Raising Venture Capital
Monday, January 17, 2005
by
Catherine Feechan and David Allan
The Rules of the Game
When looking for equity investment for the first time it is vital to understand how the fundraising process works. There are a huge variety of venture capital operations (“VC’s”) with funds to invest but it can be difficult for a company to access this cash. The information provided here helps to explain some of the issues involved in obtaining venture capital funds.
The process begins with contacting a venture capitalist and choosing the right VC firms to target is a key issue. Failing to properly research the most appropriate VC’s can elongate the time taken to raise cash and can lead to over exposure for your business plan. Before approaching a VC, consideration should be given to their industry specialisation, geographic criteria and preferred deal size.
A VC’s investment criteria can be researched by asking them directly, talking with other VC investee companies and looking through the directories of the British Venture Capital Association (http://www.bvca.co.uk/) and the European Private Equity and Venture Capital Association (http://www.evca.com/). Cold calling on VC’s is very unlikely to be successful. VC’s receive hundreds of business plans and introductions through respected professionals improve the odds of the plan being reviewed quickly and funds being secured. Biggart Baillie is active in the VC community and we would welcome the opportunity to talk to you about your financing needs.
Preparing a Business Plan
The first thing your selected VC’s will want to see is a business plan. Given the volume of plans VC’s review, it is vital that your plan stands out and gets the reader’s attention. The Executive Summary must be good enough to get the reader to look at the rest of the plan.
A business plan is not only required by VC’s but is also beneficial for the management team in that it provides a clear concise statement of the goals, objectives, milestones and strategies of the Company. A well written plan will demonstrate the commercial sustainability and potential of your business and demonstrate the managements understanding of what is required to meet the projected growth targets. In addition to providing information about the Company and positive financial forecasts, the plan should cover the following issues:-
- Is the product/service unique and why buyers will want to purchase it;
- Significant barriers to market entry;
- Strategy for market penetration;
- Market size;
- Can the management grow a business quickly and have they got the right experience;
- How much cash is needed and what for;
- Exit strategy;
If the plan looks attractive to a VC the Company will be contacted and asked to meet with the VC to discuss matters further and assuming these meetings go well the VC will conduct some initial due diligence, analysing the business, management and forecasts.
Doing the Deal
Once initial diligence has been carried out, negotiations will begin in earnest to agree the structure and terms of the financing. In consultation with professional advisers experienced in this sector the management team must gain an understanding of the various type of structures available and prepare its bargaining position. Advisers can give guidance on the issues worth fighting for. Valuation is usually uppermost in the minds of both the VC and the investee company but in order for a successful working relationship to develop a figure acceptable to both parties must be settled on. Other major issues include salaries, dilution, non-exec appointments, share transfer provisions and drag along rights.
Once basic terms are agreed, detailed negotiations on an Investment Agreement, Articles of Association and Service Contracts will take place. Only once terms of all these are agreed will the cash finally be invested.
How Venture Capital Funds Work
Professional Venture Capital funds provide finance for companies at various stages of development, seed capital, start up capital, and capital for expansion as well as funds for management buy-outs. In addition to differentiating themselves as to the types of transactions they are interested in, funds can also be categorised by sector such as technology, healthcare etc. and preferred deal size.
Venture Capital funds are usually set up as partnerships which invest the money of their limited partners. The partners in a Venture Capital Fund are usually financial institutions such as pension funds, banks, insurance companies and sometimes other venture capital funds. When a Venture Capital firm raises money from these sources, they put the money into a fund. The amount raised for a specific fund will be predetermined and this sum will then be invested for a defined time span, usually 3-5 years. Investors in the Venture Capital funds have specific requirements in relation to the returns they require and therefore the venture capitalists managing a fund must evaluate its potential investments in order to provide the required return.
As the return on the investment is critical, Venture Capitalists always invest with specific criteria in mind. Some Funds invest, for example, in deals between £2-5 million per venture over a 3-5 year period and look for companies with market potential of £50-100 million. Venture Capital Funds typically invest only in small numbers of companies and therefore each investment must be screened carefully. VC’s require a 30-40% or more annual return on their investment and look for a total return of 5-20 times their initial investment.
