Venture Capital Funding: A Practical Guide to Raising Finance

VENTURE CAPITAL FUNDING

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VENTURE CAPITAL FUNDING a practical guide to raising finance

2nd edition

STEPHEN BLOOMFIELD

London and Philadelphia

Publisher’s note Every possible effort has been made to ensure that the information contained in this book is accurate at the time of going to press, and the publishers and authors cannot accept responsibility for any errors or omissions, however caused. No responsibility for loss or damage occasioned to any person acting, or refraining from action, as a result of the material in this publication can be accepted by the editor, the publisher or the author. First published in Great Britain and the United States in 2005 by Kogan Page Limited Reprinted 2007 Second edition 2008 Apart from any fair dealing for the purposes of research or private study, or criticism or review, as permi�ed under the Copyright, Designs and Patents Act 1988, this publication may only be reproduced, stored or transmi�ed, in any form or by any means, with the prior permission in writing of the publishers, or in the case of reprographic reproduction in accordance with the terms and licences issued by the CLA. Enquiries concerning reproduction outside these terms should be sent to the publishers at the undermentioned addresses: 120 Pentonville Road London N1 9JN United Kingdom www.koganpage.com

525 South 4th Street, #241 Philadelphia PA 19147 USA

© Stephen Bloomfield, 2005, 2008 The right of Stephen Bloomfield to be identified as the author of this work has been asserted by him in accordance with the Copyright, Designs and Patents Act 1988. ISBN 978 0 7494 5230 8 British Library Cataloguing-in-Publication Data A CIP record for this book is available from the British Library. Library of Congress Cataloging-in-Publication Data Bloomfield, Stephen. Venture capital funding : a practical guide to raising finance / Stephen Bloomfield – – 4th ed. p. cm. Includes index. ISBN 978-0-7494-5230-8 1. Venture capital. 2. New business enterprises– –Finance. I. Title. HG4751.B58 2008 658.15'224– –dc22 2008011176 Typeset by JS Typese�ing Ltd, Porthcawl, Mid Glamorgan Printed and bound in India by Replika Press Pvt Ltd

To GEB, PEB and KEB – again

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Contents

Preface to the second edition

xi

Introduction: some objectives and definitions

1

Background issues The funding gap – myth or reality? 9; Mathematics 14; Market 15; Management 15; Mission impossible 16

7

2 The future revisited I: developments in legal ma�ers (in collaboration with John Short of Taylor Vinters) Legal documentation 22; Business angels 24; The professionals’ cut 27; Conclusion 28

21

3 The future revisited II: developments in regional funding (in collaboration with Max Bautin of IQ Capital) New sources of proposals 31; The structural side 32

29

4 The future revisited III: the view from the City (in collaboration with Bob Henry of Matrix Partners)

37

1

vii

Contents

5

Why do you want funding? 43 Defining what venture capital is – and is not 44; The basic question 45; The four main purposes 47; Start-up 49; Business development 52; Shareholder change 55; Rescue 57

6

Know your enemy: the venture capitalists considered 61 The myth of patient money 62; Pressures on the venture capitalist 64; Factors and issues affecting venture capital fund policies 65; Fund size and structure 66; Size of funds 78; Life cycle 79; Horses for courses 81; From the fund to the individual – background and experience 82; Fund remuneration 83

7

The mechanics of doing the deal Stages of the process 88; The business plan 89; A�racting a funder 91; Employing professional advisers 92; Selecting a potential investor 93; Deal negotiation and initial valuation 96; The preliminary offer 98; Fees 99; ‘Due diligence’ 100

8

Seeing the finishing line Stars and bars 104; The major routes out 105; The P/E trap 106; Reasons to be helpful, part 1 108; Reasons to be helpful, part 2 109; The dark side 110

103

9

Dealing with existing shareholders (and stakeholders) The effects of change 112; The best structure 113; Shareholders 115; Other stakeholders 117

111

10

Building – and displaying – the management team Four elements of a management team 123; Dropping directors 130; Succession 131

121

11

The key issues of discovery: the ‘due diligence’ process 133 ‘House style’ 135; The due diligence process 137; The process 140; Stage 1: desk review 140; Stage 2: management called in to discuss the proposal 142; Stage 3: company visits 144; Stage 4: market review 147; Stage 5: customer review and supplier review 148; Stage 6: financial and credit review 149; Stage 7: accountants’ investigation 152; The investment commi�ee 155

viii

87

Contents

12

The choice of investment vehicle: existing business or newco? Type of investment 160; Realization considerations 160; Trading record 161; Complexity 162; Tax 162; The structure of the deal and the return to the investor 165

13

Legal stages: where the going gets tough The process step by step 176; The process 179; Major features and documents 180; What the term sheet contains 180; The disclosure le�er 186; Other points 186; Formal legal documentation 187

175

14

Post-investment considerations: culture shock The failure of mutual comprehension 191; Costs 191; Additional scrutiny – and the consequences 192; Requisite skills 193; Board atmosphere 194; Increased formality 195; The false hope of synergy 195; Outside involvement 196; Personnel change 197; Tactical actions of the investor 198; Further funding 199; The problems with angels 200; Nonproblems 201

189

15

Realization of the investment Flotation – IPOs 206; Trade sales 208; Buy-outs 212; The dark side: corporate collapse 212

203

16

Summary: do you still want venture capital? In defence of other funding 216; In defence of VCs 223; The point of departure 228; General conclusion 230

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Appendix 1 Glossary of terms Appendix 2 Useful addresses Index

233 237 239

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ix

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Preface to the second edition

