose talk on the part of the fund
managers about the range of companies in their portfolio. The clear
intention of such remarks is to suggest two things: that the fund will
be well used to the particularities of the industry of which the proposing company is part, implying that due diligence will be less arduous
and /or costly; and that there will be all sorts of synergistic opportunities for the company to exploit in making use of the huge range of
contacts held within the portfolio.
Management should beware of both these claims. As we have seen,
due diligence is unlikely to be reduced for any purpose: the investor
will want to know the nuts and bolts of the business intimately and
while familiarity with the industry or technology might make finding
authorities to conduct appropriate market and technological reviews
easier, it is unlikely to substantially alter the cost of doing the deal.
As to the second point, while it may be possible for introductions to
be arranged with senior industry figures by intermediation by the
manager of a very large fund, that is about as far as it goes for most
funds. Many funds are in fact quite leery about stimulating contacts
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Venture capital funding
between their investee companies, because of the commercial dangers
that can arise when this happens. The prospect of conflicts of interest
for the investor are not hard for any one to foresee. Problems can arise
when one company in a portfolio becomes a supplier to another. A
venture manager who stimulated such an arrangement by positive
introduction would stand in a very different position from one who
happened to have two companies in his portfolio that happened to
trade with each other. To give an example, consider this case – which
is not too much of a straw man: what would happen when one portfolio
company tried to buy another portfolio company to secure a market
position? How would the VC approve a price that was acceptable to
the fund as simultaneous purchaser of one company and vendor of
another?
OUTSIDE INVOLVEMENT
While things go well, most VCs will be prepared to let the business run
on with only gentle tweaks of the rudder to encourage beneficial
change. The first major involvement of substance is likely to come
when the first post-investment budgeting round begins. Up until this
time, of course, the fund’s non-executive director will have been
participating in board meetings and making reports back on the
progress of the investment. At the budget round, they will begin to
engage fully in the process of making sure that the business sticks to
the promise of its business plan, the premise on which the investor
made his choice to invest.
However, it is only when things start to go wrong that the real power
of the investment agreement can be brought into operation. That is
when the management of companies will begin to appreciate the size
of the elephant that they have got into bed with. There are very many
devices that the VC can employ to get his way in an investment that is
not proceeding according to plan. He will use them all if necessary.
Don’t forget – venture capital is all about understanding and reducing
risk. In a situation that is going pear-shaped, reducing risk is accomplished by taking action.
The first action that can be taken is to suggest that budgets be
trimmed to preserve the profitability of the company. The legal
agreement (following on from the term sheet) will have given the VC
the power to approve or reject the company’s budgets. The quickest
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Post-investment considerations
way of making a business profitable in the short term is to reduce overhead costs – that almost always means reducing staff numbers. These
suggestions will usually be voiced through the directors appointed by
the VC if they have not been made first by the incumbent management.
One of the things that often comes hard to previously independent
boards is the involvement that the VC will often want to have in setting
pay levels for senior staff. The legal agreements will undoubtedly carry
a provision that enables the venture investor to approve (that is, reject)
pay increases for senior managers. If they are not commensurate with
the performance of the company, they will not be approved: the
budgets that the company presented in seeking to raise finance
(perhaps as amended during the due diligence process) will be the
guiding light for this.
PERSONNEL CHANGE
Persistent weakness in the performance of individual directors will be
spotted by the appointed directors and if the VC believes that such
weakness is potentially damaging, then action can be expected to be
taken. The term sheets and legal agreements of major funds will have
provided that board changes are one of the areas where the VC has
leverage.
Angel investors may not be able to call on a legal armoury in the
same way but will usually make their views known forcibly – not least
because their likely greater involvement in the day-to-day operation
of the business is likely to give them a faster perception of who is doing
a good job.
The legal agreements will have provided specifically for the situation
where directors have to be sacked by incorporating vesting rights and
forced sale provisions (sometimes called ‘deemed disposal’), with
respect to management shareholdings, into the shareholders’ agreement and/or the articles of association. VCs are not known for their
sentimentality where their investments are concerned and will not
hesitate to have these provisions activated if they believe that they will
preserve the value of the investment and protect its potential. And it’s
no use the management thinking that if they all stand together then
they can resist the investor’s wishes or play off multiple investors’
interests against each other. VCs have been there before, too, and know
the way out of that one.
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TACTICAL ACTIONS OF THE INVESTOR
The shareholders’ agreement will provide that the VC has the right to
approve or reject numerous actions that the board may wish to take. If
that does not meet with compliance, then share class consents will have
been built in for many actions involving variations from the business
plan (increased borrowing, change of senior personnel, acquisitions
and disposals, among others). And if all those still do not produce the
desired effect, then board-packing provisions – the appointment of
overwhelming majorities of non-executives to control board actions
and the presentation of policies – can be employed. Such drastic actions
are not often used but can be very effective in pushing policies through
at board level. Their use would be an extreme measure but often the
threat of extreme measures can often be just as effective as actual
deployment.
Despite these descriptions of the powers available to venture capital
investors, punitive measures are not very often employed in running
investments. Their adverse side effects in resolving the difficulty are
usually disproportionate to the magnitude of the problem that is
presented. The force of argument is usually much preferred by VCs but,
inevitably, problems do arise that cannot be easily disposed of. The
legal agreements are there to deal with such matters and the VCs will
use them without compunction.
There are more subtle methods of control, though, which have at
least as great an effect, and in combination with diligent communication between the investor and the company can be more powerful
because they are less damaging.
In Chapter 10, reference was made to the possibility of investments
being staged: the total amount of money is injected in tranches
according to the achievement of specified milestones. This method of
drip-feeding investments is not suitable for every situation. It rarely
works with management buy-outs, for instance.
In the small proportion of proposals where it can be employed it is
a very useful method for the VC to exercise control over the progress
of the investment. Using a series of agreed markers – pre-tax profit
growth perhaps being the crudest, product development and margin
change being more subtle – the investor makes sure that the investment
performs as expected before cash is introduced to the business in the
entirety suggested by the business plan. The advantages for the
investor are very obvious – perhaps less so for the management unless
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Post-investment considerations
the reduced use of cash can be rewarded by some form of ratchet
mechanism.
FURTHER FUNDING
The power of denial is also available to the investor. The glaring gap
in the shareholders’ agreement, from most companies’ point of view,
is the absence of any requirement on the part of the investor to supply
further capital when needed by the company. Most funds will puff on
about how they support their investments during the courting stage
when tempting proposals are eyeing up the available sources of funds.
The reality is that most funds will only want to follow through on an
original investment if the combined rate of return from both the old
and the new rounds is at least as good as the original projections.
(Anything less, of course, and the return will be diluted). And the
failure of an existing investor to follow through may leave a new
investor with serious doubts about the wisdom of making an investment, effectively denying management who have not performed to
plan, the ability of raising additional cash to get back on track.
Of course there is less of a problem in finding funding for an existing
investment that has fulfilled its initial promise and where the management team have acquitted themselves creditably. But even so existing
investors will regard the application for further funds as another
discrete funding opportunity that has to be evaluated and negotiated
as a separate deal. Some large funds may go so far as to appoint new
managers to evaluate and pursue such proposals to ensure that there
is no prospect of the original manager having ‘gone native’ and having
his judgement clouded.
The drag-along/tag-along rights that were contained in the term
sheet and later embodied in the shareholders’ agreement will further
constrain the ability of the management to do anything that affects the
position of the venture shareholder. The bond between the company
and the venture fund is soluble only at the instigation (or at least with
the acquiescence) of the venture fund.
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Venture capital funding
THE PROBLEMS WITH ANGELS
Early-stage companies nearly always require more cash to fulfil their
potential. Few can grow from nought to maturity on the basis of one
injection. But there are major hurdles to be overcome in securing
additional funding. These problems are caused by the different ethos
of very early-stage funding and development funding (of which more
in Chapter 13). The difficulty, in the VCs’ eyes, often lies with the fact
that these small companies were originally funded by angels on fairly
straightforward terms often using a fairly simplistic structure.
The unique difficulties of arranging what used to be called blow-out
financing (now often called ‘cram-down’ or ‘washout’ rounds) have
already been dealt with (in Chapter 5). Incoming investors buying in
at a value which may accurately reflect the busted record of a business
may well encounter obstacles caused by anti-dilution clauses that
protect the capital value of a previous investors’ position.
These problems will eventually be overcome because it is not often
in anyone’s interest to see a company that can be salvaged, go bust.
And of course not every refinancing problem is caused because the
company is not performing. Young businesses which were able to raise
finance in frothy market conditions, at advantageous prices, often find
that they next go to investors for funds just as the stock market or the
economy takes a tumble. Valuations of venture deals reflect the market
moves and everyone finds it difficult to justify P/Es that seemed
eminently reasonable only a few months ago. The business’s prospects
may not have changed but the surrounding landscape has.
A similar sort of problem can afflict early stage companies that have
been funded by angel investors. Venture funds can often be snotty
about the price that companies initially funded by angel investors’
funding think that they can command at second round funding. In
other words, the VCs don’t like the terms they are offered: they will
often balk at the price they are asked to pay for the equity that is on
offer. The venture funds will complain that the funding structure that
the angel used encouraged an inflated expectation of further value for
the company and that the terms of the initial funding will have
corrupted the company’s ability to secure subsequent money. You will
gather from such exchanges that many VCs do not have much time for
most business angels.
The problems are usually resolved with a diminution of the ‘premoney’ valuation made in favour of the VCs: a deal which offers
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Post-investment considerations
money is better than no deal and no money at all. Or alternatively, the
company may decide to shop around until it finds a better deal from a
more sympathetic backer.