In order to maximise their return, many VC’s wish to actively participate in managing their investment. Rather than investing cash and leaving companies to manage their own affairs VC’s will often become involved as advisers to management and require a seat on the company’s Board of Directors.
Given the hands on approach of many VC’s, it is important for a company to perform due diligence on any proposed investor in order to ensure that the maximum benefit is attained by the company. Issues to consider are as follows:-
Valuation Issues
The essence of equity investment is that funds to allow corporate growth are exchanged for a share of the ownership of the business.
The Shareholders of the company on one hand will be attempting to raise as much money as possible whilst giving up as small share of the ownership of the Company as is feasible. The flipside of this is that VC’s obviously wish to maximise their investment returns by putting in as little money as possible for the largest share of ownership possible.
By negotiation the parties must come to agreement. It is a difficult balance to strike and there is no right answer. VC’s are concerned to leave company founders enough ownership to provide them with an appropriate incentive to make the business succeed. Without management driving the business to succeed, neither party can achieve its financial goals. It is important for management to understand the VC’s view on valuation issues in order that both parties can be satisfied with their deal.
The negotiations will begin by determining the current value of the company. A key factor in determining the value of the company prior to any investment is what stage of development the Company has reached. A start up business with no product revenues or financial history and an incomplete management team will obviously receive a lower valuation than one having a complete management team, product revenues and profits. There are however various stages in between. At each stage the valuation given to the business will be higher as progression through the stages shows the ability of the management team to meet the milestones and therefore reduces risk for VC’s.
When a VC is working out how to price their investment this involves working out the future value of the company at the time of their exit. This is a highly subjective exercise and there are a number of theoretical approaches available. Once a value has been selected, the estimated percentage ownership required by the investor at the outset can then be calculated given the investment return required by the VC. For example, to realise a 30% return on an investment of £2 million the VC would need to own 48% of a company with an estimated future market value of £20 million after 6 years. If the future market value estimated is higher, then this percentage ownership will provide the required rate of return ie. £60 million – 16%.
Why Write a Business Plan?
A clear business plan provides the VC with all the necessary information about a company. It also sets out measurable, operational and financial objectives for management which can be used to monitor progress. It is a key element in convincing investors that the management have what it takes to develop a successful company and provide them with the level of return they require.
The most important part of the business plan is the Executive Summary. This should be no longer than 2 or 3 pages and must generate sufficient interest in the reader that the full proposal will be reviewed. It should convey the company’s growth potential and contain only vital information.
In many VC firms less than 10% of the plans received, get a full review. In some cases this is because the Executive Summary shows that the plan does not fit the VC’s investment criteria, but more often it will be because the summary failed to generate sufficient interest.
Business Plan Contents
Executive Summary
The Executive Summary should cover the following items:-
- what the company does, a brief history, milestones achieved and future plans
- key members of the management team – age, qualifications and relevant experience
- product/services – a short non-technical description of the product/service highlighting unique selling points, competitive products/services
- market information – statistics on the market with legitimate sources, explain how much of the possible market the company intends to obtain and how this will be achieved, give brief details of selling strategies to be used to enter the market
- state the amount of cash required and specify precisely what it is to be used for
- summary of financial projections – summarise projected revenues, net income and assets and liabilities and explain at what points additional funding will be required.
Introduction
This should describe the company’s history including the reasons for founding the company and the nature of its business. This will allow the VC to gain a clear idea of the market in which the company operates. The company’s vision for its future strategy should also be laid out. VC’s require to be reassured that the company’s strategy is more than an idea. The plan will need to demonstrate that a profitable business can be created based on the strategies laid out by management.
An important factor in the VC’s decision on whether or not to invest in a company will be interviews with the management team. VC’s will look very closely at the individuals to ensure that the team is properly balanced, contains individuals with proper qualifications in all the necessary specialist areas and the personalities to cope with the stresses and strains involved in managing a rapid growth business. This part of the plan should explain the qualifications and experience of each member of the management team, including what they have learned form their previous business experiences.