The three years since the first publication of this book have seen many changes in venture capital. Some of these are dealt with in three new chapters, which consider respectively developments in legal ma�ers, some of the changes that have occurred in regional pa�erns of investment, and the investment perspective from London. I am indebted to the named collaborators for their advice on each of those topics – and if there are any faults in the descriptions of the changes they belong to me. Most of the changes examined in those chapters stem from the period of collective frenzy that has become known as ‘the dotcom boom’ – but more accurately should be called ‘the dotcom bust’. Some of the changes may have been for the good in the long run – in the short term many have had seriously adverse effects on businesses trying to develop and wanting to gain access to external sources of funding to do so. But most significantly, what has also happened over that three-year period is that venture capital – or perhaps more appropriately private equity – has entered the public consciousness. Unfortunately, that entry was in a blaze of ignominy. High-profile deals in the UK to take over household names like Boots and Sainsbury’s impinged upon the public’s daily activities in xi

Preface to the Second Edition

more ways than one in 2007. Newspaper readers could hardly avoid references to familiar supermarkets being threatened with takeovers – o�en hostile ones or with some hint of boardroom squabble to give added spice. The eventual near-collapse of one of the smaller UK banks, which led to a minor paralysis of the banking system, was even linked to the perceived buccaneering of private equity by more than one newspaper commentator. And when they weren’t reading about supermarkets being gobbled up to be broken up readers were treated to stories of extravagant wealth being generated for the few. The flotation of Blackstone’s in the United States and the slightly unsavoury use of tax breaks by the chiefs of venture capital in the UK brought the vast wealth that private equity can generate into full view. When those UK supermarket deals stalled – either through internal obstacles to the deal (like pension fund problems) or through external ones (like the collapse of banking arrangements) – the headline sizes grew proportionately. Since the UK banking system then went into shock, with some unexplained linkage between the two in the minds of some headline writers, private equity in the UK began to develop a very unfortunate reputation in a short space of time. Since this coincided with a dull political period, private equity chiefs found themselves in front of a parliamentary select commi�ee trying (mostly unimpressively) to explain away their sumptuous tax breaks and convince a sceptical press that they did not really only buy wellloved businesses just to break them up or else fa�en their P&Ls by slimming down their workforces. In the summer of 2007, the general ignorance in the mind of the average voter about what venture capital is and does was reinforced strongly. The story assiduously cultivated by the BVCA of how venture capital has generated substantial new business growth over a 30-year period was overwhelmed in this three- to four-month central period by examinations of the tax affairs of a very few individuals at the tops of the venture capital trees. But the large deals represented by private equity investment are only a small part of the total picture, as the statistics in Chapter 1 show. It would be a pity if, as a result of the summer of 2007, the abiding general impression of venture capital is that it is the province solely of the new fat cats.

xii

Introduction: some objectives and definitions

Mythology, n: The body of a primitive people’s beliefs concerning its origin, early history, heroes, deities and so forth as distinguished from the true accounts which it invents later. (Ambrose Bierce, The Devil’s Dictionary)

Most informed business people will know something about venture capital – or more likely some of the myths about venture capital: the rudiments of finance are part of the currency of business conversation. But much of the detail of what actually goes on when an investment is being made is unknown by most outsiders. Since nature abhors a vacuum, myth rushes in to fill the gap le� by the absence of knowledge – and some of the mythology, for instance about the instinctive rapid decision making or the managerial toughness of the venture capitalist, has been cultivated by some venture capitalists themselves. What really happens is that, as with every profession or commercial activity, a shorthand grows up around common activities, 1

Venture Capital Funding

and practitioners develop their own jargon – at least some of which is intended to act as a barrier to outsiders. For some practitioners – those who revel in their ‘superiority’ in knowing things that the outsiders apparently do not – if the jargon helps to make the subject seem more technical and daunting than it really is then so much the be�er. The combination of this jargon and the half-truths that grow up from stories passed on from friends of business friends who have ‘done a venture capital deal’ and the partial understandings that grow up from half-understood precepts make the process of winning venture capital for developing businesses seem more daunting than it need be. The purpose of this book is: first, to clear some of the fog that exists about how venture capital works; second, to illuminate some of the background processes that exist in venture capital businesses (taking the term to mean both the funds themselves and those businesses that are funded by venture capital); and third, to puncture some of the myths that have grown up about venture capital. In keeping with those three aims, what the book will try to do is illuminate some of the following areas:  what sort of businesses will be a�ractive to the different types of venture capitalist;  the processes of investment, so that businesses that do want to raise funding can then make a case for investment that will have a be�er chance of success than one made in ignorance of the subtleties of the venture capital process;  the particular targets of venture funds; and  the pressures on the venture capitalists themselves as individual investors. The intention in doing this is to make it easier, for those businesses that want to, to secure venture capital by understanding what venture capitalists want, what they are willing to invest in and on what terms. It is best to be clear from the outset that this is not a guide that simply says, ‘Do this, this and this and you will get venture capital funding.’ Apart from the fact that it would be dishonest to write a book that claimed to be able to guarantee success in securing funding, in truth some businesses quite simply do not deserve to be funded by venture capital. And there are some businesses that would be be�er off not even seeking venture capital and should search out other types 2

Introduction

of funding instead. The dotcom boom of the late 1990s and first couple of years of this century should have indicated this to many people on both sides of the funding fence. As far as the first objective of the book goes, we need to arrive at a definition of what we are talking about fairly quickly to make sure that we minimize confusion. What makes the job of description slightly complicated is that there is no one animal called ‘venture capital’: the term is really a conflation of several different things, hiding under a catch-all name. Briefly (because we will return to them in greater detail later), the usual categories (in ascending order of likely investment and descending order of risk) are: seed capital; venture money; private equity; and mezzanine finance. Properly, seed capital is the money that is used to start a business off – perhaps to provide the first set of premises or to patent a piece of intellectual property or develop a prototype. You can think of it as comparable to the process of ‘seeding’ clouds to make them disgorge rain or, perhaps more closely, to the process gardeners go through when they put lots of seeds in the ground knowing that only a few will make it to maturity. It is o�en the financial contribution of entrepreneurs or their family or friends to ge�ing the enterprise off the ground. Or it can also come from very specialized funds (frequently affiliated to a university or a government ‘enterprise’ initiative) or from private individuals or philanthropic trusts. It will usually require continuing equity participation in the business, but on vastly diluted terms; if it doesn’t, because for instance it comes in the form of a government grant, then in consequence the term ‘capital’ is sometimes misleading. ‘Venture money’ is the original term that was used to describe the funding that got businesses started in the United States in the 1960s and 1970s, when individuals put money behind bright ideas – that later grew into businesses like Apple Computers, Cisco Systems and Netscape – without any certainty of return. It is closer to seed capital than other forms of funding and is an area of the market in the UK that is increasingly becoming the province of ‘business angels’ and specialized investment firms. Larger investors find it difficult to invest in this area for reasons that will be discussed later. Venture money is the supposed plug for the so-called equity gap that has been around since that term was first invented in the 1930s. People talk increasingly about ‘private equity’ instead of venture capital, and this is generally taken to imply the money that comes from large institutional investors – money that is usually invested in well-established businesses o�en well beyond the stage of product or 3

