Understanding Venture Capital: A view from both sides of the table
Whilst the cost-of-living crisis and rising interest rates have undoubtedly created a more restrictive and therefore challenging environment for raising capital, opportunity remains.
Appetite from investors has not abated, but the quality bar before deploying capital has undoubtedly increased. The potential to generate returns in excess of those available in the public markets and fixed income sees continued investment be deployed into the best and brightest private businesses, but with more rigour and at lower valuations than previous years.
The different types of investment
When securing funding for your business, there are traditionally two key avenues:
Debt - an instrument that attracts an interest rate, and needs to be repaid. The lender will traditionally have no control over your company, and no involvement once repaid. In the event of sale, debt will be repaid before equity holders receive anything.
Equity - an instrument that sees investors take a stake in your business in exchange for an injection of funds. Equity is not repayable; participants become part-owners. This aligns all shareholders - investors are entitled to votes based on the numbers of shares held, and participate in the growth of the value of the business through share price appreciation and potentially future dividends.
Equity investment takes many forms, and comes from many sources:
Crowdfunding: as the name suggests, crowdfunding sees individuals aggregate their investment together and acquire shares as a group, typically at the nascent stage of a company’s development.
Angel investment: traditionally, early-stage investments are made by high net worth individuals who are investing in businesses where they believe they can add value through their expertise, network or mentorship. These investments are typically at the nascent stage of a company’s development.
Venture Capital: early-stage institutional funding for companies demonstrating significant potential for future growth. These companies need not be profitable at this stage, with investors cognisant that they will be funding loss-making businesses; their upside comes from the uplift in share value in future. A Venture Capital leading a funding round will likely take a board seat to support the company with its growth trajectory.
Private Equity: typically reserved for established, profitable and cash generative companies at later-stage than those attracting Venture Capital, this form of institutional funding results in the majority acquisition of a company, often cashing out the entrepreneur. The Private Equity firm will typically expect the entrepreneur to remain as the manager of the business, with a minority shareholding to align interests amongst shareholders who will likely take board seats and have some control over the company.
Why Venture Capital funding is different
When comparing Venture Capital funding to alternative options during earlier stages of a company’s life, typically you would expect superior access to capital, operational know-how and sector expertise when compared to Crowdfunding and Angel Investment. Venture Capital funds typically possess deep expertise, and the best performing funds globally are recognised as picking category defining companies such as Amazon, Uber and Netflix before they penetrate public consciousness.
Indeed, the top performing funds have delivered returns in excess of 35% to their investors for over a decade.
Identifying companies at the earliest stage of development, such as pre-revenue companies or those who have just achieved product market fit, is a skill and requires capabilities that you are unlikely to be able to replicate as an individual. With dedicated teams for identifying, conducting due diligence, structuring and monitoring investments, it is nearly impossible to replicate the level of sophistication that Venture Capital funds bring to businesses at the early stage.
What Venture Capital funds look for?
At the early stage, the chance of failure is materially higher - developing a portfolio of investments becomes increasingly important for funds seeking to deliver returns to investors. The portfolio construct will depend on the fund’s specialism - examples of specialisms include the stage of investment, the target sector and geography.
Beyond this, a clear product, a market size that supports the opportunity, the potential routes to market and the founding team are just some of the key components that funds look for. This all goes to the potential a company exhibits at the earliest stage.
The stage of business that a particular VC fund will invest in, whether pre-Seed, Seed, Series A, Series B or pre-IPO, comes down to expertise and risk-appetite. Naturally, early investment offers the potential for greater returns, owing to lower valuation and long-term growth potential. On the other hand, a more established business will likely have a higher valuation, but a lower risk of failure.
Different funds adopt different approaches, tailored based on the specialism within the team and experience. Those looking to secure investment from Venture Capital funds should try to identify those with track records of deploying capital in similar sectors, stages and geographies as the company.
Securing VC investment
Once a list of funds to target have been identified, based on sector, size and geography, the next question is how to best equip yourself to secure investment.
A compelling business plan outlining the company’s vision, market opportunity, growth strategy and financial projections will go a long way to demonstrating why a business is a good investment. Progress achieved and success stories will prove a useful tool to help build the business case.
Companies should also be prepared for a rigorous due diligence process when engaging with a Venture Capital fund. Whilst all investors will make thoughtful, researched decisions, funds tend to have a more structured due diligence process requiring detailed financial and operational information.
Despite the well-documented slowdown in investment into private companies and haircuts to valuations in recent months, Venture Capital funds are still looking for opportunities to back the people and businesses that will be the category defining businesses tomorrow.
