Venture capital (VC) funding is a form of private equity investment, where a business obtains long-term funding in exchange for a share of its equity.
VC funding is mainly sought by start-ups or new businesses with high growth potential. Companies can also use it to expand, fund management buy-outs or buy-ins, or develop new products.
VC investments are made by companies, drawing on private equity funds set up by large investment institutions and are generally on a larger scale – typically over £250,000.
Venture capitalists are less likely to become involved in the day-to-day operations of a company they take part control of, or to supply advice or expertise. VC funders are also likely to have a defined exit strategy to realise their profits.
You may find that VC funding is not suitable for your business. If so, there is an alternative type of private equity investment – business angels.
This guide provides an overview of VC private equity funding for businesses, and outlines strategies for securing it.
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What is private equity and venture capital?
Private equity (PE) funding is a general term for investments in private companies – usually financed from a fund set up by big institutional investment firms.
Venture capital (VC) companies draw on private equity funds to invest in new businesses with high growth potential, eg technology start-ups. In exchange, they take part of the business’ ownership, making a profit when they sell their stake and exit the company. VC’s typically invest in businesses with:
- a minimum investment need of around £2 million, though smaller regional VC organisations may invest from £50,000
- an ambitious but realistic business plan
- a product or service that offers a unique selling point or other competitive advantage
- a large earning potential and a high return on investment within a specific timeframe, eg five years
- sound management expertise – although VCs tend not to get involved in the day-to-day running of the business, they often help with a business’ strategy
Business angel investments are another form of PE investment, where wealthy individuals use their own money to invest in small companies with growth prospects. For more information, see our guide on business angels business angels.
Types of PE funds
Many PE funds specialise in a geographical area or industrial sector, while a few serve general investment purposes.
There are four main types of PE funds:
- Independent funds – the most common form of PE fund. Their capital is supplied by third parties, with no one party holding a majority stake.
- Captive funds – have one major shareholder, contributing most of the capital. A captive fund can be a subsidiary of a bank or an insurance company, or an industrial company looking to invest in its own sector.
- Semi-captive funds – have a majority shareholder, but also significant minority shareholders. They can be subsidiaries of financial institutions or run as separate companies.
- Public sector funds are made up of capital supplied partly or completely by the public sector.
PE funds have either a limited lifespan – usually ten years – or an unlimited lifespan, where the managers can continue to operate as long as they have capital to invest.
Is private equity right for your business?
Most companies seeking venture capital (VC) private equity (PE) investment are start-ups, or new businesses offering investors a potentially high return.
Common uses of PE funding include:
- launching a new product
- exporting goods or services to new markets
- recruiting senior employees
- selling part or all of a business
- taking over another business
How entrepreneurs can attract private equity investment
Most entrepreneurs will need some form of private equity investment to launch their businesses. To attract interest from PE funds, you must be prepared to:
- make sure the business is well organised
- assemble a talented and loyal team
- give up part of your business to investors
- have ambitious growth plans
- share important decisions with major shareholders
- prove your business has a competitive advantage over your rivals
- agree an effective exit strategy for investors
Find the right kind of private equity funding
There are various forms of PE funding for different phases of a company’s development, eg:
- Seed financing – funding while you research and develop a project or concept until you are ready to launch a company. This form of PE is mainly provided by business angels – for more information, see our guide on business angels.
- Start-up financing – to help you develop a product and begin marketing it. This sort of funding is often based on your business plan and VC investors may often join your company to help bring the product to market.
- Post-creation funding – capital used to finance manufacturing a product and a sales drive, so your company can begin to make profits.
- Expansion and development – investment is used to increase production capacity and sales activity, for companies growing strongly. Funding is often provided by new VC investors attracted by previous significant investments in the company. It may be supplied as bridge financing – ie to maintain cashflow until revenue from a product begins to flow – or a rescue or turnaround investment.
Transfer or succession funding
Transfer or succession funding is a form of VC investment used to finance management buy-outs or buy-ins – eg after the retirement of a company’s founder or chief executive officer.