Venture Capital Funding

process development. These businesses are o�en very large, and the opportunity for outside funds to invest comes when an even larger business is broken up (perhaps a�er a takeover) or when a division of a large business is sold off or perhaps when expansion money is needed to take a developing business to the next level just before flotation. The share capital of such businesses o�en has the characteristics that are associated with listed companies. Mezzanine capital is a very specialized branch of lending that has most of the a�ributes of a loan coupled with a few characteristics of equity: it a�racts principally a rate of interest (like a loan) but may also have the right to convert into equity on a sale or flotation, or it may have a guaranteed (modest) equity element. The origin of the term could be from one of two sources: either as a sort of financiers’ li�le joke, since it stands halfway between the ceiling of equity and the floor of lending (or perhaps vice versa); or perhaps from those swaggering, padded-shoulder days when ‘financial engineering’ was in vogue and being a vaguely architectural term in origin it seemed to be appropriate. It is o�en short-lived in nature – a sort of bridging finance that plugs the gap between what bankers are willing to lend on an asset-backed basis and what private equity suppliers will put up, with a high rate of return compensating the lender for a brief period of high risk. Consequently, as a hybrid, although it fulfils a purpose, it is o�en slightly disliked by both sides – by bankers and equity providers on the one hand who, while grateful for the gap plugging, resent the terms imposed, and by management on the other, who – also grateful for the gap plugging – don’t like the rates of interest and dilution of their own holdings that mezzanine finance brings. Since the late 1970s there has been a general gravitation of investment towards larger and larger deals – and consequently away from small and developing businesses. This is not an absolute, of course. Many thousands of small and medium-sized businesses have found venture funding. In the UK in 2003, nearly 1,300 businesses were funded by private equity funds – a figure that excludes investment by business angels. The size of the average deal fluctuates but generally increases, suggesting that, although the market goes through periodic changes when activity swells and subsides, it is a fair bet that the ‘equity gap’ will not go away. It will always be difficult for a small and developing business to persuade financiers to part with their money. The sting of ‘risk’ is not an intellectual concept investors or bankers are happy with unless it is followed very quickly – in speech, in writing and in the course of real-world events – by the balm of ‘reward’. 4

Introduction

Unfortunately, the investment world goes temporarily mad every so o�en – and indulges in changes of fashion even more frequently. Gold, jewels, land and oil have been the favoured obsessions throughout history, but foreign trading rights and even tulips were the objects of the speculators’ a�entions in the 17th century. And at the end of the 20th century we had the dotcom boom and then the dotcom bust. The worst excesses of that frenzy saw ‘investors’ making deals based on the flimsiest of suppositions about marketplace robustness, managerial ability and likely returns. The consequences should have been obvious, but only the steeliest-nerved funds decided to ignore the race to the bo�om. The conclusion of all this was the same as in every speculative frenzy: investors who filled their boots with the then latest fad (because they had no real grounding in experience and still less in common sense) now found it hard to make sensible investments as they surveyed the wreckage of their portfolios – if they still held their jobs, that is. Unfortunately, the tendency of the lemmings was so strong that it caught not only the gullible, newly-minted MBA investment neophytes but also the experienced managers of established funds, who should have known be�er. In some ways the worst of that period of excess was that it spilled over into affecting perfectly good businesses for several years later. The same aberrant a�itudes may be traced in the latest (at the time of writing) debacle – the ‘sub-prime’ scandals. So now no one among the survivors wants to be caught with his pants down a second time. The consequential overreaction is sad for potential investee companies and, although it is understandable for individual funds, it makes no collective sense. In truth most venture capital investment is more akin to riverboat gambling than anything else: knowing something about the psychology of the players, about risk and reward and about the environment in which you are playing will help to move the odds in your favour but it’s still a gamble; there is no certainty. And in this lies the key to understanding what venture capital is and how it is conducted. The simple fact at the heart of every venture capital deal is that venture capitalists are always trying to reduce their risk. There are three ways of doing this: first, knowing the marketplace as well as possible (through due diligence and industry or deal-type specialization); second, trying to gather together the best possible management team for the opportunity (more due diligence and selection or rejection of deals); and third, making sure that if things do go wrong then the maximum amount of manoeuvring room is available to the venture capitalist (making sure the legals – the legal terms of the deal between 5

Venture Capital Funding

the business and the venture capitalist – favour the investor rather than the management). These three activities condition all venture capitalist behaviour, as we shall see. But first we need to consider the seller’s part of the bargain – the business that is seeking to raise venture capital.

