February 15, 2016

A Very Simple Guide to Venture Capital

What is Venture Capital?

Venture Capital (VC) is an investment in a business in exchange for a share of the business (equity).

The investment can come from the private sector or the public sector and the fund can be supplied by a number of parties (an independent fund) or a single entity such as a subsidiary of a financial institution or private company (a captive fund).

The funding might be used in a number of ways:

  • funding to research and develop a new concept (Seed funding often provided by Business Angels);
  • to finance a new start-up company. Venture capital investors may often join a company to help bring a product to market;
  • to finance manufacturing and marketing a product.

VC funding is often provided in discrete portions referred to as funding rounds. This manages the risk of the investment and also allows different investors to enter or exit (although one fund might provide all the rounds) in response to the investor’s appetite for risk.

What is Venture Capital looking to invest in?

The characteristics of a VC investment are most often:

  • a concern where there is a competitive advantage, a unique selling point or some other barrier to entry for “me too” followers;
  • a requirement for a minimum of £2M;
  • to create value; for example, funding an ambitious but realistic business plan to realise a large earning potential or high return on investment within a specific time period;
  • management expertise, either pre-existing within the company or to support the recruitment of expertise necessary to support the business plan.

What you need to do before approaching Venture Capital?

The market is highly competitive. For every hundred business plans submitted, ten will be a seriously considered and only one will be funded.

Different types of investment are suitable for different stages of business development and different funds specialise in different sectors or stage of company. If you fit the criteria, you will have a competitive advantage. Find out which funds specialise in your company’s stage of development, the sector you operate in and the investment’s purpose.

Tailor your business plan to the investor. A well thought-out and up-to-date business case fully articulates:

  • your business’ funding needs (how much, when…)
  • whether your plans for the business are achievable (have you looked at risks?)
  • whether you need external investment (is there revenue coming in, collateral for loan etc.)

Your business plan may contain commercially sensitive information, so you need to start with an outline proposal to see if a VC investor is interested. Once the conversation becomes more serious you can prepare a letter of confidentiality. This should be signed both by your business and the potential investors before you send them your full business plan.

Although you need to determine what a particular VC fund will require before they invest in your concern, a common set of criteria is:

  • audited accounts usually for a two year period (this can be a problem for recent start-ups)
  • evidence of current performance (again a problem for recent start-ups – what is your track record in the field?)
  • a profit-and-loss forecast for next year. Seed investment will be different and may focus on the “exit strategy” or how the initial investors will recoup their investment and make a profit.
  • business bank statements for the past six months
  • profiles of each partner or director in your business. Particularly with start-ups the investor is looking at your human capital, know-how and expertise. Are staff committed?

The term “investment ready” is often used to describe companies which meet meet the criteria above.

Pros for the company

  • The investment is relatively long term
  • The amounts involved can be substantial depending on the value of your business and the prospective return outlined in your business plan
  • You retain management control over the day to day operation of your business
  • There are no repayments or interest
  • You don’t need collateral

Cons for the company

  • You give up a share of your business
  • The process can be challenging, time consuming and therefore costly
  • Not generally suitable for small amounts of investment
  • Finding a VC investor which is a good fit to your needs might take some time.

Pros and cons for the investor

  • VC is an illiquid investment in a concern which has no current value. In other words it can be difficult to get your money out until the term is complete.
  • The returns on investment can be significant if successful. However these are only achieved if the company is bought or offers shares on a public stock exchange and only around 1/6th of start-ups ever goes public and around a third acquired. VC funds will therefore hedge their bets by investing in a number of concerns.

Common mistakes

  • Your business case should be specific to the investment required. For example, in larger companies seeking to launch a new product or expanding an existing product, the business case should refer to the specific opportunity to make it clear what is required and what the return will be. It should also refer to any resources specifically allocated to the opportunity within the context of your larger business activity. It should also put the opportunity in the context of the larger business.
  • You need to clearly articulate when any exit opportunities where the investment and profit can be recovered by the VC investor.
  • Look for a good fit in terms of your companies stage of development, market sector, geographical location and amount of finance required. There are many specialist VC funds out there and you have a better chance of securing investment if you understand what they are looking for.
  • Would you, or have you invested in your concern? It’s good if you are confident enought to take a stake in the investment.
  • Are you investment ready?

Further information

The British Private Equity and VC Association: http://www.bvca.co.uk/

How Much Equity Should Advisors Get?

It’s an age-old scenario: You’re building a company, you have a product idea, and you’ve got the framework laid out in your head, but you want some expert advice and guidance on how to take the next steps. So, you go out to find a veteran entrepreneur, ask her to be an advisor in your fledgling company … and then what?

This is where a lot of founders get stuck. Entrepreneurs want to compensate their mentors and advisors for the time they dedicate to helping their businesses grow, but they have no idea how much equity to offer. Not to mention, once the founder and advisor have nominally agreed to a relationship, law firms enter the mix and seed the new advisor with a mountain of paperwork — legal agreements, options agreements — documents stuffed with legalese and binding statements. Just this hassle alone is sometimes enough to scare an advisor away from the relationship, at which point both sides lose.

So, the Founder Institute has developed a solution to this long-standing pain in the ass that all startups experience. After speaking with dozens of founders, mentors, advisors, and startup teams, the startup accelerator and network is publicly releasing what it calls the “Founder Advisor Standard Template” (FAST), a free document designed to provide founders and advisors with a simple legal framework to formalize their relationship without all the legal chaos.

“We’ve been seeing at least one post per week on TheFunded concerning mentor compensation”, said Adeo Ressi, the founder of both Founder Institute and TheFunded.com (a site focused on revealing the inside truths of the Venture Capital world). Having to invent ad hoc terms to work together, negotiating terms, and throwing money into hiring lawyers can really hamstring the formation of productive founder-advisor relationships — something that can really make or break a startup in its early stages.

This is where FAST enters the picture, which Founder Institute has developed in conjunction with the Orrick Law Firm and Silicon Valley entrepreneurs, to standardize the process and remove the hassle, cost, and delay to the formation of these relationships. Now, with a few signatures and a couple of checkmarks, founders and advisors can decide (in minutes) how they want to work together, what to accomplish, and how much equity will be in play.

In an effort to standardize the process with FAST (and let everyone just get back to building great companies), Founder Institute and Orrick have denoted three “levels of company maturity” that have different implications for how to define the advisor-founder agreement: idea, startup, and growth. In addition, they qualify the terms with three “levels of engagement” that define how advisors will work with founders and have varying influence on how they are compensated: standard, strategic, or expert.

equity-matrix

For example: If an advisor meets with the founding team monthly, is involved in recruiting talent for the business, and takes a few customer calls, then that advisor would be entitled to 1 percent of the company in the form of restricted stock or options, vesting over a two-year time frame. For a growth stage company, in comparison, this level of engagement would earn an advisor 0.6 percent.

What’s more, the idea here is that the agreement is codified by the two parties in such a way that it meets the minimum legal requirements but is flexible enough to allow advisors to end the relationship in as little as five days, for example. Traditionally, both beginning and terminating these contracts can take weeks — even months.

But what’s so cool about this is that, in the spirit of this flexibility, the team is architecting the document by way of crowdsourcing. This means that, until they finalize the agreement (Ressi tells me that the target date is September 30th), they will be taking the input of readers, founders, startups, and beyond, incorporating the best feedback into its development. In particular, Ressi said, the team is interested in reactions to the above equity matrix.