But simply securing the cash with which to expand is no more the
end of the fundraising for a second round company than it is for a first
rounder. Problems can develop when the business angels and VCs are
expected to co-exist side by side on the same board. The abilities,
procedures, methods and objectives of the two types of funder are very
different and it is probably best not to mix them together. A business
requiring second round funding (Series B funding as it is now known)
should seriously consider whether that is a signal for a business angel
to retire from the company and leave the way open for the venture
investors to take up the funding burden – or, perhaps, for a syndicate
of other angels to come on board and supply the necessary financial
resources.
NON-PROBLEMS
The picture is not uniformly bleak, though, and to give a one-sided
view of how VCs act would be doing no justice to the many businesses
that thrive after a venture capital injection. The newer venture funds
are finding ways of ensuring that the problems that afflict many small
businesses after they have taken on an outside investor are dealt with
by the process of their investment.
For instance, some smaller funds are now recruiting stables of
industry experts whom the fund can call on to do the due diligence that
would previously have been done by consultants. The twist is that the
deal goes ahead only if the industry expert wants to put his own money
in. Provided he is acceptable to the management on this basis, he also
becomes the non-executive director appointed by the fund. The added
advantage, especially for the company, is that the due diligence is also
done very cheaply.
Such schemes make clever use of combining the practical skills of
the business angel and the greater funding muscle of the venture fund.
Many of the issues that loomed so large during the investment
process – especially the legal stages – also fade in significance once the
deal is done. Warranties are mostly never called upon; sensible VCs
know that the business plan is just a best guess of what might happen;
the shareholders’ agreement is filed and never looked at again.
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Venture capital funding
Although the VC will want to see that the overall targets of the
business plan are being achieved he will probably be content with a
business that is meeting broadly the objectives that it set itself in terms
of the composition of the profit and loss account, provided that
turnover and margins grow as predicted.
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Realization of the investment
12
Realization of the investment
Ambition, n: an overmastering desire to be vilified by enemies
while living and be made ridiculous by friends when dead.
Ambrose Bierce, The Devil’s Dictionary
n
The realization event
n
Types of realization distinguished
n
Public flotation
n
Trade sale
n
Forced realization
n
The dark side
The realization of the investment – when the business turns into money
in people’s bank accounts – is the purpose of the whole investment
exercise. This modern-day piece of alchemy, transforming the base
metal of under-funded businesses into gold, is only achieved – like the
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Venture capital funding
experiments of the medieval alchemists – with much effort, hard work,
usually long apprenticeships and not a little failure.
At the very beginning of the investment one of the key factors in
helping an investor decide whether to proceed with a proposal will
have been the attitude demonstrated by the management team to the
concept of realization of the investment. Only if the management team
understood that the VC has to sell at some point in order to make the
investment – and could demonstrate that appreciation – will the
investment have gone ahead in the first place. But at the same time
there will have been other, conflicting signals given during the
discussions and these often create false impressions among lessexperienced management teams.
For the discussions held during the investment process will usually
have contained numerous statements about what VCs claim to do
which a brief review of their actions demonstrates they often do not.
They will have talked about the need for the management team to
demonstrate ‘commitment’ to the business by investing as much as
they can afford in the deal. Yet they are unemotional about their own
investments.
They will have offered reassurance about the fund’s willingness to
support its investments with refinancing if required. Yet this happens
only under very strictly limited circumstances and only when the
auguries are right for the VC.
They will talk about being long-term investors. Yet they are ready
to sell at the first whiff of a good price to a third party.
What management teams forget is that venture capital is the business
of the VCs. The investment fund is their company – not the investment
– and commands their first loyalty. Their own skins come first.
VCs and bankers both provide money to businesses. But no one
thinks that a banker’s business is anything other than banking: he is
usually rather remote, sees the business only once or twice during the
year, maybe (if things are going well) and has a rather formal relationship with the company. Because the VC often gets deeply involved in
the management of a business, the expenditure of time in touring
round subsidiaries and talking to staff at all levels, and a presence at
occasions other than board meetings, are often taken as evidence of
something more than a simple financial relationship. Shared experiences round a board table tend to encourage the management to believe
that the investor is one of them.
Consequently, this willingness to sell out is something that
upsets some management teams. They often consider it a sort of
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Realization of the investment
abandonment. They were exhorted to demonstrate commitment to the
business (as if hitching your career, your standard of living and your
family’s future to a risky commercial venture was not commitment
enough) and they may well have sweated many nights over it. Yet it
appears that the investor will demonstrate a complete lack of loyalty
to their interests in the business if a suitable offer is waved under his
nose. They feel that the investor is always ready to sell out when he
gets a good price regardless of their position. They are quite right.
The management may have loyalty, enthusiasm, deep affection, in
some cases even passion (a much over-used word) for their business.
The VC will regard it as a commodity. The business is something he
buys into and, most importantly, sells out of. In the slang of the trading
floor, VCs are price tarts. They are opportunists.
So the first thing to realize is that realizations may occur at any time
in the life of an investment, when the opportunity presents itself, no
matter what the original plan said. But only certain types of realization.
Trade sales can occur when there is a willing buyer and willing seller
and may be opportunistic events that can be completed in the space of
a few weeks, perhaps even a few days in some cases. Flotations of the
company on a stock market – IPOs – are a very different matter and
can hardly be described as opportunistic since they take a great deal
of time and a great deal of planning to bring about.
There is a further consideration which has to be brought into the
open and should be made plain by the VC who negotiated the deal.
Chapter 3 made mention of the ‘carried interest’ which funds award
to managers. Carried interest provisions trigger for the executives of
the fund when the businesses that they have invested in achieve a
successful realization. So it will be in the interests of the fund manager
to achieve a successful realization. Quite a lot of money will depend
on it for the manager as an individual.
We have already seen there are four basic ways out of an investment
for VCs (and management, too):
n
flotation (IPO);
n
trade sale;
n
buy-out by the company;
n
commercial collapse.
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Venture capital funding
Although corporate collapse is not contagious, many investors have
superstitions about considering the event in the same breath as
beneficial realizations. The spectre of collapse always hangs over any
commercial enterprise, a continual reminder of the potential mortality
of the corporate entity. So collapse is not talked about much in polite
company – but most VCs have experience of collapse of some sort,
especially after the dot.com debacle of a few years ago. Respecting
tender sensibilities, we shall also put it in an isolation ward and
consider it in a separate section. The main features of the other three
routes are considered below.
FLOTATION – IPOS
Selling shares in a company on a regulated public market was once
seen as the most obvious route for investors to release the value of their
holdings in venture-backed companies. But flotation is an expensive
and very detailed business. It takes much time to plan for, much time
to execute and a great deal of money to bring into effect. Not the least
of the reasons for this is the amount and quality of information the
company is required to put into the public domain.
The standard of reliability for the information that is required for a
prospect to enable shares to be listed is one of ‘utmost faith’. What this
means in layman’s terms is that all the pieces of information that go to
make up a prospectus are issued, checked and then checked again to
ensure accuracy. The people who do the checking are teams of lawyers
and accountants from the big metropolitan partnerships – such
resources do not come cheap.
The precise details of the process are long, tedious and complicated
and beyond the real scope of this book. A number of things need to be
emphasized about IPOs:
n
The business needs to identify the date when it wishes to float and
then work back several months to identify the time when the whole
process should start; this means that a great deal of planning is
required. Sensibly, a period of a year should be set aside, as a
minimum, for the preparations for a full flotation. During this time,
much management effort will be required to control the process.
Only so much of this can be delegated, since directors of companies
intending to float are personally responsible for the content of
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Realization of the investment
prospectuses and must therefore be active contributors to the
process. While flotations on the subordinate markets are less
onerous than full flotations in terms of the regulatory requirements,
the burden is still heavy.
n
The business that chooses to float must be capable of running
without the detailed daily intervention of senior managers. The
effort that is required for preparation will take much of the attention
of directors in the months prior to the event. This means that the
business’s internal systems must be sufficiently robust to cope.
While the actual period of preparation will be measured in months,
the true run up will be much greater. Only businesses with a full
complement of support functions, including a properly staffed
company secretaries’ department, should contemplate any form of
listing. Furthermore these support departments should be used to
working with each other and not be brought together immediately
before the flotation process begins.
n
Flotation will not suit everyone. Putting a company’s shares on a
public market now involves continuing regulatory burdens that are
costly and heavy. Some companies which floated with high expectations of the benefits of public markets– Richard Branson’s Virgin
Group and Andrew Lloyd Webber’s Really Useful Group, to name
but two – have now been bought back into private ownership. The
intense scrutiny to which they became subject – and the need to
propel earnings forward all the time without any form of respite –
hobbled their development.
n
The sanctions that the market regulators may impose on the
management and venture shareholders of a business that is considering listing may involve shares being ‘locked up’ to prevent the
market being swamped. When these provisions have been dealt
with, management shareholders are still subject to (increasingly)
detailed regulation concerning the closed periods when they may
not sell shares.
n
Venture investors may be reluctant to give some of the warranties
that are required to enable the listing to proceed smoothly. While
these things can usually be worked through, the progress to market
will not be smooth. (And see below for similar problems in trade
sales.)
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Venture capital funding
n
Not everyone can get out at the same time: the market makers will
require lock up periods as we have already mentioned but, in
addition, on the smaller markets particularly, buyers and sellers
may not always be in the market at the same time. One of the
persistent complaints of companies on AIM is the lack of liquidity
of the market.
n
Being listed puts a company ‘in play’ as far as predators are
concerned, once the lock-up period for founders’ shares is over.