6

1

Background issues

Plan, v.i: to bother about the best method of accomplishing an accidental result. (Ambrose Bierce, The Devil’s Dictionary)

 A brief definition  The availability of funding and the ‘myth’ of the ‘funding gap’  Some statistics  A brief review of the history of venture capital in the UK – an insight into the current market’s provenance  The mantra of three Ms – mathematics; market; management  What can and what is unlikely to be invested in Despite the run of conventional wisdom to the contrary, it is now probably easier to obtain some form of external funding to grow your business in the UK than it has ever been. Yet this runs against the common belief that somehow the market has failed in providing 7

Venture Capital Funding

resources to fund developing businesses and that it is difficult to get money for all but large and sophisticated deals. The mistake that is commonly made in complaining about the availability of money for direct investment into unquoted companies is in confusing the amount of money that is available with effective access to that money. The la�er of these is a complicated combination of understanding how to make the argument for funding, knowing to whom to make it and – most significantly – appreciating how to clinch the deal. It is with these factors that this book will seek to deal in large measure by explaining how venture capitalists (VCs) go about making investments and the processes that lie behind the doing of a deal. This availability of resources is down principally to the strong growth of the venture capital business in the UK, which has grown steadily so that it is now without doubt the largest in Europe and second only to that of the United States in terms of size and experience of the people who manage funds. In 2003, according to figures from the British Venture Capital Association (BVCA), UK venture funds had £6,357 million under management. By the end of 2006 that amount had risen to £21,853 million. That is big money by anybody’s reckoning. Throughout this book, the term ‘venture capital’ will be used in the sense that it has been commonly used in the UK – to describe all forms of equity funding in unquoted businesses made by parties external to the original business. This may run against the more recent fashion to distinguish between specific types of funding by type. In recent years there has been a tendency among practitioners to distinguish between the terms ‘venture capital’ and ‘private equity’ – with the former following the US usage and meaning early-stage funding, and the la�er referring to development capital and buy-out money. The trouble with that distinction though is, first, that it makes for cumbersome titles and, second, that VCs in the US sense can o�en go on to become private equity investors in the same (invested) business. ‘Venture capital’ seems to be easier and cleaner as a title, since everybody in the business world is likely to be broadly familiar with the concept even though it may not satisfy an academic distinction between the two types in terms of terminology.

8

Background Issues

THE FUNDING GAP – MYTH OR REALITY? Entrepreneurs in this country grumble about the lack of available funding – arguing from the particular circumstances of how their ideas were spurned by the professional investors, to the general theorem of a funding gap that afflicts all businesses below a certain size. There also appears to be a general belief among business people, officials and government ministers that it is impossible to get funding for a deal unless it is a management buy-out worth many millions of pounds – probably hundreds of millions. Yet the evidence runs to the contrary – at least partially. Figures produced by the BVCA show that businesses of all sizes do a�ract funding every year. In 2006, UK venture funds invested over £10.2 billion in 1,318 companies in the UK; that figure was a small increase on the previous year in terms of numbers of companies but a 150 per cent increase in terms of the cash invested. The detail of where the money went is very interesting, and gives a snapshot of Britain’s industrial and commercial structure:  Investment in start-ups increased in 2006 by 332 per cent over the previous year, with 245 businesses receiving funding.  The amount of money invested in management buy-outs (MBOs) accounted for over half the total invested at about £6.6 billion.  Expansion finance rose by over 53 per cent to just under £3,000 million invested in 573 businesses. Sectorally the picture looks like this:  Communications businesses have long been a favourite with venture capitalists and took £243 million in 36 companies – although £152 million of this went into just four MBOs or management buyins (MBIs).  Of the businesses that received investment, 39 per cent were in computer-related activities, with the bulk of this being in so�ware (196 companies received £231 million in total); £91 million went to 101 early-stage businesses.  Biotech continued to experience strong growth year on year, with over double the previous year’s total amount being invested at £122 million going into 43 companies. 9

Venture Capital Funding

 E-commerce investment was over three times the level of investment of the previous year at £547 million – despite the problems of the dotcom bust.  Travel and leisure accounted for £1,880 million – a 42 per cent increase over the previous year, although the number of companies invested in increased by only 6, or less than 8 per cent.  Among the traditional sectors, construction and construction materials took up 11 per cent of the total of all funds invested and accounted for a cash amount of £1.1 billion. Regionally, there is a strong North–South divide:  London is the leading region for investment (by company domicile) and together with the South-East accounts for 60 per cent of the total amount invested.  An unusually strong level of activity in Yorkshire and Humberside meant that this region’s share of total national investment tripled in 2006 to account for 12 per cent of the total. These figures show the increasing significance of early-stage activity, despite the more-or-less continual migration of funding to the highervalue deals over the past 20 years. However, the poverty of returns experienced overall from this category has been particularly badly skewed by the dotcom experience of 1999–2001, with funds that have trapped large numbers of dotcoms in their portfolio reporting returns since inception of just over 1 per cent per annum. Over a 10-year investment period, firms with a specialization in technology investments record a negative rate of return. With all this money moving around, why is there such a prevalent belief that there is a funding gap? The probable truth is that there are two reasons. It is easy to see from the figures that the vast majority of private equity money (using the academic distinction) goes to fund changes in ownership of existing businesses – MBOs and MBIs. Existing businesses are proven to work (at least they did at some point). So the numbers of successful applications for funding coming from the ranks of these types of business will probably be greater than those from start-up and early-stage businesses. That means that rejection rates will be fewer, giving rise to the obvious (and probably partially correct) belief that VCs are more a�racted to MBOs and MBIs than to early-stage deals. 10

Background Issues

But that still leaves a powerful amount of money (nearly £4,000 million in 2006) available for expansion and development purposes and for funding early-stage opportunities. With this amount of money available, is there really a funding gap? The answer to that is probably twofold as well. First, some businesses just don’t deserve to be funded: that statement deserves further explanation and will be explored in the concluding chapter. Second, a good many worthwhile proposals miss being funded because the entrepreneurs behind them have no idea what it is investors are looking for and have no appreciation of how investors think about doing deals. By the same token, if basic thought had been applied about what it is that investors are looking for, many inappropriate deals would never even get beyond the back-of-the-envelope stage, saving the expenditure of much time, effort, money and heartache. It is the failure of these inappropriate deals, just as much as potentially good but badly explained deals being turned away, around which the myth of market failure has been built. Many potentially good deals get thrown out for poor communication of the key elements, for inadvertently missing a crucial selling point or for some other presentational quirk. These could probably achieve successful funding if the entrepreneurs presenting them knew which bu�ons have to be pressed to a�ract investors. While this applies most of all to the small investment opportunity where entrepreneurs are less likely to have access to sophisticated help, it is almost certainly applicable (in diminishing volume) to all sizes of business from all sectors. What disappointed entrepreneurs miss in constructing their general arguments based on individual experience is that, unless a proposal hits a potential investor as being worth pursuing very quickly, then it is likely to get discarded. The reality of the marketplace is that, like the princess in the fairy tale, VCs have to kiss a good many commercial frogs before they find the business equivalent of Prince Charming. And in consequence they are probably not willing to waste much time on trying to understand individual deals. Proposals that demand a lot of active involvement in ‘sweetening’ will be passed over if there is a chance of a be�er return by spending the same amount of time looking at five other possibly more profitable (and possibly more easily malleable) proposals: hence many disappointed entrepreneurs – and the persistence of the ‘funding gap’ theory. The existence of a funding gap or ‘equity gap’ has been argued about probably since the first Phoenician galley-owner failed to get backing 11

