An inside track on the venture capital process
If you are seeking venture capital for the first time it may feel like standing at the entrance of a maze. You know there is a way in and a way out – but anticipating the length of the journey and what might happen as you move forward can seem daunting.
While experiences may vary, depending on which venture firm you partner with, the investment process should be broadly similar. Gaining an insight into the process will help you formulate important questions to ask an investor and to prepare for what they might ask you. It will equip you with the knowledge you need to progress confidently towards a deal and eventually to an exit that rewards your hard work and reflects the value you have built in your business.
Is venture right for your business?
Before you get into talking about a deal it is important to be clear how venture funding works. Venture capital is a subset of the private equity industry: if you have an early stage company with high growth potential but don’t generate enough cash from existing operations to fund growth, venture capital may be an appropriate option.
Venture firms provide long term finance, typically in return for a minority equity stake in your company. As shareholders, their return on investment is entirely dependent upon the future growth, profitability and liquidity of your business. Unlike bank debt, a venture investor has no legal right to repayment or interest. That means that a venture investor’s interests should be aligned with yours – to grow the business and increase shareholder value.
Venture capital typically focuses on early stage businesses (it can include seed and start-up capital) but can also encompass expansion and growth stage funding. By contrast, private equity can provide growth capital, but also offers finance for business restructuring and turnaround, replacement capital and funds buyouts. A key difference is that private equity firms typically take a majority stake.
SEP typically provides investment of up to £20 million to fund innovative high growth businesses but we also have the flexibility to provide replacement and buyout funding.
Regardless of which type of venture capital best suits your business, the investment process will be broadly similar. It consists of 4 main elements: investment appraisal; deal execution, value creation and value realisation. Here is an outline of what to expect at each stage:
Investors will consider your business plan and meet you to learn more about your business and your management team. The investor will begin due diligence, a process which usually entails researching the market opportunity, growth potential and risks and sensitivities facing your business. They will build a financial model to help structure the proposed investment and assess the financial sustainability of your business. This is essential to validate the investment opportunity and to begin initial negotiations on deal terms. At this point you should receive an outline term sheet setting out the main elements of the proposed investment.
If investment terms are attractive, discussions will progress and formal due diligence will be carried out. The investor may appoint external advisers to help assess the technology, market, financial history and projections, management and legals (these will be tailored to the investment opportunity). You can expect some final negotiation on investment terms based on formal due diligence findings. The next step is approval from an Investment Committee and legal documentation to complete the investment. The journey from initial discussions to legal completion could take 3-6 months, depending on progress made against key milestones along the way.
As soon as the investment has completed, the partnership between management and investors really crystallises. Most investors, like SEP, will take a seat on your board and seek to have a positive relationship with management, helping with the company’s strategic and commercial development. In practice this can include assisting with board or senior management recruitment, strategic planning, budget setting and corporate governance. Your investor may also make key introductions to help your business grow and support future fundraising or M&A activity.
Exit planning underpins investment rationale. So while a venture investor will be very focused on working with management to build a valuable business, they also need to be able to realise that value and must keep an eye on the exit horizon. The appropriate time and strategy for exit will be influenced by the stage at which you have received funding – seed stage businesses typically take longer to exit than later stage, more established companies but in all cases an exit must be carefully planned. The SEP approach is generally to be patient and to grow the business until it makes strategic and financial sense to run a sale process or consider IPO – this can often take 4-5 years from initial investment.
Whatever the exit strategy, there should be no surprises. It is important for investors and management to maintain an open dialogue on exit plans throughout all stages of the investment process from initial appraisal to eventual exit.