That may not suit some companies.
Because of the trading record requirements that are imposed by the UK
stock market (and most other senior bourses) few start-ups are likely
to make the long run from inception to listing with venture backing.
With the increasing sophistication of regulation undertaken by market
authorities (with consequent cost and size implications for regulated
businesses) it is likely to be businesses sponsored by private equity
players that are entrants to listing.
It is very difficult for a company to move to a flotation unless there
is unanimity on the part of the shareholders and directors. As such, the
desire to undertake a flotation is probably driven as much by the
management team as by the investors. The same unanimity is not
required for other types of realization.
TRADE SALES
Once seen as a second best way out (less kudos, less fanfare), trade sales
may well be a far superior exit route for all concerned (less hassle, fewer
restrictions, possibly more cash).
There are no regulatory requirements for a trade sale, of course.
There are no obligatory long run-ups – although selling a business
privately may also take a very long time. There are no requirements to
have a fully staffed battleship of a business; trade buyers are looking
for synergy, not heavy cost superstructures that have to be dismantled.
But that does not mean that trade sales are the universal panacea.
Nor that they do not demand a good deal of effort to achieve a
satisfactory conclusion. Nor that they are accomplished without much
stress.
Trade sales fall into three different categories:
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Realization of the investment
1. those initiated by the investor;
2. those initiated by the management; and
3. those where both parties agree that a trade sale would be beneficial.
Investor-initiated sales often occur where the investor has some form
of pressure being placed on him to liquidate investments: perhaps the
running-down of a closed fund or a desire to liquidate to produce a
good rate of return, or even an insight into market conditions that is
not generally shared.
Unfortunately, not every story has a happy ending. Despite the best
efforts of the management, some businesses never make the breakthrough and languish in a steady state of marginal profitability. The
point at issue for venture-backed businesses is that this state of affairs
cannot be allowed to persist. Privately-owned businesses can trundle
along forever just making enough profit to satisfy the owners’ income
needs and servicing their market niches. Venture-backed businesses
cannot be allowed to do that. If they are not swimming, they are
sinking.
Sometimes investors just lose patience with management teams and
decide that the investment would be better off under someone else’s
wing. Management can resist such pressures if they are very strongwilled or can marshal very good arguments against a sale – but as we
have seen in reviewing the potency of shareholder agreements, the
trumps are mostly held by the investors. Both negative and positive
powers of compulsion are available to investors. If they hold anywhere
near a majority of the company it will be difficult to resist their
pressure, and in the absence of such large holdings they can still make
life difficult for management by refusing to approve salary increases,
saying no to acquisitions that would require more cash; refusing to
allow changes to management structures and so on. This may all seem
rather petty but it often works.
The management is on something of a sticky wicket if it tries to
initiate a sale without the approval of the investor. Few investors take
kindly to being driven into a sale and will probably scurry off to consult
the shareholders’ agreement to see what sanctions can be applied. Of
course, if the deal is a good one, then the salve of a high price will
soothe any bruised feelings. But most investors will immediately
assume that they are being outfoxed if the approach is made to the
management directly without the courtesy of an approach to them in
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Venture capital funding
the first place. They will have expected the management to discuss the
business’s prospects with them beforehand to enable a strategy to be
developed for a sale.
Joint decisions about the strategy of a sale are likely to work best –
and of these, the ones that work best of all are those where management
have a good idea of who the potential buyers might be. If consultants
have to be brought in to arrange a sale, then fees have to be paid and
the result is rarely as slick as when inside industry knowledge is
applied. Too often, if a potential sale falls over, the business begins to
look sickly as a purchase and word rapidly gets around – no matter
how good the confidentiality agreements – that the company is up for
sale. Then the rumour mill starts going into overdrive.
Essentially the process of selling a business to a trade buyer is the
mirror image of selling to a venture investor. The legal documents will
be similar, the requirements for information and warranties will also
be closely related. But some twists will give rise to a variety of problems
that have to be dealt with when businesses reach the point where the
shareholders want to commit to a sale:
n
In contrast to a flotation, there is a danger that impetus can be lost.
A sort of weariness can overtake businesses that are up for sale –
especially if trading conditions have been difficult recently.
n
In a flotation, there is a definite target to aim for, and while
flotations do get pulled when market conditions change or if
something evil is discovered lurking in the corporate broom
cupboard, the process is probably more under the control of the
company than a sale to a third party. Corporate sales that collapse
can have a serious impact on collective morale which can severely
affect a business’s performance – especially if attention has been
diverted from trading performance in order to get the deal done.
n
Individual directors in a business that is to be bought by a competitor or new parent often begin to wonder about their positions in
the new regime. This can sometimes lead to fissures opening up
between individuals sitting around the boardroom table, as they
begin to manoeuvre for positions in the new organization structure.
Individual ambitions rather than the collective ambition begin to
dominate events. There is less of this in a flotation, where there is a
unity of purpose.
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Realization of the investment
n
There may be problems created between the investor – who will
usually be bought out of the new arrangement by the incoming
buyer – and the management shareholders. The employees may
well find that they are required to exchange their holdings in their
own business into holdings in the new one through a share-forshare exchange. This is done both to reduce the cost of the deal for
the purchaser and to encourage retention of good employees.
Businesses are often taken over for the quality of the management
team and the last thing that the new owner wants is to see his new
employees with their pockets stuffed full of drop-dead money
(newly-rich employees can tell their employer to ‘drop dead’ if they
don’t like what is being suggested). Very few investors, of course,
will ever accept a share swap – as we have seen in looking at the
legal documents.
n
Resentments that have remained hidden during the course of
trading often resurface when money is being released. Management
shareholders often harbour grudges if the progress of an initial
investment did not run smoothly and they were disadvantaged in
some way in consequence. Revisiting legal agreements during the
course of the new sale revives these grudges and the course of the
deal then becomes difficult, especially if the other pressures that
have been noted above are also in play.
n
Venture capital investors will not give warranties to incoming
buyers, as a matter of course. Even though they may have held
directorial positions they will refuse to accede to demands for
warranties and will throw the burden entirely on the shoulders of
the management shareholders. Most purchasers and all other VC
investors understand this attitude (possibly even sympathize with
the logic of it) but the game of demand/refusal/counter-demand
and offer has to be played out nonetheless. Management shareholders may not understand the game, though, and although the
practical effect of the investors’ refusal to conform is limited, this
misunderstanding can again lead to difficulties between management and investors. The management shareholders will perceive
this as a further example of existence of two sets of rules – one for
the venture investors and one for them. The effect will be particularly problematic if the sale falls through – regardless of whether
the reason was for problems with warranties or not.
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Venture capital funding
Needless to say, given what has been outlined above, no sale is ever
finalized until the ink is dry on the paper and the cash is in the bank
account. The one principle that management should try to adhere to
during any negotiations for a sale – either to a trade buyer or to the
public through some sort of flotation – is to run the business as if
nothing out of the ordinary was going to happen. Easy advice to give
but very difficult to implement.
THE DARK SIDE: CORPORATE COLLAPSE
No one likes to think about it but most people in senior positions in
business will have contemplated corporate collapse at some time. The
inevitable periods of cash flow stickiness, the crucial contracts that
seem to take ages coming through, the nose-dive of a competitor – all
prompt the shudder of realization that things are usually balanced on
a knife edge in the commercial world.
The brutal language of the legal agreements also casts a shadow over
the fundraising process. The lawyers are paid to think about what will
happen in the worst of situations and prepare documentation to cope
with it.
Despite the unemotional attitude that they adopt to investments,
most venture capital funds will do what they can to prevent businesses
going under. This will probably involve practical help in the form of
introductions to consultants or company doctors, perhaps more time
discussing strategies to dig the business out of a hole, using their
contacts to find companies that might take on some bits of the business
to relieve cash flow problems. However, ‘what they can’ usually falls
very far short of pumping more money into a dying business. VCs are
very strong on not throwing good money after bad.
Unfortunately, as in all venture investing, there are pressures that
impinge on individual investments differently at different times.
Market falls will alter the prevailing P/E rate that contributes to
calculating rates of return and so make recovery financing more
difficult; even mild economic recessions affect investor confidence,
investment committee willingness to contemplate rescue packages may
decline; portfolio considerations may inhibit individual managers’
ability to arrange rescues – particularly if there has been a spate of
problems in the portfolio. Investors with board positions in a number
of companies are also very mindful that they have legal obligations
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Realization of the investment
which must be observed. As directors of businesses that fail they will
be subject to the potential scrutiny of the DTI inspectors if they are
involved in cases where there has been financial misbehaviour.
Even so, investors are usually anxious to avoid failures in their
portfolios for a number of reasons:
n
First, it obviously damages the portfolio rate of return.
n
Second, it does their reputations no good to have failures – although
everyone encounters them at some time.
n
Third, no one likes having to deal with such problems.
n
Fourth, it takes time away from doing profitable deals.
n
Fifth, it costs them money individually through the carried interest
provisions of the fund.
n
Sixth, it makes future fundraising very difficult if they gather
reputations for making more poor investments than normal, even
if the overall rate of return is still good.
n
Finally, turning businesses round from the brink brings its own
form of kudos – both within venture capital circles and among
investors.
Recent revisions in the law of insolvency have made company voluntary arrangements more attractive and practical. This may well bring
fewer liquidations of venture-backed businesses, since it is usually in
the interests of very few creditors to see companies go under. With the
removal of Crown preference for debts in the Enterprise Act 2003, the
pressures on businesses to fold are now much more likely to come
directly from the banks.
