While economic conditions remain somewhat challenging, the venture capital market remains buoyant, and we frequently advise our start-up and high-growth clients that the VC market has much to offer in terms of access to valuable capital.
Nevertheless, VCs remain cautious and processes to obtain finance are taking longer than normal. VC firms need to be sure they’re backing the very best entrepreneurs and if you’re in the market for VC finance, you need to be aware of their minimum requirements and we’re here to help.
In this article, we explore venture capital funding and answer some of the most frequently asked questions from businesses looking to secure a VC deal.
Jump to individual FAQs:
- What is venture capital?
- What’s the difference between venture capital and angel investment?
- What are the advantages of venture capital funding?
- What are the downsides of venture capital funding?
- When is the best time to seek venture capital funding?
- How do I find a venture capital firm?
- Are there different types of venture capital trust?
- Who can get venture capital?
- What incentives are out there for venture capital investors?
- Who regulates venture capital firms?
- How does venture capital funding work?
- What is a venture capital trust?
- Are there different categories of Venture Capital Trusts?
- What information will you have to provide to a venture capital investor?
- What happens if you get venture capital funding, but you can’t comply with the terms?
What is venture capital?
Venture capital (VC) is a form of finance that businesses use to fund their company’s operations and growth ambitions. It’s typically provided to seed and early-stage businesses that investors believe have long-term growth potential. The VC firm offers capital in exchange for company shares, and the terms on which funding is given will depend on the VC’s view of the risk involved.
VCs usually take equity rather than offer a loan.
What’s the difference between venture capital and angel investment?
Angel investors are individuals who invest their own money, whereas venture capitalists typically invest money raised from third parties.
In addition, angel investors are often willing to invest at an earlier stage in the company’s life cycle than venture capital funds, perhaps even in the initial funding round of the start-up stage. Angels may also offer their expertise as part of the package.
What are the advantages of venture capital funding?
Venture capital can provide a company with a cash injection at a key stage in its lifecycle when they have the strongest potential for growth yet don’t have a proven record of profitability. VCs are more open to risk and prepared to offer larger amounts than traditional lending institutions like banks.
Because VCs take shares in the business, no loan repayments are needed so the business can use all its available cash to grow.
VCs don’t just bring money – often their mentoring and contacts can be crucial to helping the business achieve its aims.
What are the downsides of venture capital funding?
It can be difficult and time-consuming to find the right VC partner for your company. When you’re just starting in business, there may be a risk that you spend too much of your valuable time on the search rather than running the company.
The main disadvantage of VC funding, however, is that you’ll be giving up some of the equity in your company in return for their capital, so your share will be diluted. If the injections of funds from the VC help to grow the value of the company, you may consider this to be worthwhile.
Another disadvantage of VC investment is that they may want to be involved in the direction and decision-making of the company, and as shareholders, they will have a certain degree of involvement as of right. There’s a risk that the VC pushes the business to grow too fast since their principal focus will be on getting a good return. In addition, you may find yourself in disagreement about how the business should be run.
A venture capital investor will usually require at least one seat on the board, as well as a veto over certain business decisions. The extent of control required can vary between investors, so you need to pick your VC partner very carefully, and make sure you fully understand the legal effect of any agreements you sign.
You will need agreements that govern the working relationship between you such as a shareholders’ agreement, so that all sides know their rights and duties and what to do if there’s a dispute.
When is the best time to seek venture capital funding?
You should allow six to nine months lead time to find a VC investor. Picking firms to pitch to will take up some of this time, and even when you have a VC in place, the process of agreeing the terms of their investment will add further delay.
Don’t wait until your business is stalling at a key growth stage to look for VC funding – have a business roadmap ready and identify the points where additional capital will be needed. You’ll need to show a VC firm exactly what its funding will do and how that will help the business to grow.
How do I find a venture capital firm?
There are various venture capital associations and online directories of VC firms with details of the types of companies they invest in, typical investment stages and size of investment. You can buy access to the member directory of the British Private Equity & Venture Capital Association (BVCA).