It can also be used when:
- a large company sells off a business unit
- investors buy shares in a family firm
- investors from earlier stages of a company’s development exit the business
VC fund managers attract transfer funding by creating a holding company – using it to seek funds, in the form of debt, to buy the target business. Once this has been done, they use the target business’ dividends to pay off the debt. Equity capital may also be used, where the target business gives up part control to the fund managers in exchange for funds.
Buy-outs and buy-ins using transfer funding can help companies restructure efficiently after senior figures retire, helping to protect jobs and employee shareholdings.
Alternatives to private equity funding
You may find that other forms of funding are better for your business than VC funding such as loans and overdrafts or government support.
For other sources of alternative funding, see the page on alternatives to equity finance in our guide on equity finance.
Finding and approaching venture capital investors
Before you approach a venture capital (VC) firm, you should research what sort of private equity (PE) funding would be best for your business needs. Different types of investment – eg seed funding, product development and succession funding – are suitable for different stages of business development.
See the page in this guide: is private equity right for your business?
When choosing a VC fund, look for:
- funds targeting your business sector
- investment criteria
- quality of advice and support provided by investors
- amount of finance – some PE firms specialise in investments below £100,000
- geographical location of PE investors and how near they are to your company
The British Private Equity and Venture Capital Association (BVCA) publishes an annual report on private equity investment and you may find that this is a useful research tool.
Matching investment criteria
VC managers will invest only in companies that match their investment criteria. You should carefully check this before making an approach. You should also make sure that your business plan is up-to-date with detailed financial forecasts tailored to the investor concerned. Business plans are used by investment managers to assess:
- your business’ funding needs
- whether your plans for the business are achievable
- whether you need external investment
See our guide on how to prepare a business plan.
See our guide on how to use your business plan to get funding.
Making your business investment ready
Your business also needs to be investment ready, which means providing:
- audited accounts for the past two years
- evidence of current performance
- profit-and-loss forecast for next year
- business bank statements for the past six months
- profiles of each partner or director in your business
See our guide on how to secure equity investment.
Data confidentiality
Once a VC investor firm has shown interest in your outline proposals, 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.
Data confidentiality can be an important issue for smaller companies applying for investment, particularly where proposals contain details of commercially valuable products or strategies.
Negotiating a venture capital investment deal
Negotiations for investment with a private equity venture capital (VC) firm can last up to a year, and follow several key stages, from presenting your business plan to final negotiations and sign-off for the investment agreement.
Special advisers
Most companies seeking VC funding employ specialists to advise them on the various stages of the negotiation process. They can include:
- accountants – who can help you draw up and review your business plan
- legal and tax advisers – for legal planning and fiscal aspects of the deal
Your advisers should also be able to help you consider the wider aspects of the deal, such as how the fund managers work with other businesses, and whether they are likely to be a good fit with your company.
Presenting your business plan
Use your first meetings to try to decide whether you would feel comfortable working with the investors long term. You should also research the fund’s investment performance with similar companies, and how it operates.
After you present your business plan, the investor will decline your proposal, request more information, or ask for another meeting.
Initial negotiations
If they are happy with your outline proposals, the fund managers may offer you an initial memorandum. This is a programme of further negotiations, based on your business plan.
Issues considered at this stage include valuations of your business, and what role the board of directors will play.
The discussions will also cover the forms of finance to be used – usually a combination of equity and debt.
Company valuations
Price negotiations centre on the amount of equity you are prepared to give up in exchange for investment. The agreed price forms the basis of the fund’s return on investment.
Both you and your potential investors can use analytical tools to determine values.
Common valuation tools include:
- measuring discounted cashflows – comparing positive cashflows with risk-free investments such as a government bond, and building in a risk factor ‘discount’
- comparing your company to similar companies – eg in terms of profit, cashflow and turnover
- opportunity cost analysis – comparing the likely profitability of your proposal with that of investments with similar risks
Companies with intangible assets can be hard to value because they cannot easily be compared to other companies.
Offer letter
After agreeing a valuation, the fund will give you an offer letter, detailing its proposed investment. The document summarises the interim terms of the deal, subject to due diligence. Once you have accepted the letter, due diligence and final negotiations can take place.
Due diligence
Fund managers must ensure they have exercised due diligence before they invest in your company. This involves audits by lawyers and other consultants of both your company and your proposal.