VCs probably consider it is better to cut their losses early and put a
business into an orderly shutdown rather than go through the messy
and traumatic process of forced receivership. This may run counter to
the wishes of the working directors, of course, who usually stand to
lose far more financially than the VC. They are more likely to try to run
businesses out of trouble, since they have fewer options. They cannot
walk out of their offices and into another boardroom and another deal
as the VCs can. Consequently, they are more likely to skirmish with the
problems of insolvent trading than the VC is willing to do. Working
directors lose their investment and their livelihood; VCs (angels
excepted) just lose someone else’s money.
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Venture capital funding
13
Summary: do you still want
venture capital?
Faith, n: Belief without evidence in what is told by one who
speaks without knowledge, of things without parallel.
Ambrose Bierce, The Devil’s Dictionary
n
Are you sure you still want venture capital?
n
In defence of other funding
n
In defence of VCs
n
Overall verdict
n
The point of departure
In Chapter 2 the question was raised as to whether inviting VCs into
your business is like doing a deal with the devil. After an introduction
and 12 chapters you may be closer to being able to making a judgement
on that. Or maybe not: maybe this book has dealt more with the
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Summary
mechanics of raising venture capital than with the reasons for doing
so. Maybe we should put the case more formally and consider the two
options, and work out an argument in defence of doing without
venture capital funding and one in defence of working with VCs.
IN DEFENCE OF OTHER FUNDING
There are potential problems with venture capital funding at every
stage of the process – which is what makes the alternatives to venture
capital attractive to some businesses. The problems can be dealt with
by looking at the investment opportunity in a number of ways and
contrasting the different approaches
Size of investment
The funding gap may or may not exist; the statistics can be used to
‘prove’ the case either way. But what is certainly true is that if you are
seeking only a modest amount of funding – say, much below £250,000
– you are going to find it difficult to attract venture capital funding.
That is, of course, unless it is very obvious that the total amount
that you require over a fairly brief period is quite considerably larger
in the longer run – the sort of situation where the initial modest amount
will get you through the first six months but then you will need a
further tranche of at least as much again to start the business moving
on.
The upshot of this is that you are better off finding a business angel,
or using the goodwill of your family or friends (if they have cash) or
remortgaging your house if you need much less than a couple of
hundred thousand.
One of the other routes for funding that is often neglected – despite
the amount of effort that goes into publicizing it – is the rich seam of
grants and matching funds from public money that can be used for
defraying the cost of starting up a business; getting training; taking on
staff and designing and building prototypes. VCs will think more
highly of a funding proposal where any or all of the above routes have
been tapped first when it comes to securing additional funding – even,
despite what has been said in earlier chapters about the slightly fraught
relationship that often exists between the two, the angel route – which
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Venture capital funding
indicates that basic market research has been done and that someone
has been willing to back a deal with cash.
Science-based opportunities may well be able to raise small amounts
of funding from university seed funds (either captive or associated
ones) or some of the semi-philanthropic bodies that exist to provide
early-stage development money. Public funding is also a suitable
source for proof of concept money for proposals coming from this
sector.
Angels are the obvious source of funds where a commercial business
needs between £25,000 and £200,000. The smaller sum is usually within
the compass of one investor and the larger amount can be raised by
attracting a syndicate of angels. (If you need less than £25,000 then you
really should be thinking about raising it from your own resources.)
They will apply common sense to assessing the opportunity and
management skills in helping to develop the business.
Verdict – find your funding from other than a VC if you don’t need
much money.
Score – Others: 1, VCs: nil.
Type of funding
The basic rule in funding any cash gap is to match the life of the debt
with the life of the activity being funded. Approaching VCs to fund an
imbalance between seasonal trading levels and available cash is a surefire route to becoming one of the proposals on the reject pile. The same
will be true of talking to business angels. If you need to plug a
temporary cash hole then go and talk to your bank about an overdraft.
Venture capital – either provided by a fund or by an angel – is for a
fundamental change in the business, not a temporary cash embarrassment. But angels are likely to be more flexible in injecting the money
since they will want to be involved in spending it too, through their
usual requirement that they get involved in some sort of managerial
capacity.
Verdict – match the cash source against the life of the project.
Score – draw.
Cumulative – Others: 2, VCs: 1.
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Summary
Type of opportunity
Chapter 2 dealt with some of the opportunities that cannot be followed
up by VCs: sole traders, businesses run by those with criminal records,
illegal or embarrassing businesses (the crack house; the porno cinema
chain), are unlikely to get much of a hearing. The same will be true for
reputable angel investors.
Geography and sector play their part in what makes a proposal
fundable, too. If you are in a high tech business you are probably a
better bet for a VC than if you want to build a nationwide chain of
Better Blacksmiths Ltd. (Don’t laugh – that was an opportunity offered
to the Coal Board Pension Fund in the early 1980s.) If you live in the
South East of England, the East or West Midlands or the (near) South
West then you are probably in a better position than if you live in
Hawick or Stornoway
But the truth has to be faced that some businesses, even though they
apparently have the right structure (incorporated), are seeking the right
amount of money, are located in the right place and seem to address
the right marketplace, are just uninvestable. And the reason is that the
people behind the investment opportunity cannot command the
confidence of potential investors.
A popular myth seems to have built up, over perhaps the past
decade, that everyone who wants to start a business ought to be given
the chance to do so. This stems from a corruption of the entirely
appropriate and reasonable idea that there ought to be a more level
access to the funding process which doesn’t distinguish between
gender or race or eliminate you at the outset if you didn’t go to the right
university (or even no university). But making sure the door is wide
enough and making sure that everyone passes through are two very
different things. And so they should be.
It used to be that everyone thought that they had a book inside them
– everyone thought that they could have written Harry Potter or Eats,
Shoots and Leaves if only they had had the idea first/had had the time/
had the application/possessed the sheer doggedness/had the grit to
pick themselves up from each defeat and kept on going. But they didn’t
– so they didn’t deserve to have the best seller either. The same goes
for business.
Unfortunately, government policy, popular culture, the press and
television all conspire to make the lazy, the gullible or the chronic
daydreamer think differently. Encouraged by the ‘Pop Idol’ mentality,
starting business is now a sort of televisual event. (At the start of 2005
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Venture capital funding
there was even a programme called Dragon’s Den with a panel of judges
who sifted good business ideas – few – from the rubbish – many, vast,
overwhelming – that people dream up every day, and lampooning the
unfortunate rejects in the process, of course, to make good television
for the sofa-bound masses.) The unpalatable fact for many would-be
entrepreneurs is that building a business is a very hard slog for which
only a few have the appetite or the aptitude.
It does not matter whether you approach a VC or an angel; if there
is no basic attraction to the business in terms of the personnel or if the
idea is bankrupt from the start, you will get turned down – by both.
Verdict – not every opportunity deserves to be funded (or re-funded,
see below).
Score – goalless draw.
Cumulative – others: 2, VCs: 1.
Re-funding
For many businesses that struggle to achieve the promise of their
original business plans, the existence of a venture capital investor
among their shareholders can become a financial strait-jacket. They can
wriggle a bit but they can’t get free. Not doing well enough to attract
further funding from the original venture funder, they will be stuck in
financial no man’s land where the prospects of them achieving funding
from anyone else are also very limited. The powers of the shareholders’
agreement that protect the position of the original VC may make
bringing additional capital on board in a timely way very difficult.
To be fair, VCs are no happier with this sort of situation than the
management of the company. The usual way out in such circumstances,
if no compromises can be made over pricing and/or shareholding, is
a distress sale to a business which might have a strategic fit or a change
of senior personnel to try to revitalize the business (a process which
was discussed in Chapter 12). A secondary trade in large investments
is now developing among very large venture capital funds (which are
now so large in some cases that they have become industrial holding
companies rather than venture funds) and this also provides some
possibilities of shifting companies to different owners who can try
different tactics with different senior personnel.
A venture-backed business that has performed badly is extremely
circumscribed in its ability to raise additional funding because of the
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Summary
anti-dilution clauses that protect the venture investor’s shareholding.
When you consider that perhaps three out of every ten early-stage
investments go badly wrong (see the BVCA statistics in Chapter 1) then
this sort of restriction may be contributory in killing off a large number
of businesses. So not doing well with venture capital on board is a
highly risky situation for the individual entrepreneur or management
team.
In mitigation of the VCs’ attitude over this, many businesses which
go badly wrong do not deserve another chance; failure is not always
simply ‘a bit of bad luck’. Recognizing this, VCs are not very tolerant
of failure in management teams and are unlikely to be able to inject
further funds in an ailing business without substantial managerial
changes.
Angels will probably be no more tolerant of failure but may have the
time, ability and hands-on approach that will contribute to catching
such problems before they occur. In addition, since they are less reliant
on detailed and complex investment agreements they can be more
nimble in sorting out problems after the event.
Very early-stage investments often lack managerial capacity as well
as being vulnerable to market movements and are probably better left
to the attentions of skilled business angels whose time and application
can, again, be brought to bear in sorting out soluble problems in a way
that fund mangers cannot afford to do.
Verdict – higher risk and small opportunities probably do better out
of the detailed attention that can be given by business angels.
Score – others: 1, VCs: nil.
Cumulative – others: 3, VCs: 1.
Complexity of the deal
Well over two-thirds of the amount of money raised in 2003 by UK
venture capital funds for investment in this country came from US
sources. If we take into account the local subsidiaries of US banks and
venture funds that are operating in the UK, that means that somewhere
around three-quarters of the money that goes into UK businesses, as
part of venture capital funding in rounds soon to come, will be of US
parentage.