Venture Capital Funding

for a speculative trading voyage further up the coast. Almost certainly Christopher Columbus grumbled for many hours in Genoese taverns about the short-sightedness of investors before he managed to sell his business plan to King Ferdinand and Queen Isabella and convince them about the potential of America (which he had yet to discover, of course). In the UK, it is usual to date the existence of the discovery of the funding gap phenomenon from 1931 when the then government commissioned a commi�ee chaired by Harold Macmillan to investigate sources of funding to stimulate an economic revival. Economic policy was reeling from the effects of the Great Crash and, under pressure from industry, the government was seeking ways to kick-start economic activity. The commi�ee included, among others, the luminary economists John Maynard Keynes and Lord Bevin – and was the first of many reports into the problem. Over 70 years later, the problem of the funding gap – or maybe now the mythology of the funding gap – persists. Government officials and (disappointed) entrepreneurs still argue that there is a failure of the market to provide funding for new and developing businesses: ‘The equity gap was originally defined in the Macmillan Commi�ee on Finance and Industry report in 1931. Since then, the defined amount of the gap has varied according to subsequent reports. Currently the figures used to define where the gap can be encountered are investments of between £250,000 to £1 million’ (www.businesslink.gov.uk, October 2004).

Of course, for disappointed entrepreneurs the funding gap is where they pitched the failed proposal. But the VCs would say differently and claim that there is, in fact, a dearth of good funding opportunities rather than an absence of cash. If anything, the VCs are probably right, given their record of making their investments work. Rates of return had obviously been affected by the dotcom debacle but still remained comfortable for generalist funds and those concentrating on larger deals, even a�er this depressive effect. Venture capital funding in the UK is now a phenomenally large business – definitely the largest in Europe and with a significant place in national economic and industrial policy. The British venture capital business has a substantial record of achievement, over something like 40 years (from its origins in the Industrial and Commercial Finance Corporation), in developing ideas with commercial potential into 12

Background Issues

highly successful growing companies and embryonic businesses, and from these into large thriving concerns (although not without the occasional spectacular failure). This suggests that either VCs in aggregate do know something about what they are doing or that they are having a phenomenal run of good luck. On balance, the former is more likely. It is obvious from the statistics quoted above that a very large number of businesses find their funding from venture capital investors every year – even though individual years may show some variation because of economic conditions. What distinguishes the businesses and proposals that do achieve funding from those that don’t – aside from the cases that are inherently ‘unfundable’ – is that they have hit the right bu�ons in a number of areas that investors consider to be sensitive. Whether this is by accident or design is difficult to generalize about – some entrepreneurs will know naturally what it is that a�racts an investor; others will have been supported by previous experience, either of their own or of others. However, what can be distilled and communicated is that these ‘bu�ons’ centre principally on the question of risk and how to mitigate it in the inherently uncertain area of the business world. As such, they are dependent at any one time upon the evaluation of what is risky and less risky, and what is desirable, according to the prevailing fashions and beliefs of operators in the venture, unquoted and private investment arena. These things can change: at the turn of the millennium, any investment fund that wasn’t pushing dotcom investment proposals through its investment commi�ee was, according to the market gurus, out of touch with the reality of the changing marketplace. It should have been evident, according to those self-same gurus, that everybody was abandoning the out-of-town shopping centres just as they had abandoned the high street, and buying their daily groceries and consumer goods by staring at a computer screen and clicking on a mouse. Investors who didn’t understand this, in one of the more inane clichés of the time, should ‘wake up and smell the coffee’. Unfortunately, no one had told all those people who still trawled the shopping centres and the corner shop rather than the internet that they were buying from the wrong place. So the pet supplies companies, the grocery businesses and the clothing companies that spent millions in venture fund money on devising elaborate websites that took minutes to download and complicated logistics systems that could deliver single cans of baked beans to individual customers with perfect accuracy lost 13

Venture Capital Funding

those same millions almost overnight. It would be difficult now to find an investor who claims not to have seen the crash coming and stayed out of the frenzy or sold out just before everything in the market started to melt. Few people – especially those with collective egos as sensitive as those of VCs – like to admit to being taken in by both the emperor and his new clothes. Even if market fashions do rule temporarily, the basics of pu�ing together an investment proposal and seeing it through will remain the same. The basic factors are largely unchanging: clarity of purpose in seeking funding; clarity of exposition in describing an opportunity; and ability to see the opportunity brought to fruition. This is reducible to a mantra of three Ms – mathematics; market; management.