Further negotiations or changes to the terms of the deal may follow, depending on the results.
Final negotiations
During final negotiations, the terms of the deal are agreed and signed off.
At this stage, you and your senior management team can negotiate your personal equity stake in the company, post-investment. This should take into account issues such as the company valuation and the investors’ exit strategy.
Investment deal documentation
After sign-off, lawyers for the parties will draw up acquisition documents, detailing the terms of the negotiated contracts according to legal requirements. These include:
- shareholders’ agreement – the rights and obligations of each party
- investment protocol – share prices and numbers of shares
- changes to company statutes
- warranty letters
- contracts with senior and junior members of staff
All parties should then sign the final agreement. At this point, the capital funds will be released to your company. For a management buyout, sign-off marks the point where the holding company acquires the target company.
How venture capital investors work with and exit from companies
If you accept funds from an external investor, you must share information about your company with them and delegate some decision-making. You can draw up a shareholders’ agreement to establish how joint decisions will be made, and to balance the interests of different shareholders.
The shareholders’ agreement will also cover the rights and duties of your investment fund managers, eg:
- receiving regular company performance reports
- consultation on important decisions, eg business acquisitions and disposals
- control of the exit process
Day-to-day operations
You should keep in contact with your fund managers, as they can help you with strategic decisions and issues such as:
- organising further investment
- negotiating with banks
- negotiating the sale of the company to partners in the sector
Investing fund managers generally leave day-to-day operations and growth strategies to the company’s senior management. They may, however, take a more hands-on role if there is a crisis, if the company is a start-up, or if the investment is a complex one, eg a debt-financed operation.
Company committees and boards
Most fund managers will expect to be present or be represented on a company’s board, subject to normal corporate governance standards.
Financial board members are subject to their own professional codes of conduct, including those which cover conflicts of interest between different investments. Fund managers can also play an active role in important committees, eg for audit or remuneration.
Liability
A fund manager sitting on a company board has a duty of care to its shareholders and creditors. They will generally avoid involvement in day-to-day operations, as this will increase their liability should the company collapse.
Experienced fund managers should be able to identify signs of crisis in a company, such as a sharp rise in fixed costs or high staff turnover.
Exit strategies
Venture capital (VC) investors may decide to sell their investment and exit a company. Alternatively, the company’s management can buy the investor out (known as a ‘repurchase’).
Other exit strategies for investors include:
- sale of equity to another investor – secondary purchase
- stock market floatation
- liquidation – involuntary exit
Private equity firms may decide to not sell all the shares they hold. In the case of a flotation, they are likely to hold the newly-quoted shares for at least a year.
The exit value of a company must be mutually agreed between all parties, and will depend on:
- the type of operation
- the number of shares sold
- the original valuation of the company
Private equity funds have either a limited lifespan – usually ten years – or they can continue to operate as long as they have capital to invest.
In limited funds, a small group of investment managers work together, by agreement with the institutional investors, to invest blocks of capital in companies matching the fund’s investment criteria.
When the fund exits – divests – from a company it has invested in, any profits are usually distributed to the fund’s capital investors. Profits above an agreed level are split between the investors and fund managers.
At the end of the fund’s lifespan, all remaining investments must be divested and profits distributed.
Unlimited funds are run in similar ways to limited funds but without the requirement to wind up all investments after an agreed period. Fund managers often reinvest part of any capital gains they make into the fund.
See our guide on how to secure equity investment.
Communicating with investors
Communications with potential investors – eg sending a business plan to them – are classed as financial promotions and regulated under the Financial Services and Markets Act (FSMA).
Under the Act, anyone carrying out a financial promotion must be authorised by the Financial Services Authority, although most proposals sent to private equity houses seeking funds are exempt from the restrictions.
Under FSMA rules, you are not allowed to include ‘misleading statements’ in documents, such as a business plan, designed to induce or persuade people to:
- enter into investment agreements
- buy or sell shares in companies
You must be able to prove any statement, promise, or forecast, contained in any communication or document you send to potential investors.
You should consult your legal adviser to ensure compliance with the rules on financial promotions, before approaching potential investors.
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