All money comes with strings, and in the case of the UK venture
funds raising money in the United States, this means there will have
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Venture capital funding
to be a regime of regular and detailed scrutiny of investment returns.
Venture fund managers in the United States are accustomed to much
more regular scrutiny than their UK counterparts and have a need to
justify their investment records on a more frequent basis. UK fund
managers will have to do the same, and may have to increase the
frequency of their formal reports to their investors.
Unfortunately, small and young businesses often take more time to
develop than the period between the reviews conducted for investors
in the funds. Although returns in good small businesses can be
explosive, they often come with a bang at the end of a long hard slog
rather than in a steadily increasing accumulation. This does not suit the
VC – unless he can arrange it that his portfolio of small companies all
fire in sequence rather than in a lumpy pattern. Consistency and risk
reduction go hand-in-hand down the investment path.
In the United States, the wealthy lawyers, dentists, doctors (and
pension funds) who fund the US venture managers’ bets prefer solid
and consistent returns. Consequently the fund managers cater for their
preferences in order to raise more funds next time round (to preserve
their own jobs). A similar process began some time ago in the UK –
mixed with the desire of managers to mobilize their funds quickly. So
there have been four pressures on funds in recent years:
n
the need to prove solid returns;
n
the need to provide good returns (from controllable situations);
n
the shortening time span for generating positive returns;
n
the need to mobilize large amounts of cash.
Not surprisingly, the market for funds has moved to bigger, safer deals
– as we have seen, over 90 per cent of the private equity pot now goes
into MBOs and MBIs.
The transatlantic influx of cash has been accompanied by an influx
of transatlantic-style legal agreements. When the UK market for
venture funding developed strongly in the late 1980s and early 1990s,
US venture funds entered the UK market in strength and they brought
their style of legal agreements with them. Although they often sit oddly
with English company law (with its bias towards favouring the rights
of the creditor above those of the shareholder) the style of US agreements (which is founded in a body of law which adopts the diametrically opposite tack) has been adopted by most venture managers. (For
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Summary
some time it looked as though 3i might hold out against the trend and
develop a uniquely British way of doing deals but with the market
flotation of that company, it has succumbed to the general flow). The
adoption of US practice has tended to give rights and powers to venture
funds, as shareholders, which are considerably out of kilter with the
responsibilities that they have towards management and other shareholders. This means long and detailed investment agreements – the
component parts of term sheets, shareholders’ agreements, due
diligence reviews, accountants’ reports, completion audits and so on.
All this documentation – all of which is completely understandable,
and necessary in many respects – has led to a ponderousness in the
behaviour of many funds that the managers of companies seeking
finance can find very frustrating. Many entrepreneurs seeking to raise
cash find the approach taken by VCs painfully bureaucratic; legalistic;
costly; and – dare it be said – risk averse.
Angels, by contrast, often seem to be extraordinarily nimble in the
way that they can review, evaluate and complete deals. They will often
evaluate the deal by ‘feel’ and using their own industry knowledge;
they will complete on fairly simple legal agreements involving,
perhaps, only modest modifications to the articles of association:
warranties tend to be limited in nature.
Unfortunately when the big funds try to compete in the nimbleness
races they often come severely unstuck. Too often, in order to get
nimble, the funds have to bend rules. So when feeding frenzies like the
dot.com mess arise, they bring out the worst in VCs as they bend their
own rules to accommodate their greed. The ClickMango debacle,
which was briefly detailed in Chapter 10, is a prime illustration of this.
The legal documentation was point-perfect but the basic work on the
prospects for the deal had not been done. Although ClickMango
collapsed honourably, in an orderly shut-down, collapse it did.
It is, perhaps, unfair to concentrate on ClickMango again when there
are numerous other examples that could be used. But the point is that
the funds – with their formalized paraphernalia of methods, their
house styles and so on – are like elephants in the slow, focused and
stately way that they advance through their procedures. It’s when they
try to tango that they start to trip over their feet – and elephants
dancing mostly make themselves look ridiculous.
Complex legal agreements and long and detailed due diligence may
not be suitable for every deal. We have already seen that some smaller
funds are experimenting with doing deals differently – combining
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Venture capital funding
elements of the approach adopted by business angels – with the best
of their own practices. By making the process of investment less costly
this development may well be the way forward for the smaller funds
and will be welcomed (if it succeeds) by companies seeking smaller
amounts of capital.
Verdict – VCs like complexity; it makes them think that what they
are doing is more respectable than riverboat gambling (but with the
added frisson that they are using other people’s money).
Score – (assuming you don’t like complexity) others: 1, VCs: nil.
Cumulative score – others: 4, VCs: 1.
OVERALL VERDICT
With a cumulative score of 4 to 1 it looks like, on most counts, other
sources of funding – retained income, mortgage funds, the 3Fs (friends,
fools, family), soft loans, grants and so on – are a better bet than VCs.
But hold on. We haven’t made the case for VCs yet. And the raw
scoring conceals some fairly close similarities on some aspects. How
does venture capital score when we look again at some of the aspects
of funding and include some different ones?
IN DEFENCE OF VCS
We shall review the case for the same points as we have discussed
above. At the moment the VCs appear to have lost fairly conclusively
on:
n
small size deals;
n
deal complexity; and
n
(some) elements of re-funding.
and have come out neutral on:
n
type of funding; and
n
type of opportunity.
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Summary
We shall have to look again at these and perhaps other factors to see if
the VCs can come out with a better score on other aspects.
Let’s concede small size deals. Most VCs are not equipped to deal
with them since the cost of doing the deal in the complexity that their
procedures require, makes them uneconomic. Most VC funds, mobilizing large(ish) amounts of money simply can’t get the return they need
in the volumes that they require to make these deals worthwhile. Let’s
also recognize, though, that there are honourable exceptions to this
among the smaller funds – so it’s not a total whitewash.
And let’s concede complexity, too. The reason that the VCs’ deals
are complicated is because they are dealing with large amounts of other
people’s money that have to be properly stewarded. The business angel
is looking after his own money and can do what he likes with legal
agreements and due diligence. When syndicates of angels get together
the complexity of the legal agreements also usually increases (although
perhaps not to the level of a typical VC term sheet). Again, not a total
whitewash – a bit less than an honourable draw though, because the
VCs are being driven by the people pulling their strings rather than
opting for complexity for complexity’s sake.
Where VCs score is on the following.
Follow-on funding
With a total of nearly £9 billion under current management, venture
capital funds are not short of a bob or two. Their capacity for followon funding is virtually unlimited – at least collectively. With this
amount of money available to them they are always looking for
sensible ways to spend it – indeed the BVCA’s standard line is that
good proposals will never go short of an offer (although that offer may
not be acceptable of course) because of the sheer weight of funds that
have to be invested. The investors in the funds do not expect to see their
money sitting idle while the managers draw management fees; they
want their money invested.
Business angels only have pockets of limited depth and while more
angels can be brought in to provide more cash, eventually the number
of participants can become unwieldy. Above a certain size, unless the
angels act like one venture capital investor it will be better, easier and
simpler to deal with only one investor. For sums above a million, then
it may be difficult to find sufficient angels to contribute the amount
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Venture capital funding
required while still retaining the flexibility that is the hallmark of their
contribution.
It is rare for an investment that has achieved its targets not to be
supported by a first round (or Series A) funder. However, some small
funds may find themselves unable to follow on simply because of
portfolio constraints. The regional venture capital funds , for instance,
are limited in the amount that they can put into any one investment
by their charters. The idea of this was to prevent them moving
upstream into progressively bigger deals but many of the regional
managers are already chafing at this restriction. So it is conceivable that
some investee companies which have done very well will find that their
original investors cannot give them the extra push that they want. This
will be a problem for the RVCFs rather than for their companies to
work through, but it may well involve some hard negotiation on the
part of all concerned – companies, RVCFs and new investors.
The major constraint on follow-on funding is that the rate of return
for the period of growth for which the funding that is being sought has
to be at least as good as that which has been already achieved or the
overall rate of return will be diluted.
Verdict – VCs have deep pockets.
Score – other sources: nil, VCs: 1.
Large and complicated deals
The converse of the fact that business angels are probably the best
sources of funds for small deals is that venture capital funds are probably the best for large ones. Business angels are simply unable to operate collectively in sufficient numbers to generate the funds that large
deals require. Few angels will be willing to place sums of more than
£200,000 in any one investment (there simply aren’t the number of
people with that level of funds to invest coupled with the desire to
invest directly). So raising funding for a business turning over £40
million (the average venture-backed business turns over that amount
at investment) would involve more angel investors than I have fingers
and toes to count on – I know it’s not worth taking my shoes and socks
off to try.
Angels also make a virtue of their simple approach to investment –
a feature that many small firms greatly appreciate. The other side of
this is that complicated deals involving many subsidiaries, complicated
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Summary
inter-trading, or long supply chains are not suitable fodder for business
angels.
Verdict – if you like or need complexity then VCs are the right source
of funding.
Score – other sources: nil, VCs: 1.
Cumulative score – others: nil, VCs: 2.
Cross-border transactions
With Europe increasingly becoming a single market for many types of
consumer good, as economic reality takes over from the political
rhetoric, many large businesses are now in play for venture capital.
Consequently there is an increasing tendency for British venture capital
firms to test the waters outside the UK. In 2003 nearly 200 such deals
were done. Not surprisingly, many of these deals involve vast amounts
of money as pan-European conglomerates are broken up. The Parmalat
affair in 2004 provided many operational managers with a chance to
test the appetite of European venture capital firms to invest in Europewide food businesses, for instance.