In many new ventures, the management team is incomplete with key areas such as finance or sales missing. If this is the case, it is vital to highlight the deficiencies in the team, showing the VC that you are aware that this is an issue which requires to be addressed. The plan should give an indication as to how it is intended that this gap be filled and in many cases VC’s may be able to assist using their own contacts. Advisers well connected in the field may also be a source of assistance in finding the “missing members” of your team.
Product/Service
A clear description of the product/service offered by the Company in jargon free English is required and this description should include characteristics that set the product/service apart from the competition. A comparison of the strengths/weaknesses of the product/service against competing products and details on expected competitor responses will show management have clearly thought out their strategy.
An overview of all product/service accomplishments and milestones achieved to date should be included with an indication of timescales for achieving remaining milestones. This will show a VC that the management has already overcome several obstacles, knows what needs to be achieved and has a clear idea of how and when this will happen.
An outline of the intellectual property rights, patents, copyrights and trade secrets and their current status together with any other barriers to entry for competitors should also be included.
Market Analysis
This should cover specific analysis of the company’s market together with a description of the customers for the product/service. All data used in this section of the plan should be verifiable and come from a reputable source. It should also be as specific as possible.
Analysis of the sector including market growth rates, technical advances, regulatory issues, future trends and customer information should be set out.
The percentage of the target market the company aims to capture should be shown, together with a marketing plan to achieve this.
The sales projections included in the marketing section will be key for putting together the financial projections and the plan must include an outline of plans for product pricing, distribution and promotion.
Pricing
VC’s will want to see an explanation as to how pricing has been arrived at and a breakdown of the important components of price – image, competition, margins, discounts, structures.
Distribution
The business plan should clearly show how the product will get from the company to the customer in any manufacturing operation. In a service operation, how the service will be promoted will be more important. Distribution channels for manufacturers include direct sales, using distributors or wholesalers or retailers. Each of these has their own advantages, disadvantages and financial consequences and these must be made clear in the business plan. The reasons for selecting distribution approaches should be fully explained, together with the benefits that they will provide. A schedule of projected prices, discounting strategies and commissions should also be included.
Promotion
The VC will want to see plans for advertising, on-line strategy, trade shows and any other promotional materials. The VC will require to be convinced that the company has the ability to take their product/service to market and it should be clearly explained why certain methods of promotion have been selected and others excluded, giving the financial benefits of such selection.
Operations
This section of the plan must outline how the company operates, location, size of manufacturing facilities, labour force, accessibility of materials, proximity to market and any other operational considerations. This description should be reasonably detailed as the VC will wish to see if there are inconsistencies between the information set out in the operations section and the financial projections.
VC’s will be concerned to see that the company can meet planned expansion targets and that there are plans in place to deal with that growth, ie. that there will be sufficient, properly trained workers, manufacturing facilities etc.
Financial Forecasts
A full set of financial forecasts demonstrates to VC’s that the management have properly thought out the financial implications of the company’s growth strategy. The forecasts should integrate the goals outlined in the plan into financial terms so that profitability milestones can be clearly set out and allowing investors to calculate clearly their projected returns. The forecasts will be used by VC’s to determine whether or not the returns offered by the company will be sufficient and whether or not the projections are, in their view, realistic.
Financial Statements should include the balance sheet, income statement and capital statement for 3-5 years. Monthly statements until break even point are often requested and thereafter quarterly statements should be prepared for 2 years followed by yearly data for the remainder of the period. A key issue in preparation of financial forecasts is the major assumptions used in their preparation and having the forecasts reviewed by an accountant experienced in corporate finance is prudent.
Practical Issues
Once a plan has been completed, it should be clearly and professionally presented and several copies should be provided to VC’s in order to allow the review process which often involves a number of individuals to be completed as quickly as possible. A plan presented to a VC by a reputable adviser is more likely to get reviewed quickly. Biggart Baillie have excellent contacts in this area and we are happy to assist clients by sending their business plans to those VC’s most likely to be interested in your business.
Doing The Deal
The structure of an equity investment will be discussed by the VC and the Company in conjunction with professional advisers and will depend largely on the investor’s preferences.
