It’s worth saying, a business has done well even to merit asking this question. But, once it reaches a certain size, or needs a cash-bump to allow for faster growth, considering venture capital investment is definitely a sensible avenue to explore. After all, some of the biggest companies in the UK and worldwide have received VC funding in their early stages. So, should you consider taking venture capital into your business?
This blog looks into venture capital, what we mean by that term, what are the pros and cons, and other things founders of growing businesses ask in the round.
What do we mean by venture capital?
Venture capital, often referred to as ‘VC’, is a subset of private equity investment i.e. a third party investing in a company with a view to, essentially, sell their shareholding at a gain.
VC investment is aimed at younger companies and is generally higher risk (from an investment perspective) as a result. In return for cash, the company offers shares to the VC investor, allowing the company to then invest the cash in its future. In return, the VC investor will take a sizeable proportion of the ownership of the company.
Companies that are still too small may not be able to attract VC investment either as they are too small to get any attention or deemed too risky. Conversely, once a company has reached a big enough size that it either doesn’t need the funding, or the returns from a potential investment are reduced, VC investors won’t necessarily be interested.
In a traditional VC scenario, the funds are raised by a VC firm from a variety of sources (e.g. high net worth individuals and pension funds). Those investors know their monies will be used by the VC firm to invest in younger ‘portfolio’ companies with a higher risk factor, but also a greater opportunity of richer returns. They also know the monies will (or could) be locked away for several years.
Is venture capital good for small business?
Often, raising money from bigger investors of an institutional nature, or as a bank loan, won’t be possible for small companies and so venture capital becomes the most obvious, if not only, means to cash investment.
In theory, the investors and founder(s) of the relevant company will be on the same page in terms of the future. In most cases, both will be looking to maximize the value of the company and, it follows, their shares in the company. Recognising that it can take years for a small company to grow to the size where it can benefit from its own economies of scale, VC investors can have a long-term view to their investment (but rarely as long as the founders’).
The obvious benefit is the cash that the investor will put into the hands of the company’s management, allowing it to buy that new machinery, develop that software, or apply for those patents. But, there are other advantages, principally:
Connections
It’s who you know, not what you know – and VC investors will often be well connected. In particular, if your proposed investor is industry/sector specific, they’ll probably already have established relations with the suppliers and other players within an industry.
Knowledge
Related to the above, they will also have knowledge of developing businesses that founder(s) necessarily won’t. This guidance can be invaluable to the company’s management exploring routes it had not previously considered, most obviously by working with the management to produce a post-acquisition business plan using the new funds invested.
VC resources
The VC firm will also have its own access to tax, HR, legal and other advice in a way that the smaller portfolio company won’t. This can provide support that otherwise wouldn’t be there.
Should I take venture capital money?
Needless to say, investment comes at a cost. That cost is principally borne by the founders/shareholders of the company diluting their ownership. The ramifications for this will come in a reduced % of dividends in the shorter term, but on any future sale (or indeed listing on a stock market) they’ll also receive a lower % of the proceeds than if they’d kept their 100%. Clearly, of course, the gamble is that the value of the company will be so much greater than it would have been without the investment that it was still worth it.
That cost is clear enough, but there are other things to think about too:
Control
With the loss of shares, and especially if the VC investor acquires more than 50% of the share capital (which is unusual), the amount of control the existing owners have is diminished. For many, this will mean they aren’t their own boss going forward, which is a price some would rather not pay.
Timings
Whilst VC investors are often alongside their portfolio companies for longer than other forms of investment, it will rarely be the working life of the existing shareholders who might not want to sell (or list) when the VC investor wants to, but this is often outside of their control. VCs do still want to get a return on their investment within a matter of years (and often will need to act quicker than even they might like to) and their exit will create upheaval. If a company would be better suited to steadier growth where the investors remain stable throughout, they may be best off not taking VC investment in the first place.
Management
It’s not just big decisions where a VC investor will have veto rights. In all likelihood they will have board representation and could materially change the management structure of the company.
Funding Problems
Unlike private angel investors, venture capitalists will often have strict performance criteria before they can invest more money in your business. This can hamstring you later down the line if you need cash, but can’t get it from your existing VC, whose existence puts off other potential investors. Conversely, such criteria can act as a carrot and give a company’s management clear expectations.
Incentive
Traditional venture capitalists won’t be investing as much of their own money as it first appears. They’ll also be taking a % of the funds total value as an annual management fee, so the performance of individual portfolio companies won’t necessarily be that important to the heads of the VC fund you’re dealing with. Whatever way you cut it, they won’t be taking as much risk as the existing founders, who put a greater % of their net wealth into their company, but also (normally) 100% of their time.
Reporting
Even if you get away without heavy oversight of the business, you will definitely be required to report over and above your statutory requirements as a company.
What happens to VC money if a startup fails?