Many of these very large deals are now arranged across European
borders rather than within one legal jurisdiction. This involves
complicated legal arrangements which have to respect the very
different legal background of the European states. There are comparatively few people in professional practices of lawyers and accountants
who can undertake the work required to arrange such deals, and only
a few of the very large venture firms consider themselves equipped to
operate across borders. Business angels are not able to work in this
environment. They do not have the legal or accounting resources to
execute such deals.
The development of the Societas Europaea – the European limited
company that will be subject to the embryonic body of European
company law – will stimulate such developments and add a further
stratum to the market.
Verdict – very big deals that cross borders are the preserve of only a
very few venture firms, as yet.
Score – other sources: nil, VCs: 1.
Cumulative score – others: nil, VCs: 3.
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Venture capital funding
Nurturing investments through to stock market
flotations
Fully one-third of the flotations that took place under the Official List
requirements of the London Stock Market between June 1992 and
December 2003 were of businesses funded by venture capital. Since its
inception in 1995, venture-backed businesses have accounted for 10 per
cent of all flotations on the Alternative Investment Market.
The large venture capital companies have a good record in grooming
their businesses for flotation. The resources of the large funds, in terms
of the web of contacts that they have, and the skills of the individual
investment managers, are both of a sufficient level of sophistication to
support businesses aiming for a flotation – an ‘initial public offering’
of shares.
While some business angels will be able to do this it will be beyond
the ability of the majority. Some angels, of course, will have superlative
networks of professional contacts and a thorough understanding of the
complexities of the listing requirements – or more importantly the work
that needs to be done to prepare for listing over a long run-up to the
event. But these people will be very few in number. Angels specialize
in applying their practical managerial skills to the development of the
businesses they have invested in. While they may have experience of
working in big listed companies, they do not usually have big company
listing experience.
Verdict – if you are aiming for a float within a few years of the
investment being made, the support available from a large fund will
be invaluable.
Score – others: nil, VCs: 1.
Cumulative score – others: nil, VCs: 4.
Overall score – others: 4, VCs: 5.
Overall verdict
Using an additional set of measures it is not quite so clear-cut that VCs
are less desirable choices. In fact, taken overall, they have definite
advantages over other sources of funding, in terms of bringing large
amounts of money to bear and following through with that funding.
The score when taken on all counts confirms what common sense will
already have suggested – that companies wanting modest amounts of
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Summary
funds should try informal routes first, then business angels. Companies
wanting to raise larger amounts of money should go straight for
venture capital funding but grit their teeth and think of England when
confronted with some of the less user-friendly aspects of the terms they
will be offered.
For particular opportunities, VCs also have distinct advantages over
other sources of funding. Venture capital funding from larger formalized funds is most suitable for deals where follow-on funding is almost
certainly required, probably in the same sort of magnitude as the
original injection; for large and complicated deals; or those involving
cross-border ownership of subsidiaries; or for businesses which know
that they want to aim for a flotation within a short(ish) period of the
investment being completed. Angels in particular find it difficult to
match the funding capacity of the venture funds in these situations and
other sources will have run out long beforehand.
There is one further point that needs to be discussed before any
conclusive stances are adopted. It applies to all situations where there
is an investor and an investee but is probably most relevant to those
situations involving a venture capital fund rather than a business angel.
It concerns the point of departure between the interests of the two.
THE POINT OF DEPARTURE
The basic purpose of any commercial proposition that might attract
venture capital has to be the creation of wealth. This is simply because
there is no other way that the effects of the injection (and hence the
suitability of the opportunity for the investor) can be measured. So it
is a given that the objective of the VC and the entrepreneur must be
the same initially (at least). That is, both parties want to see their wealth
increase as a consequence of making the investment. Or using a notion
that is important to VCs, investors want to achieve a rate of return on
individual investments which is sufficiently high to make them commit
time and resources to attempting to achieve it. It has to have a value
that is higher than the opportunity cost of putting the money elsewhere
given the risks involved.
However, while the objective (in its rawest, least precisely-defined
form) may be common between entrepreneurs and VCs as potential
partners, not all routes to achieving it will be equally attractive to both
parties. So the point of departure from the existing position – just before
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Venture capital funding
cash is injected into a business – also becomes potentially the point of
departure between the aims and intentions of the VC and the entrepreneur(s). Consequently, it is vitally important for the health of the
investment to recognize from the outset that the interests of the entrepreneurs and the VCs will not be congruent, they will be overlapping.
The area of overlap between the intentions of the parties will be one
of the major determining factors in the eventual success of the investment. The longer the overlap can be sustained and the greater degree
of overlap the more successful the investment is likely to be.
Unfortunately there are at least two groups of factors that contribute
to confound the maintenance of this overlap. First, both the VCs and
the entrepreneur will be carrying a whole bagful of objectives – some
of which may be similar in terms of the way that they are achieved,
others of which might even serve to work against each other over time.
For instance, the entrepreneur might want the VC’s money but not the
necessity of appointing him to the company’s board (a common
requirement for many investments); or he may be happy to see the
business develop in such a way that it provides employment for his
family in the longer term, while the investor wants an investment with
a fast realization and a quick profit. What is even more complicated is
that these bags of objectives that each of the parties to the deal will
carry to the negotiating table may be explicit or implicit, recognized
or not, known or concealed.
Second, investors rarely make their investments in isolation: portfolio pressures may compel the fund’s initial realization policies to
change over time (sometimes quite quickly) and fashions in investment
can also radically affect an investor’s perception of the current value
of an individual opportunity – for better or for worse. As an example,
suppose a venture capital fund has suffered a series of reverses in the
investments that it has made and is approaching a new round of
fundraising to replenish the funds it manages. The success of just one
investment being realized through a trade sale or flotation can then be
crucial to the success of the fund managers in demonstrating that they
can pick winners, in order to secure the contribution of future participants to their funds. This may mean that they might place pressure on
a business to accept an offer from a commercial suitor even though the
duration of the investment has not been as long as was foreseen at the
time that the investment was originally made, in order to achieve that
valuable ‘signal’ realization.
But while a realization might suit the fund, the entrepreneur in
charge of this venture might feel that the profit opportunity is being
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Summary
foreshortened and that the realization is too early – waiting another
year or two until that recently-introduced new product line has fully
developed its market potential might be the better outcome for him.
Or suppose an investor has a portfolio largely composed of investments in technology-based businesses. An irrational swing in investing
fashion – like the dot.com boom – might prompt a change in investment or realization policy so that the investor feels he has to unload
his holdings as soon as possible in order to take advantage of market
buoyancy. When changes are irrational – as fashion changes in investment often are – then good performance from an individual investment
is no guarantee of immunity from policy changes founded on that
irrationality.
Third, the relationship is one-sided in its preponderance of power.
If you are thinking that it looks like most of the problems outlined
above emanate from one side of the investment fence, you are right –
the entrepreneurs’ intentions will have been pretty thoroughly flushed
out prior to the investment having been made. The investment agreement will have been drafted to favour the outside investor in terms of
the timing of a realization. What also has to be appreciated is that when
an entrepreneur does have a change of heart in some way he can often
be replaced with someone else by the VC – in fact, it happens all the
time. It will be less easy and comfortable for an entrepreneur to sit with
an impatient shareholder than the other way round – since the venture
capital shareholder will have the backing of an investment agreement
that will probably give him the power to compel the realization of the
investment if he feels it is in his interest.
Both parties might have entered the investment with the expressed
intention that it would last a certain amount of time but outside
pressures that cannot be predicted at the outset will affect the actual
life of the investment. In particular, although he might have truthfully
voiced his intentions when the investment was made, no VC will ever
commit irrevocably to a specific time horizon for the life of an investment. Above all else, VCs are opportunists.
So you can appreciate that factors that are unknown at the time of
an investment being completed, can very often overthrow the original
intentions of the parties towards the timing of the realization of the
investment.
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Venture capital funding
GENERAL CONCLUSION
What has been said numerous times throughout this book can still be
repeated with profit: venture capital investing is not about taking risks;
it is about reducing risks. Everything that VCs do is focused on this.
It has been pointed out before in this book that it may be that the
pendulum has swung too far: the desire to reduce risk has strayed into
a desire to eliminate risk for many venture capital funds. Certainly, four
factors have contributed to this:
n
Much of the legal armour that now coats venture capital deals. A
neutral reading of many investment agreements would suggest that
there is little being ventured. The extreme reaction of the lawyers
to protecting their moneyed clients’ interests actually inhibits deals
being done expeditiously and at reasonable cost; it also makes the
development of the business more difficult, except for proposals
that are racing certainties; it probably stultifies the development of
many companies by denying all but the surest of investments the
oxygen of capital.
n
The move upstream to larger and larger deals. This has become a
game of pass the asset parcel, which means that many VCs are now
concerned with asset manipulation rather than developing new
businesses.
n
The triumph of the US way of venture investing. This has transformed the style of doing deals; the pace of deal and portfolio
review and even the terms that used to be used, just as surely as
the aggressive US grey squirrel has ousted the native red.
n
The general confusion between private equity investment and
venture capital. This book has not sought to unravel that confusion
because the twin terms, private equity and venture capital, lead to
such clumsy usage when talking about direct investing generally.
But the distinction that is increasingly made within the business
itself is a valid one: venture capital really only applies to early-stage
investments; everything else is private equity. Large deals involving
changes of ownership of existing businesses are really not venture
capital at all. They are private equity plays with active investors
doing what investors in quoted businesses have been forced to cede
to management and pension fund investors – the control of the
overall direction of the business.