MATHEMATICS The business plan is the distillation of the business set out on a few pages. An experienced VC will know what is likely to prove to be a good business plan from its shape, structure and size. The business plan, since it is probably the first document that the VC will receive from most businesses, is the document that lays the foundation stone for the future of the relationship between the company and the investor. What this means is that the business plan has to stack up. ‘Stacking up’ in venture capital terms means that the business has to be capable of a growth rate around 25 per cent per annum – meaning that it can double in size as a minimum every five years. This level of potential is required in the business plan, since aiming at a return of anything less will doom the money invested if the business plan is not completely achieved. Numbers are crucial, but too many business plans, especially those prepared mostly by accountants, neglect the equally valuable explanatory aspect. ‘Stacking up’ does not simply mean that the numbers side of the business plan – the profit and loss account, the balance sheet and the cash flow – has to be accurate and without mistakes. The explanation of the opportunity must also enhance the information that the numbers show. The narrative adds to the whole package, not simply in mirroring the information provided by the numbers but also by persuading the reader of the credibility of the opportunity. Writing a good business plan is more than a mechanical process of being a whizz with spreadsheets. 14

Background Issues

MARKET In many ways, market opportunities are as much defined by the characteristics that they do not have as by those that they do. In general the market opportunity has to have both breadth and depth for it to be truly a�ractive to a VC. Ideally it should not be limited to a very short window in time or restricted to a very narrow range of customers. It should probably be capable of replication as a concept into other sectors, product areas or geographical areas if there are such limits. The size of the opportunity has to be both accessible to the individual business that is seeking the funding and realistically open to penetration by that business. As an example, while say the world market for oil is huge and represents a massive potential market for any one player, it is not possible to consider taking a substantial chunk of it by merely replicating another oil prospecting, developing and refining company with only limited venture funds. Last, there should be some characteristic unique to the company that is seeking the investment that marks it out from other offerings to the marketplace. This is what marketers call the USP – the ‘unique selling proposition’. That USP might be a positioning of some form: technological, geographical, organizational or even financial. Without some of these characteristics it is unlikely that the opportunity offered to the investor will be a�ractive as an investment. There are, however, exceptions to every rule. James Dyson was turned down flat by lots of venture funds that refused to see the opening for a different kind of vacuum cleaner. And I remember turning down a film investment opportunity from someone who went on to be one of the biggest and most respected of the late-20th-century British film producers. If I am truthful, that was mostly because he kept me waiting for an hour before he turned up for an appointment but, in my defence, also because the plan he produced was almost incoherent.

MANAGEMENT The last and the most potent of the three Ms is management. Good managers will rescue a poor proposal from ‘oblivion’ to ‘average’ and promote an average one to ‘a�ractive’. Good managers combined with

15

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a�ractive market propositions and mathematics that make sense are what make propositions readily ‘doable’. Management ability is demonstrated in three ways as far as a VC is concerned: through a record of achievement; through the way that the business plan explains and persuades; and through observation of current business operations. The record of management is demonstrated both through individual records of competence – a good CV – and through the record of the business in terms of turnover growth, profitability and a good record of returns to shareholders. Being able to explain the opportunity to an outsider demonstrates that it has been thought through by the author(s) and also gives some insight into the ability of the management to explain commercial strategies to others. The quality of the business plan will also give an insight into management’s ability to motivate staff and dispose of the business’s resources in an efficient way. VCs will then calibrate the inferences they draw from reading the business plan with observations about the business and interviews with key staff.

MISSION IMPOSSIBLE There are some businesses that VCs will be reluctant to invest in no ma�er how outstanding the prospective returns indicated in the business plan. The wider ramifications of this statement are, again, developed further in the final chapter, but it is appropriate at this stage to categorize some of the problem cases. VCs will only be able to invest in incorporated businesses – that means investments in limited companies or, since they were introduced in 2002, in limited partnerships. Sole traders are impossible prospects – since it is impossible to derive a saleable return purely from an individual. No shares can be sold in an individual, and so a VC cannot develop such a prospect. The only way to overcome this obstacle is for individuals to choose to turn themselves into limited companies for the exploitation of their managerial abilities or their inventiveness, or to grant the exploitation rights of their intellectual property to a company. In the 1980s, this is what the investors who backed Sir Clive Sinclair were taking on. Generally speaking, such investment vehicles – like the Sinclair C5 – go nowhere. Inventors who are able to constrain themselves to the disciplines of an organizational format are best advised to form a limited company, 16

Background Issues

properly staffed with some commercially experienced managers, and to seek the assistance of business angels for the cash required to exploit their ideas. Only when the ideas get big enough to support substantial amounts of venture money will the time be right to approach venture funds rather than individual investors. Until that time few professionally managed funds will have any idea how to deal with a lone inventor. The only exception to dealing with lone individuals for most VCs will be when they ‘follow’ an entrepreneur from one successful investment to another. In such cases the entrepreneur will be expected to build managerial teams around his or her own strengths and then to develop conventionally structured businesses that the investors can support. ‘Serial investors’ or ‘serial entrepreneurs’ like Mike Southon, co-author of The Beermat Entrepreneur, or individual VCs like Jon Moulton or Sir Ron Cohen, who develop fan clubs around their own investments, provide examples of this. This sort of arrangement has yielded good returns for some of the larger funds in the past. But there is no guarantee that previous successes can be repeated: Ernst Malmsten thought that he could replicate the phenomenal success he had had in building a publishing business in Sweden from scratch, with trendy fashions sold on the internet. He started up the web-based fashion house Boo.com with his business partner and girlfriend. He ended up blowing over £9 million of investors’ funds with li�le to show for it except some very fancy hotel and restaurant bills, a lot of professional advisers who got fat on advisory fees and a website that took eight minutes to download. That was in the middle of the internet boom. Malmsten and his girlfriend are examples of another area where many VCs are reluctant to get involved – husband-and-wife or familybased businesses. Family businesses are renowned for two things in particular – the kitchen-table nature of strategic development and the intensity with which internal feuds are conducted. ‘Kitchen-table strategy’ is not necessarily a derogatory name for the exercise. What frightens VCs about family businesses is that the strategizing takes place behind closed doors. VCs expect that the businesses in which they invest will conduct themselves in a certain way – essentially as miniplcs. The family network is a place where they cannot be involved as equals in either the initial discussion or the subsequent development of ideas and strategies. Bi�er experiences have led many to conclude that, no ma�er how rigorously and apparently impartially the administration of a family business is conducted, blood will always be thicker 17

