Venture Capital Firms - Fund Sources

Venture Capital Firms - Fund Sources

There are several sources for raising funds by Venture capital firms. To obtain their funds, venture capital firms have to reveal a good track record and the prospect of producing returns greater than can be achieved through fixed interest or quoted equity investments. Most UK venture capital firms raise their funds for investment from external sources, mainly institutional investors, such as pension funds and insurance companies.

Venture capital firms’ investment preferences may be affected by the source of their funds. Many funds raised from external sources are structured as Limited Partnerships and usually have a fixed life of 10 years. Within this period the funds invest the money committed to them and by the end of the 10th year they will have to return the investors’ original money, plus any additional returns made. This generally requires the investments to be sold, or to be in the form of quoted shares, before the end of the fund.

Venture Capital - Investment Process

The investment process, from reviewing the business plan to actually investing in a proposition, can take a venture capitalist any period from one month to one year but typically it takes between 3 and 6 months. There are always exceptions to the rule and deals can be done in extremely short time frames. Much depends on the quality of information provided and made available.

The key stage of the investment process is the initial evaluation of a business plan. Most approaches to venture capitalists are rejected at this stage. In considering the business plan, the venture capitalist will consider several principal aspects such as:

Is the product or service commercially viable?

Does the company have potential for sustained growth?

Does the management have the ability to exploit this otential and control the company through the growth phases?

Does the possible reward justify the risk?

Does the potential financial return on the investment meet their investment criteria?

In structuring its investment, the venture capitalist may use one or more of the following types of share capital:

Ordinary Shares

These are equity shares that are entitled to all income and capital after the rights of all other classes of capital and creditors have been satisfied. Ordinary shares holders have voting rights. In a venture capital deal these are the shares typically held by the management and family shareholders rather than the venture capital firm.

Preferred Ordinary Shares

These are equity shares with special rights. For example, they may be entitled to a fixed dividend or share of the profits. Preferred ordinary shares holders have voting rights.

Preference Shares

These are non-equity shares. They rank ahead of all classes of ordinary shares for both income and capital. Their income rights are defined and they are usually entitled to a fixed dividend. The shares may be redeemable on fixed dates or they may be irredeemable. Sometimes they may be redeemable at a fixed premium (eg. at 120% of cost). They may be convertible into a class of ordinary shares.

Loan Capital

Venture capital loans typically are entitled to interest and are usually, though not necessarily, repayable. Loans may be secured on the company’s assets or may be unsecured. A secured loan will rank ahead of unsecured loans and certain other creditors of the company. A loan may be convertible into equity shares. Alternatively, it may have a warrant attached which gives the loan holder the option to subscribe for new equity shares on terms fixed in the warrant. They typically carry a higher rate of interest than bank term loans and rank behind the bank for payment of interest and repayment of capital.

Venture capital investments are often accompanied by additional financing at the point of investment. This is nearly always the case where the business in which the investment is being made is relatively mature or well-established. In this case, it is appropriate for a business to have a financing structure that includes both equity and debt.

Other forms of finance provided in addition to venture capitalist equity include:

Clearing banks – They principally provide overdrafts and short to medium-term loans at fixed or, more usually, variable rates of interest.

Merchant banks – They organize the provision of medium to longer-term loans, usually for larger amounts than clearing banks. Later they can play an important role in the process of “going public” by advising on the terms and price of public issues and by arranging underwriting when necessary.

Finance houses - They provide various forms of installment credit, ranging from hire purchase to leasing; often asset based and usually for a fixed term and at fixed interest rates.

Factoring companies - They provide finance by buying trade debts at a discount, either on a recourse basis (you retain the credit risk on the debts) or on a non-recourse basis (the factoring company takes over the credit risk).

Government and European Commission sources - They provide financial aid to UK companies, ranging from project grants (related to jobs created and safeguarded) to enterprise loans in selective areas.

Mezzanine firms – They provide loan finance that is halfway between equity and secured debt. These facilities require either a second charge on the company’s assets or are unsecured. Because the risk is consequently higher than senior debt, the interest charged by the mezzanine debt provider will be higher than that by the principal lenders and sometimes a modest equity “up-side” will be required through options or warrants. It is generally most appropriate for larger transactions.