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Summary
But there are signs that things may be moving the other way. Two or
three times, mention has been made of the newer younger venture
funds – some of which are utilizing different techniques of stimulating
enquiries and evaluating proposals. These funds are utilizing the best
techniques of the angel investors allied with the more rigorous
investigative style of the formalized funds to produce dynamic and
effective investment processes. It is as yet too early to tell whether these
will result in good returns for both investors in the funds and the
investee companies, as the funds have not yet been in existence for long
enough to begin realizing investments.
Other actions need to follow from those funds that are still active in
the venture capital field to complement these changes. Primarily what
is needed is a less legalistic way of behaving in completing deals.
The legal baggage of doing deals that restricts and inhibits and
makes raising funding more costly than it need be should be reduced.
Overly restrictive terms sheets, anti-dilution provisions, drag-along
and tag-along, liquidation preference – all should be gradually dispensed with so that the venture funds get back to being more like the
angels that they once were, willing to take the knocks and bumps of
the commercial world.
Markets where no one fails and no one loses are ossified mechanisms
that only provide for passing the parcel and the manipulation of
financial assets. They do not stimulate real investment, real technological progress or the development of wealth.
207
Appendix 1
Appendix 1: Glossary of terms
Dictionary, n: a malevolent literary device for cramping the
growth of a language and making it hard and inelastic. This
dictionary is however a most useful work.
Ambrose Bierce, The Devil’s Dictionary
This is a brief listing of some terms that may be unfamiliar and will be
encountered throughout the text. The chapter on the legal stages
(Chapter 10) gives further specific definitions of legal clauses that may
be encountered in negotiating a deal.
AIM Alternative Investment Market: the junior market of the LSE;
companies floating on AIM are not required to comply with the Listing
Rules but are subject to lesser regulation.
AQAP Allied Quality Assurance Programme.
Articles of association Legal documents required for every company
describing how the business works internally, by detailing the rights
and obligations of both the members of the company to each other and
also the company to the members.
208
Appendix 1
BBAA British Business Angels Association
Blow-out financing Refinancing that eliminates the value of previous
rounds of financing. Also – perhaps more usually – called ‘washout’
or ‘cram-down’ rounds, after US usage.
BVCA British Venture Capital Association.
Business angel A private investor willing to provide cash to a
business in return for a slice of equity. Such individuals are assumed
to be ‘sophisticated’ investors and of high net worth (HNW).
Closing The completion of a deal.
Completion meeting The meeting of lawyers, investors and management at which legal documents are signed and the investment completed.
Control premium The additional amount of money, usually beyond
the strict asset valuation, that has to be paid to gain complete control
of a business.
Development capital Funding to enable the organic expansion of a
business; sometimes called expansion capital when it includes acquisition.
Dilution The reduction in a shareholding consequent upon a further
round of financing.
Due diligence The process of investigation of an investment proposal.
Elevator pitch Originally a presentation given in the space of time
that a lift takes to go up (or down) a skyscraper; now any brief initial
presentation to investors.
Equity Ordinary shares conveying ownership rights.
Equity drift The difference between the amount of equity possessed
at the start of an investment and the final holding.
Equity gap The purported failure of the market to provide funds for
small companies or for companies requiring small amounts of capital.
Exit A sale or other event prompting the departure of the investor.
Flotation The listing of a company’s shares on a public stock exchange; now largely superseded by the US term IPO (initial public
offering).
Follow-on funding (Usually) additional financing provided to a
company by the first round (or ‘Series A’) investors recognized as being
necessary at the outset of an investment.
Hurdle rate The rate of return that an investment has to achieve
before it can be considered further.
Intermediaries Professional financial advisers of one sort or another.
Investee Someone who receives investment.
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Appendix 1
Investment committee The internal body of an investment fund that
has the final say as to whether an investment goes ahead. Usually
composed of senior executives of the fund and outsiders; perhaps even
representatives of the investors in the fund.
IPO Initial Public Offering – a flotation.
IRR See ‘rate of return’ below.
Legals Abbreviation for legal documents or legal stages.
LSE London Stock Exchange.
Main market The senior market of the London Stock Exchange,
subject to detailed regulation and control by the regulating authority.
The listing rules, which govern the market, do not have the force of law
but failure to comply with them would result in a listing being
suspended.
MBO Management buy-out; divestment of one company by another
by direct sale to the incumbent management; a variant is the MBI or
management buy-in where outsiders take over a company from a
parent, sometimes retaining members of the old management. Despite
excited press reports to the contrary there is no such thing as a BIMBO
– supposedly ‘buy-in management buy-out’ – at least not in finance.
Memorandum of association A counterpart document to the Articles. The memorandum explains what the company has been set up to
do.
Mezzanine finance Intermediate funding with some of the characteristics of debt and some of the characteristics of equity.
Minority rights Certain legally protected rights of small shareholdings; enshrined in Table A of the Companies Act 1986 and by
default in all other articles of association.
Non-executive director A legal officer of the company; a director
without line or staff functions but still owing a fiduciary duty to the
company whose appointment is registered at Companies House.
Offer letter Now usually called ‘term sheet’ – the document setting
out the terms on which the investor proposes to make his investment.
It is non-contractual and may be negotiable as to specific terms.
P/E The price–earnings ratio – a measure of the comparative value
of a share.
Pre-emption rights The right of first refusal to buy (or sell) shares.
Ratchet A device for transferring shares between investors and
management shareholders. It operates (usually) through convertible
shares, is dependent upon certain targets being achieved and can be
either positive (gives a proportion of the company back to managers)
or negative (retains shares in investors’ hands).
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Appendix 1
Rate of return (RoR) Specifically the internal rate of return. The
compound annual interest rate that will reduce the value of an
investment to zero over a given period of time.
Realization A sale or some other event at which shareholdings
become both crystallized and liquid – sequentially, of course.
Rescue capital Funding provided to salvage a business – often
provided on penal terms.
Risk–reward ratio The investor’s perceived balance between the
attractiveness and disadvantages of an investment proposal.
RVCF Regional venture capital funds – established in every English
planning region, professionally run by private sector managers with a
mixture of public money and privately raised capital.
Sweat equity The immeasurable component of an investor’s direct
contribution.
SWOT A SWOT analysis investigates a business in terms of strengths,
opportunities, weaknesses and threats.
Term sheets See ‘offer letter’.
Trade sale A sale of one company directly to another business.
Working capital The amount of money tied up in debtors, creditors
(including future taxation) and stock.
211
Appendix 2
Appendix 2: Useful addresses
Many useful documents are published electronically and free of charge by the
BVCA and by BBAA. Consult their websites for more information.
BVCA
3 Clements Inn
London WC2A 2AZ
Tel: 020 7025 2950
E-mail: bvca@bvca.co.uk
Website: www.bvca.co.uk
British Business Angels Association
52–54 Southwark Street
London SE1 1UN
Tel: 020 7809 2305
E-mail: info@bbaa.org.uk
Website: www.bbaa.org.uk
212
RVCF contacts (as at January 2005)
North East fund
David Wilson
Northern Enterprise Limited
3 Earls Court
5th Avenue Business Park
Team Valley
Gateshead NE11 0HF
Tel: 0191 442 4300
Fax: 0191 442 4301
E-mail: David.wilson@nel.co.uk
Appendix 2
East Midlands fund
Mike Piper/Rob Carroll
Catapult Venture Managers Limited
BioCity
Pennyfoot Street
Nottingham NG1 1GF
Tel: 0870 116 1600
Fax: 0870 116 1601
E-mail: mike@catapult-vm.co.uk/ or
rob@catapult-vm.co.uk
South West fund
Keith Masson
YFM Ventures Limited
Argentum
Bristol Business Park
510 Coldharbour Lane
Bristol BS16 1EJ
Tel: 0117 906 3410
Fax: 0117 906 3646
E-mail: southwest@yfmgroup.co.uk
North West fund
John Hardcastle
RVCF Fund Manager
North West Equity Fund
Antler House
Crouchley Lane
Lymm
Cheshire WA13 0AN
Tel: 01925 759 246
Fax: 01925 759 792
E-mail: JohnH@nwef.co.uk
South East fund
Derek King
South East Growth Fund
2nd Floor, Orbital House
85–87 Croyden Road
Caterham
Surrey CR3 6PD
