Venture Capital

An approach to investing in early-stage companies

Venture Capital (VC) firms invest in early-stage but high-potential companies, providing capital in return for ownership of a stake in the recipient. Such companies often have little access to alternative means of financing, but can grow quickly and thus appreciate in value significantly. However, the VC model is inherently risky and so firms invest across a portfolio in the expectation that some will fail, most will achieve moderate success while a small percentage will be highly successful.

History

The model first arose in the US in the 1940s and has been most successfully employed within Silicon Valley in California, where VC-backed success stories include Ebay, Google and Apple. Nevertheless, the VC industry today operates globally with hundreds of active firms managing billions of dollars. Track record is extremely mixed, with a small number of top-tier firms accounting for the majority of returns across the industry.

Business Model

VCs manage a pot of money ('fund') provided by so-called Limited Partners (LPs), which are typically pension funds, insurance companies or corporates. VCs charge LPs a management fee (normally 1%-2% of fund size p.a.) and retain a portion (e.g. 20%) of any profit made once the portfolio has been sold ('exited'), known as 'carried interest'. A typical VC fund will operate over a 10 year lifecycle, with primary investments completed during the first 5 and then managed to exit over the remainder.

Strategy

Strategy varies across different VC funds: some opt to focus on certain geographies, sectors or company stages (from nascent 'seed' stage to more mature growth-stage companies). Strategy influences the typical deal size and number of portfolio companies. Most VCs seek certain key features including strong management (especially people that have successfully built and exited businesses previously), product/service differentiation, large addressable markets and evidence of customer traction.

Process

The VC investment process may take several months to complete. Following initial review of a business plan, VCs will work with management to build a deeper understanding of the company and market, before finally negotiating a deal and arriving at a heads of terms, which outlines the key features of the agreement. Pre-money company valuation is determined with reference to a number of sources including company growth potential, comparator transactions and similar listed companies.

Key Terms

Financial returns are assessed with reference to Internal Rate of Return (IRR) and Multiple of Capital. Desired returns reflect the risks involved and thus company stage and sector. Most VCs will seek to attach special rights to the instruments that they hold, including liquidation preference (the right to receive capital invested as a priority on any exit event). VCs will typically look for other rights including:

- Anti-dilution: reconfiguration of shareholding in the event of future fundraising at a lower valuation - Board representation - Consent Rights: a veto over certain actions (e.g. selling the business) - Drag & Tag: ensures full shareholder participation in exit event - Information rights: regular access to financial and operational information - Pre-emption: ability to maintain shareholding through future fundraising - Restrictive covenants: compels management to refrain from certain acti

Post Investment

The level of involvement with portfolio companies post-investment often varies between VC firms. Most VC investors claim to offer access to other sources of capital, advice on key issues (e.g. hiring and sales) inherent in growing a company and expertise in positioning the company for eventual exit, either through a trade sale (i.e. strategic acquisition by a relevant company), listing on a public stock exchange (Initial Public Offering, or IPO) or acquisition by another financial investor.