Venture Capital Funding

than the ink signed on the bo�om of an investment agreement. And if it is not, then the chances are that the resulting family feud will destroy any value generated in the business. Investments where one family holds a substantial shareholding are very difficult to manage both for external investors and for their representatives on the board. The advent of limited liability partnerships (LLPs) in 2002 meant that VCs could enter into investments with members of professions and mixed professional practices without compromising the professions’ regulations. Previously the law on the division of responsibility for debts incurred by the partnership meant that this was an area they could not enter. However, while an interest in an LLP can be bought out by another party, it is still not possible to arrange a listing for one on a stock exchange. That cuts off one exit route for the deal, effectively condemning any deal with an LLP either to a restricted size or to the company converting itself into a limited company in due course. VCs mostly still prefer to enter ground they know rather than blaze new trails. Limited-life deals – where investments have to be liquidated within a specific period of time for tax reasons – will be of no interest to VCs, since they will want the manoeuvring room permi�ed by unlimited time to rescue or maximize the value of an investment. Investments in subsidiaries of holding companies will be of no interest, since VCs will always want their investments to be where the power lies – in other words in ‘topco’. This minimizes the amount of jiggery-pokery that they are subject to – anything from the movement of money from subsidiaries to holding companies, to shi�s in costs and accounting policies that favour the ultimate owner of a business. With the increasing stringency of money-laundering regulations, venture capital funds now have to conduct very detailed checks on the backgrounds of those they do business with, and aside from minor infractions of minor laws few will be willing to invest in businesses where there is anyone in a senior management position with any form of criminal record. There is a hard practical reason for this. Not only would such a disclosure probably alarm an investment commi�ee too much to proceed, but it would certainly make the subsequent sale or flotation of the business difficult to accomplish. Certain markets may also be out of bounds to some funds. The words ‘ethical’ and ‘venture capital’ are rarely found in the same sentence, but there are markets that probably disqualify themselves from venture capital investment for reasons of reputation. I have yet to come across a business set up specifically to manufacture pornographic films 18

Background Issues

receiving venture capital funding, for instance. And a business that deals exclusively with tobacco products probably wouldn’t get very far in its discussions with investors either. Companies that are domiciled overseas but are in the UK for operational purposes will probably also be difficult to sell as investment opportunities to most VCs. This is for much the same reasons as they don’t want to invest in anything but topco: essentially, the investor wants to be able to control what goes on in the investment, and a distant domicile makes this difficult. However, some of the very large venture and pension funds are now operating internationally – in Europe at least – and will arrange to conduct investments with corresponding partners based in the jurisdiction where the company has its main operating base. The development of the Societas Europaea – the European public company – may well encourage more of such ventures.

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2

The future revisited I: developments in legal matters

Duel, n: a formal ceremony preliminary to the reconciliation of two enemies. Great skill is necessary to its satisfactory observance; if awkwardly performed the most unexpected and deplorable consequences sometimes ensue. (Ambrose Bierce, The Devil’s Dictionary)

 Changes in legal documentation  More sophisticated angel funding  Increased ‘richness’ of funding and changes in deal structuring  Greater liberality on how professionals’ deal fees are recouped Even in the space of the few years since the original edition of this book appeared, there have been at least seven developments that can be identified in the legal side of deal doing. Some of these tendencies may 21

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well have been developing as the original edition was being wri�en, were overlooked then and have merely become more visible; others are certainly recent changes in practice. Not all of them will apply to every deal: some are applicable only to larger deals and some only to smaller deals. Some of the effects will be particularly apparent in deals done outside London. Some of them have an impact on the legal side rather than being legalistic in themselves. Other commentators might be able to distinguish even more tendencies. Briefly, among the significant changes that have appeared or developed in the past three to five years are the following: 1. increased standardization of legal documentation; 2. more sophisticated angel funding leading to increased complexity in legal documentation for ‘initial’ deals; 3. increased amounts of angel–professional collaboration – on a semiformalized basis, which reinforces the point above; 4. the prevalence of fast lay-off of risk by first investors – leading to quick exits by first funders and rapid refinancings; 5. continuing – and expanding – use of preference shares as a means of bridging the valuation gap between entrepreneurs and investors; 6. increased ‘richness’ of funding – sources, specializations and panEuropean collaboration, all of which require accommodation in deal structuring; 7. greater liberality on how professionals’ deal fees are recouped.

LEGAL DOCUMENTATION The fallow period of inactivity that followed the collapse of the dotcom boom at the start of the 2000s led to some consolidation among funds and, as a result, some rationalization of processes affecting investigation, negotiation and execution (of deals, that is). As a consequence, legal terms and documents, processes and procedures (in particular) have now converged – even if they have not completely standardized to a commonly accepted format. For instance, the use of the term sheet – both as a technical phrase and as an instrument – is now almost universal among VC fund managers (instead of the older ‘offer le�er’, which has come to mean something different – the term sheet accompanies the offer le�er, if the la�er is provided at all). 22

Developments in Legal Matters

The BVCA has been instrumental in this process and publishes standard documents on its website for the use of investors – and education of entrepreneurs. These have become the stylistic template for legal documentation for many deals – certainly along the lines of ‘à la carte’ choice if not quite ‘menu prix fixe’. The reason for this development is that types and styles of investment are becoming less individualistic and more institutionalized. At the simplest level this is because with fewer players in the market there is li�le need for lots of different types of investment style – the funds that have survived the debacle of the dotcoms have their own preferred styles that they have developed to cover the sort of investments that they are likely to make. At a secondary level, the still-existing houses may well a�ribute their survival to certain styles of investment that helped bring them through, so there is li�le demand to change set formats until a market shi� occurs. Such a market shi� might be a fundamentally new concept of deal doing or a market development that requires adjustment. This development might be industry-based (a new industry springs up with radically different funding dynamics), or it might be financial or regulatory (the furore over carried interest and tapering tax relief that occurred during the summer of 2007 might prompt some form of change in deal structures, for instance). Whatever those changes are, until the new conditions present themselves then the established (and still incrementally evolving) legal formats will pass muster. As a third factor, semi-standardization helps to slow the rate of price increase in doing deals – practitioners become familiar with the wrinkles in basic documentation and, as a result, the costs of negotiation of legal materials for each deal can be mitigated, even if the origination costs remain relatively fixed. This has a bearing on another factor – how professionals recover their fees from a deal, which will be considered in more detail on pages 27–28. Despite the elimination of some of the variants of documentary style, there are still wide disparities between the calibre of the materials that are produced by different firms. The location of the firm is not necessarily the best guide to ability, although it might reasonably suggest itself as the first filter. Large London-based firms probably see more deals and so should be more skilled in document preparation, but regional firms may well specialize, to their advantage, in certain deal types and know how deals should be legally structured to accommodate the quirks of particular businesses. Personal experience 23