Often VC’s take a mixture of ordinary shares will full voting rights and redeemable preference shares which receive interest on an annual basis and are redeemed on a specified schedule. For tax reasons in certain cases investors prefer to provide some capital by way of loan rather than redeemable preference shares. The detailed documents relating to the investment will lead to a number of issues and advice from an adviser with experience in this area can greatly ease the negotiation process. Arguing over every point with the VC will lead to problems in developing an on-going relationship of trust and openness and advisers will be able to explain which issues raised by VC’s are relatively innocuous and which should be more heavily negotiated.
The key documents in any transaction are the Investment Agreement and the Articles of Associations and the issues which commonly arise in these documents are set out below.
Articles of Association
- Class Rights - the Articles will set out the rights attaching to each class of shares issued. VC’s commonly request class rights for their shares and this means that if the ordinary shareholders wish to carry out certain actions such as disposing of part of the company, allotting shares, winding up the company etc., such actions cannot be taken without the prior approval of the VC.
- Transfer Provisions – the Articles commonly provide that if shares are to be sold by any party, they must first be offered to other parties holding the same class of shares and then to other members of the company. Permitted transfers to family members are sometimes allowed. In addition, good leaver/bad leaver provisions are often included. These will state that where a member of the management team leaves the Company he will be forced to sell his shares and if he leaves as a “bad leaver” he will receive only the nominal value of his shares rather than their true market value at that time.
- Drag along provisions - often Articles will contain provisions requiring the ordinary shareholders to sell their shares on the same terms as a VC, should the VC find a buyer for the Company. This is not often acceptable to the management team if they have majority control over the company.
- Non-Executive Directors - the Articles will normally allow the appointment by the VC of a Non-Executive Director whom they can replace at will.
Investment Agreement
- Warranties. On the date of the investment the company and the management will be required to warrant the company’s financial, tax and legal position. Liability under the warranties is usually capped at a maximum of the investment being made by the VC and some VC’s are amenable to capping managements individual liabilities at a salary multiple. The Investment Agreement will govern the conduct of the company’s business post investment.
- Covenants. The Agreement will contain a number positive and negative covenants
- Positive covenants form a list of things that the management will be obliged to do, such as keep the company’s assets insured, keep proper accounting records, provide management accounts and audit the accounts within specified time frames, hold Board Meetings, etc.
- Negative covenants are a list of things that the management will not do without the prior consent of the investor. Examples include creating mortgages, security or charges over property, departing from the business plan, making loans outside the ordinary course of business, disposing of or acquiring heritable property, entering into contracts above specified values and borrowing money in excess of specified amounts. It is important when reviewing these covenants to ensure that they are not so onerous that they impact on the management’s ability to run the business on a day to day basis but that they provide VC’s with the comfort that no material change to the business will take place without their knowledge.
- Observers. In addition to being able to appoint a Non-Executive Director, a VC may request that they have the right to send observers to Board Meetings. This is because Non-Execs are independent of VC’s and must act in the interests of the company and its shareholders, whereas a VC representative present at Board Meetings will be observing entirely with the VC’s interests at heart.
- Restrictive Covenants. Management will be requested to enter into restrictive covenants undertaking not to compete with the business for specified periods of time in specified geographical locations when they leave the company. The duration and breadth of such covenants will be the subject of substantial negotiation.
A variety of other documents will also be required in relation to any equity investment - service agreements, assignments, guarantees, insurance documents, board minutes etc. Once all these are in an acceptable form the funds will be made available.
The key issue and the most difficult for management in the negotiation of the above documents is the level of control of the business they are required to give up. For those who have been used to running their businesses with a free hand, it can be difficult to adjust the disciplines required to comply with the more rigorous requirements of a company which receives venture capital investment. Management will require to be more disciplined with regard to the production of regular information updates for investors and to be prepared to answer questions on all business issues. However, this level of intervention is a necessary part of the company’s growth strategy and negotiation of these documents is all about finding an acceptable compromise. Again, advisers providing experience in this area will be invaluable in helping you to decide what is and is not acceptable.
Often the person negotiating the transaction for the VC and the person doing on-going monitoring are different. It is important to clarify how the on-going relationship will operate in order to ensure that you are happy with the person having responsibility for the company over the longer term.
For more information please contact or Catherine Feechan or David Allan.
The information contained in this article is given for general information only and does not constitute legal advice on any specific matter.