If you’re just in the stages of initial research, there are several lists of VC firms maintained by respected online publications, for example, the Entrepreneur Handbook’s list of VC and early stage funds in the UK and Startups A-Z directory of VC funds.
You should do your own research however – there are several online databases and directories owned by specialist private companies that may suit you better than more mainstream lists. Research in detail before you approach any VCs and try to get an introduction through a mutual contact or networking circle.
For further guidance on finding the right VC for your business, read our article on how to find venture capital investors.
Are there different types of venture capital trust?
Here’s what VC investors typically look for a business:
- One-of-a-kind business models or products that can disrupt market sectors
- Businesses with a potentially very large market
- Businesses with high growth potential
- Well-researched and professional business plan
- Evidence of high potential, or excellent early returns
- Higher-risk businesses with the potential for high returns
Who can get venture capital?
Venture capital firms are looking for young companies with little or no little trading history.
These types of business typically have few resources and little capital – this will give a VC owning shares more influence as a minority shareholder than they would have in a more established company.
The bottom line for a VC is how much return they will get on their investment, so you’ll need to demonstrate to them when they’ll get their money back. For this reason, VCs often invest in more technology-based sectors where, due to the rapidly expanding technology market, there is a likelihood of profit at a quicker rate than in more traditional industries:
Popular sectors for VCs include
- Software, particularly enterprise, telecommunications, cloud, and big data
- Digital media ecosystems
- Life sciences, including biotechnology, health, and medical technology
- Financial technology
- Information security
- Educational technology
What incentives are out there for venture capital investors?
In the UK, there are certain schemes designed to offer tax relief incentives to investors in small companies that have a higher level of perceived risk. Here’s a summary:
|Type of scheme||Overview of scheme|
|Enterprise Investment Scheme (EIS)||Used by individuals to make investments directly in small to medium businesses.|
|Seed Enterprise Investment Scheme (SEIS)||Used to make investments directly in early stage start-up businesses.|
|Venture Capital Trusts (VCT) scheme||Used as a vehicle for individuals to make indirect investment in small, medium or start-up businesses.|
|Social Investment Tax Relief (SITR)||Used by individuals to make investments directly in certain social enterprises (a social enterprise is an enterprise applying commercial strategies to maximise social impact, typically improvements in financial, social and environmental wellbeing).|
Who regulates venture capital firms?
VC fund managers (as opposed to the fund itself) in the UK are regulated by the Financial Conduct Authority (FCA).
There are restrictions on VC firms in terms of their ability to market themselves, and the contents of their prospectuses. Many VC firms also choose voluntary self-regulation by adhering to industry guidelines and standards.
How does venture capital funding work?
The first step is to attract a venture capital investor or fund to your business. You need a. captivating pitch, a great presentation, and a realistic business plan.
Make sure you research each VC firm or investor, and only approach those that are known to invest in your industry and type of business. It’s advisable to approach only one VC firm at a time.
Once your business has found the right VC partner and developed a relationship, the next step is to agree the terms of the investment transaction and document these. The investor will then do due diligence on the company and its founders.
The UK venture capital industry has developed a set of standard investment terms and the BVCA has published “Model documents for early-stage investments” for use in transactions such as a Series A funding round so that documents are familiar to the negotiating parties and contain widely recognised terms. This helps deals move faster and cost less as there will be less negotiation between the parties.
The key documents involved in the investment will be:
A letter of intent to set out the key terms agreed between the target and the investor
An investment agreement or a subscription and shareholders’ agreement that describes the terms between the company’s existing shareholders, the investors and the company, and documents the share subscription by the investors and how the investment will be made (for example, some investments are made in two or more tranches)
Depending on the level of risk, the investment agreements will usually contain warranties given by the founders to the investor regarding the company and the business plan. There are also likely to be rights given to the investor to access information and appoint to the board. The investment agreements will usually cover the commercial terms (profit sharing, recovery of capital, investment policies, fees) as well as setting out any regulatory compliance requirements, for example relating to the type of investment activities that can be offered or the maximum size of the investment.