As an original shareholder in a company that fails, but which has had VC investment, there isn’t a particular downside to you over and above what would have been the case without the investment (provided any assurance given to the VC investor to induce them to invest was true). So, you will have lost your own equity value in the company and would likely need to find a job, but these are no different to what would have happened without the investment. Founders in such situations will also very probably care more and be more emotionally upset about a company failure – it was, after all, a much larger part of their daily life than any of the VC investors’ representatives.
Ultimately, the money invested in the failed company is lost. It’s worth bearing in mind that the money invested is put into the company, and not given to the existing shareholders (generally), so they won’t have gained any monies from the sums invested.
For the VC itself, of course, it will suffer the loss of however much time and money it has put into the failed company. A lot of companies that VC investment falls to do fail, of course, which is offset by the big gains that the success stories make. There could also be reputational damage to a VC investment firm if portfolio companies (especially in one sector) continue to fail.
Am I personally responsible for repaying VC money if the business fails?
In the absence of something unusual, no.
As part of the VC investor coming on board, they will have required a series of assurances around the state of the company prior to putting their money in. Those assurances will be given by the company, but personally guaranteed by the existing shareholders (the VC won’t want to sue the company it now owns a major stake in). Provided those assurances were true at the time of the investment, there shouldn’t be any fall back to the existing shareholders simply because the VC has lost monies to a bad investment (albeit all deals are different and conceivably some sort of claw back could have been agreed).
What should I ask potential VC investors?
Any founder/shareholder in a company should be undertaking their own due diligence of the potential VC investor. That won’t be going into the same level of detail as the VC’s due diligence into the company of course, but you should be comfortable who you are going to be working closely alongside for a sizeable portion of your company’s life.
It’s important to know and consider:
- What the VC’s goal is?
- How much control and oversight do they want to have of what you do?
- Do they want to have representation on the board (probably) and to what extent? Who will that be? What experience do they have?
- Are there any decisions about the operation of the company that they will require you to get approval from them for?
- What timeframe are they looking to work towards both in terms of investing, and their exit?
- What are their hopes and expectations with regards to selling their shares in the company? Are they considering publicly listing the company in an initial public offering?
It wouldn’t be unreasonable to contact the founders of other companies they have invested in (subject to any non-disclosure arrangements you have). Speak to them – what are their thoughts? Has the VC over promised or over delivered? Are they as hands on/off as they claim to be? Are there any such persons you can source whose company didn’t succeed who would be willing to share their views with you?
What legal steps do I need to take to get venture capital investment?
Generally, you’d expect a transaction to involve the following (high level) steps:
Heads of terms
- Also often known as a letter of intent or term sheet.
- This non-binding document sets out the key terms of the deal such as the amount being invested, the amount of shares being issued and the rights the VC fund will have in the company.
- Aside from a confidentiality agreement, it’s likely to be the first thing the parties sign, but it is non-binding and all parties could still walk away.
Due Diligence
- The VC fund will undertake due diligence into the company, effectively reviewing the state of its contractual arrangements, liabilities and assets and ensuring that what it thinks it knows about the company is true.
- This will typically be split into: financial, tax, legal and commercial due diligence.
- For a lot of start ups seeking VC investment, intellectual property will be one of the key assets of the company. The VC will want to ensure that the company itself owns such IP (and not the founders individually or some third party).
- They’ll also want to know customer, supplier and employment contracts of the company are in place and will continue to benefit the company once the transaction has completed. Material contracts with short termination periods, or clauses that allow the counter party to terminate where a change of ownership occurs could all be red flags.
- Undertaking a dummy DD exercise in advance if time and funds allow can make this process more straight forward when the VC’s advisors are undertaking it for real. Not only can documents be sourced so they are to hand, but any issues that come to light can be rectified at this time.
Transaction Documents
- Assuming the VC remains happy with everything after its DD (or whilst it’s ongoing), the transaction documents (based on the term sheet) will be produced.
- The subscription agreement setting out the terms of the investment and what the VC expects in return will be one of the two most important documents in a normal scenario.
- The shareholders’ agreement (between the existing shareholders and the incoming VC) will be the other significant document. It will set out the parties’ rights as between each other in relation to the company and, particularly, any management and veto rights the shareholders will have.
- Any documents that are necessary as a result of the VC’s DD will also be produced at this time. This could be anything that requires rectification such that the investor is comfortable, but typically examples would be codifying employment arrangements or the terms of occupation of a property.
All such agreements are likely to be produced by the VC in the first instance, but the founder(s) and company’s lawyers will need to review them to be comfortable the term sheet is reflected, and that the VC is not receiving anything beyond market norms.
These agreements should be clear and understood by the founders before they are signed: they will dictate the future of the company’s management for the foreseeable future and could materially hamstring the founders in the future, whether in seeking new investment, selling their own shares or deciding the course of the company.
Everything is negotiable. If you want investment but can’t give up x, y or z, you might find someone who will.
How Moore Barlow can help
Needless to say, legal advice should be sought to ensure that nothing excessively friendly to the VC makes its way into such agreements. Our Corporate lawyers would be delighted to assist in such corporate transactions to ensure you and any other shareholders are comfortable with what you’re signing up to.