Tel: 01883 337111
Fax: 01883 337112
E-mail: mail@segrowthfund.co.uk
London fund
Geoff Sankey/Ian Cameron
YFM Venture Finance Limited
Brookmount House
62–65 Chandos Place
Covent Garden
London WC2N 4LP
Tel: 020 7812 6772
Fax: 020 7812 6773
E-mail: london@yfmgroup.co.uk
Yorkshire and Humber fund
Mary Broadhead/Richard Taylor
YFM Venture Finance Limited
Handsworth House
35a Handsworth Road
Sheffield S9 4AA
Tel: 0114280 0918
Fax: 0114 280 0923
E-mail: sheffield@yfmgroup.co.uk
West Midlands fund
John O’Neill
Midven Ltd
37 Bennetts Hill
Birmingham B2 5SN
Tel: 0121 710 1990
Fax: 0121 616 2223
E-mail: john.oneill@midven.com
East of England fund
Boyd Mulvey
Create Partners Ltd
Victory House
Victory Park
Histon
Cambridge CB4 9ZR
Tel: 01223 202876
Fax: 01223 484511
E-mail: enquiries@createpartners.com
213
Index
Index
accountants
accountants’ investigation 47,
75–76, 129–32
due diligence process, role in 115
employed as professional advisers
69–70
flotation, role in 182
as venture capital fund managers
60
working with business angels 44
Alternative Investment Market 202
annual compound growth 119
anti-dilution provisions 160
Apax Partners 59
Apple Computers 3
assets
significance of in due diligence
process 78
balance sheet 15, 51, 66–67, 118, 145
balloon loan 143
see also loans
banks 45, 97–98, 180
account history 127
captive funds 49
214
loans 143–44
mezzanine capital 4
overdraft 192
sources of finance 24
Beer and Partners 45
Beermat Entrepreneur, The 18
Bevin, Lord 12
biotech 10, 118
Bloomfield’s Laws
First 101
Second 104
blow-out financing 87, 138, 147, 150
see also refinancing
board packing rights 146
Boo.com 18
Branson, Richard 183
British Business Angels Association
(BBAA) 43
British Venture Capital Association
(BVCA) 9, 27, 39, 72, 77, 199
business angels
desk review by 117–19
individual investors 3–4, 18, 43–45
investment structuring 149
problems with angels 176–77
Index
selecting as investor 72–73,191–205
as sources of finance 24, 192, 195
syndicates of 54–55
types of investors 26–37
business life cycle 25–26, 46, 57–59
Business Links 72
business plan 15–17, 53, 66–69,
128–29
desk review 117–18
due diligence process 114–16
routes out 82
Cambridge Phenomenon 50
Candover 50
captive funds 49
see also semi-captive funds
carried interest 62–63, 181
cash flow 67, 114
corporate collapse 188
routes out 35, 83
CinVen 49, 50, 59, 114–15
see also Coal Industry Nominees’
Industrial Investments
Cisco Systems 3
clandestine arrangements 34
ClickMango 155, 197
Coal Board Pension Fund 114
Coal Industry Nominees’ Industrial
Investments (CINII) 50
see also CinVen
Cohen, Sir Ron 18
Combined Code (London Stock
Exchange) 171
Companies Act 1985 160–61
completion audit 129–32
conditions precedent 75–76
consortia 54–56
consultants 43
control premium 32
convertibility rights 145–48, 159
corporate collapse 188–89
corporate investors 8
County Court Judgements (CCJs)
127
cram-down rounds see blow-out
financing
creditors 96–97, 139
cumulative rights 144–45
CVs 100, 114, 118, 133
deal brokers 43
deal structuring 136–51
deemed disposal see forced sale
provisions
deemed liquidations 158
Department of Trade and Industry
45
desk review 117–19
development capital 9, 31–33
development funds 112
directors 107–09, 146, 167–68
chief executive 100, 103
dismissal/release of 108–09
executive 61, 100, 107–08, 132,
163
finance director, importance
of 101
non-executive 61, 107, 132, 168,
172–73, 177
succession, of directors 109
disclosure letter 162
discretionary trusts 35
disposable net assets 44
dividends 144–45, 149
rights to see preference shares
dot.com boom 3, 5, 14, 58, 59, 155
drag-along rights 161
see also tag-along rights
DTI inspectors 189
due diligence 5, 65–67, 75, 78–79,
86, 96–97, 100–01, 114–34
adverse reports 131
remit given 115
Dyson, James 16
early-stage specialists 112
e-commerce 10
effective access 8
electra 49–50
electronic filing 66
elevator-pitches 29
Enterprise Act 2003 189
Enterprise Investment Scheme
equity 4, 144, 147–50
45
215
Index
Equity Capital for Industry (ECI)
49–50
ECI Partners 50
ECI Ventures 50
equity gap 3–4, 26
Europe 8, 14, 20, 201
European Union 51
exit route 23, 25, 30, 32–33, 35–36,
66–67, 71, 80–88, 184
buy-back 83
factoring business 26
financial engineering 4
flotation 32, 35, 82, 84, 181–84
follow-on funding 71, 175
forced sale provisions 173
founders’ shares 159
see also vesting terms
functional coverage, management
102–03
functional specialists 48
fund of funds 51
fund life cycle 57–59
fund size 56–57
funding gap 9–13, 51, 191
Great Crash, the 12
Great Eastern Investment Forum 45
Hermes 49
high net worth individuals 44
high-tech field 58
house investment style 112, 133
impatient money 41
incorporated businesses 17
Industrial and Commercial Finance
Corporation (ICFC) 50
see also Investors in Industry; 3i
Information and Consultation of
Employees Regulations (2004)
140
initial public offerings (IPOs) 154,
158, 181–84
see also flotation
intellectual property 3, 17, 29,
75–76, 78
216
internal rate of return (IRR) 69, 77,
133
see also rates of return (RORs)
inventors 18
investment
committee 47–48, 133–34
fees 116–17, 120
fora 28
funds, sources of 8, 42
managers 28
process 65–66, 73–75
ratchet 113
statistics 9–10, 13
investor-initiated sales 185
Investors in Industry 50
invoice discounter 26
judgement, matters of
in due diligence 130–31
‘going native’ 175
and management 106, 111,
key man insurance 163
Keynes, John Maynard 12
Land Rover buy-out 34
leadership 120
legal stages 6, 65–66, 105, 152–64,
187
complexity 198–201
and shareholders 94
legal title 78
limited companies 17–18
limited liability partnerships (LLPs)
19, 46
limited life deal 19
liquidation 87
liquidation preference 158
liquidity 22
Lloyd Webber, Andrew 183
see also Really Useful Group
loans 39, 143–47
see also balloon loan
Macmillan Committee on Finance
and Industry report 12
Macmillan, Harold 12
Index
Malmsten, Ernst 18
management
details in business plan 67
functional coverage 102–03
as key determinant 69, 78, 100
key elements 101
management buy-ins (MBIs) 9–11
management buy-outs (MBOs)
9–11, 33–35, 90
management information reports
161
merger 26
mezzanine capital 4
mezzanine finance 3–4, 82, 151
Moulton, Jon 18
Netscape 3
newco 95, 136, 138–39
Nobbs, David 48
offer letter 156
see also term sheet
off-shore trusts 35
opportunism 40
ordinary share 144–49
see also shares
Parmalat 201
participating preferred ordinary
(PPOs) 144–45
see also shares
patent protection 30
patient money, myth of 39–41, 78
philanthropic trusts 3
Phoenix Fund, the 54
portfolio 44, 48, 69, 81, 148, 171–72
constraints 200, 205
life-cycle 43
rescues 188
pre-emption rights 160
preference shares 35, 144–45, 150,
157
preferred ordinary 144–45
see also preference shares
pre-tax profit growth 174
price–earnings ratio (P/E) 83–84, 115
prediction of 83–84
private equity 3–4, 8–9
profit and loss account 15, 178
public limited company (PLCs) 19,
33
PWC/BVCA Performance
Measurement Survey 13
qualified by experience (QBE) 60–61
quasi-equity 150–51
see also equity
ratchets 31, 113, 159
convertibility 146
final offer letter 76
positive and negative 146, 159
reverse ratchet 113
rates of return (RoRs) 27, 118, 203
significance of 15
see also internal rate of return
realization 179
Really Useful Group 183
see also Lloyd Webber, Andrew
redemption rights 144, 150, 159
refinancing 87
see also blow-out financing
regional venture funds (RVCFs) 29,
31, 60, 200
details of 52–53
limitations on 51–52
rescue funding 35–36
residual shareholders 89–94
rights of first refusal 160
risk 14, 111–12, 148
avoidance 114
categories of venture capital 3
individual 44–45
investigation 78
managers 106
market risk 143
minimization 40–41, 82, 113, 116,
154, 206
partnerships 46
risk analysis 133
risk profile, perception of 72, 74,
147
risk and reward 5, 112, 143
and size of funds 56–57
217
Index
start-up 27
syndicates 54
running yield 145
Saga plc 84
seasonality 123
seed capital 3
semi-captive funds 49
see also captive funds
sensitivity scenarios 66
serial entrepreneurs 18
serial investors 18
shareholders 17, 19, 52, 70, 87, 136
change of 33–34
relationships 89–94
shares 17, 25, 108, 109, 143–51, 157–61
Sinclair, Sir Clive 18
size of fund
as determinant of investment
policy 56
and fund structure 43
RVCFs 52–53
small- and medium-sized enterprise
(SME) 51
Societas Europaea 20, 201
sole traders 17
Southon, Mike 18, 23–25
stakeholders 94–98, 108, 109
star performers, in portfolio 81
step-change 26, 105, 128
stock market 42
succession plan, managerial 109
suppliers 95–96
sweat-equity 30, 45
Sweden 18
SWOT analysis 125
syndicates 44–45, 54–56, 149–50
tag-along rights 160–61, 175
see also drag-along rights
taxation 137, 140–41
term loan 26
term sheet 75–76, 117, 156, 160–64
3Fs 27
3i 49–50, 57, 60–62, 136, 197
see also Industrial and Commercial
Finance Corporation (ICFC);
Investors in Industry
218
3Ms: mathematics, market,
management 15–17, 69
timing, of approach 29
topco 19–20
trade buyer 138
trade record 138
trade sales 18, 184–88
tranches 158
Transfer of Undertakings, Protection
of Employment regulations
(TUPE) 95, 139–40
Turnround Management Association
36
UK 8, 14
domicile for companies 20
unique selling proposition (USP)
16
United States 8, 195–96
university environment 28
Venture Capital Lite 53
venture capitalists
background and experience 60–61
pressures on 4
remuneration 62–63
see also carried interest
venture capital trusts (VCTs)
49–50
vesting terms 159, 173
see also founders’ shares
Virgin Group 183
warranties
countered by disclosure 163
legal stages 162
reluctance of VCs to give 188
washout rounds see blow-out
financing
workforce 95
INDEX OF ADVERTISERS
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www.thecapitalfund.co.uk
iv, v