Founders will usually be expected to enter into restrictive covenants preventing them from competing with the company if they leave. The agreement will also include any rights the investor may have to veto strategic or operational decisions of the company.
Articles of association. Your company will already have articles of association, but an investor may ask you to adopt new, more detailed, articles or amend your current ones.
These will set out the rights attaching to the shares in the company, particularly if there’s more than one class of share. The articles will also deal with share transfers that are usually restricted and may require founders or employee shareholders to offer their shares for sale if they leave.
A lot will depend on the number of funding rounds that have gone before the proposed investment as you will need to balance the rights of existing shareholders (who may also be investors) with those of the new investor.
Limited Partnership Agreement. If the VC fund is a limited partnership, a limited partnership agreement can be drafted or amended between the investors and the fund.
Service agreements for directors and key employees if they don’t already exist.
Company’s business plan: this can be included as an appendix to the investment agreement
What is a venture capital trust?
A venture capital trust (VCT) is an investment company that is quoted or listed – which means that its shares are traded on the London Stock Exchange. They are part of a government-backed scheme approved by HMRC and set up in 1995. VCTs are set up to invest in small unquoted UK businesses and offer tax reliefs to encourage investors to invest their money into the trust.
Under a Venture Capital Trust, individual investors buy shares in a quoted company (the VCT), who uses those funds to buy the shares of (or lend money to) unquoted companies. The VCT passes the tax relief available onto the investor, that also benefits from capital gains tax relief on any gains, as well as tax-free dividends.
The VCT must be approved by HMRC and must meet a variety of conditions.
Are there different categories of Venture Capital Trusts?
Yes, there are different types of VCTs, including:
- Seed money VCTs that provide low-level financing for developing and proving a new idea
- Start-up VCTs that provide funds for new businesses that need finance for expenses, marketing, and product development
- First-round VCTs that provide financing for manufacturing and early sales
- Second-round VCTs that provide operational capital given to early-stage companies which are selling products but not obtaining a profit
- Third-round VCTs (mezzanine financing) that provide financing for expanding a newly beneficial company
- Fourth-round VCTs (called bridged financing) that provide financing for a business to go public
What information will you have to provide to a venture capital investor?
The first thing you’ll need to provide to the investors is your business plan. This should include:
- A summary of your business proposal
- A description of the opportunity, market potential, and size of the potential market
- A review of the existing and expected competition
- Detailed financial projections
- Details of the management of the company
Interested investors will then proceed to due diligence. You’ll need to provide extensive information about its constitution, operations, and affairs. For example, the investors may want to review your management team, market potential, product/service, and business model as well as details of your assets and liabilities and any areas of risk.
You may also be asked to provide information about the structure of your company, your contracts with customers, suppliers, and other third parties, any loans, and other arrangements made between the company and shareholders/directors (both past and present).
You need to provide your accounts, latest budget, forecast and business plan. An overview of the company’s assets must also be provided by detailing what fees are being paid, existing credit arrangements, and any contracts/deals/projects in the pipeline.
The investors may also want information about employees, the terms of their employment and pensions. Further information needed may include providing details of any litigation in which the company is engaged in, data protection policies, insurance and tax.
What happens if you get venture capital funding, but you can’t comply with the terms?
If you can’t comply with the terms originally agreed with the investor, you must tell the investor as soon as practicable or you risk being in breach of the terms of the transaction documents.
It may be possible to negotiate a variation. For example, the investor may waive your non-compliance under certain conditions.
The transaction documents may set out a timetable that you have to follow to notify the investor of any breach of the agreed terms so you need to understand the documents inside and out.
If the investor doesn’t waive the breach, the investor may be able to terminate the arrangement, withdraw funding and recover any losses that result from your non-compliance (breach of contract).