Venture Capital Funding

bears this out; the contract for funding between a business recently started by the author, with documentation prepared by the substantial investor’s prestigious London-based legal firm, was (justifiably) ripped to pieces by the regional firm employed to act on the start-up’s behalf.

BUSINESS ANGELS But at the same time as some processes have simplified through standardization at the investment fund end, they have probably grown more complicated as far as the business angels are concerned at the other end of the market. In this respect, although the comments made in Chapter 12 are still valid overall, they have to be tempered with a recognition of the new realities. Business angels are, to some extent, the bellwethers of the venture capital business, as described in Chapter 6. As a class they o�en discover types of business that are later picked up and developed by the professional fund managers, relying on their nimbleness financially and their entrepreneurial intuition to get into businesses. They help to develop and exploit the potential and then move on to the next opportunity. But in the downturn of the last cycle they o�en got caught with potentially good but undevelopable investments that were affected by the overall investment freeze for sources of further funding, regardless of the quality of individual opportunities. In addition, the angels’ ranks now include a substantial cohort of individuals who have made a series of successful investments – the ‘archangels’. There are now several ‘names’ among the ranks of the angels whom professional investors will follow into deals simply because the ‘name’ is in there already with money, expertise and entrepreneurial wisdom, funding the deal initially. The ranks of these people are largely clustered around the regional centres of venture capital activity like the major university towns – locations that are themselves the focus of regional entrepreneurial activity because of the conjunctions of money, commercial skills and academic adventuring, so that venture capital activity and the presence of the names reinforce each other. These are individuals who have gone beyond the string-and-sealingwax stage of documentation in first-round investments, as a result of both their own experience and their natural predispositions. In fact, part of the allure for professional fund mangers following behind these 24

Developments in Legal Matters

people is that they know that not only will there be a decent business that is supported by the archangel (in the commercial sense) but there will also be a sensible deal structure that can be built upon rather than dismantled. This has gradually filtered down so that many angel legal structures are now becoming more sophisticated as the lawyers disseminate the best practice applied in one deal into the general pool of deals. The upshot of this is that many of the provisions previously seen only in second-round financing are now beginning to make their way into the legal documents that regulate angel deals. Investor protection clauses, clauses affecting the constitution of the board of directors, provisions for ‘milestone’ investment and so on are increasingly filtering down into what could previously be recorded (almost) on the back of an envelope. This, of course, has good and bad effects. On the one hand it helps set out the basic rules for everyone who is involved, makes secondround financing easier (potentially) and makes friction in the deal less likely once it has been completed – all of these being subject to the proviso that the investment has to be in the hands of people who know what they are doing. On the other hand, it can make deals more costly and inflexible and the process of ge�ing money into the business more protracted. The relative cheapness of a�racting the money, the flexibility of arrangements and the speed of investment were – and are still, despite the changes that are occurring – the three big virtues of angel deals. Taken overall, anecdotal evidence would suggest that the record of the angel class of investors has been no be�er and probably substantially worse than that of professional fund managers over any given period (no reliable statistics exist for angel investment overall). What can be said almost certainly is that at least the same rules will apply for the angels, as an investing class, as apply to the fund managers, as an investing class: the vast majority of investments will make minimal returns in comparison with the effort and cash invested in them, and portfolio returns will be carried by one or two stars (or else why are we not swamped with what ad people like to call ‘world-class’ businesses? Or to put it another way, to quote from a Wall Street stockbroker, ‘Where are all the customers’ yachts?’). However, it is apparent that there are increased amounts of angel– professional collaboration – on a semi-formalized basis in some circumstances (of which more in Chapters 3 and 4, dealing with recent changes as perceived by fund managers). This has also contributed to 25

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the increased sophistication of angels’ legal requirements. The serial entrepreneurs, the archangels, are schooled in what the professional fund managers will incorporate in their deals and will probably want to see similar provisions in their own arrangements with companies in which they have invested money. ‘Best practice’ has a habit of spreading. The other lesson that the angels learned in the last cycle – and which has spread to be an industry-wide phenomenon – is that they didn’t want to be le� holding the parcel when the music stopped. As long as the investment cycle was rolling along then angels could take a view about the length of time that they were prepared to invest for. When the cycle shortened and second-round funders became less enthusiastic about making investments then the angels were hard hit. The whole of the venture capital business is seeing its time horizons reduce, and fund managers are increasingly concerned with realizing profits from an investment in shorter and shorter periods in order to sustain their own funds’ lifetimes, as their investors get increasingly picky and hard to please. This effect too has an impact on the structure of angel deals at the legal–commercial boundary – it may make the initial valuation gap greater as business angels seek to minimize the cost of their investment in preparedness for aggressive pricing at the second-round stage, while also having the effect of si�ing out the eligibility of prospects that angels are willing to invest in. Valuations are ge�ing harder and tougher at all levels and by all investing classes. There has been a definite tendency to require businesses to service investments through dividends, for instance in the event that a realization cannot be obtained in the anticipated period. So embryonic businesses may now be required to evidence an ability to generate cash in their business plans, as a fall-back a�er some reasonable period, which they may not previously have had to do. This will mean that certain additional protection clauses will have to be incorporated into the legal documentation. Yet at the same time as these pressures are working against entrepreneurs the potential universe of funders is still expanding. Money is beginning to come into the UK for investment in early-stage deals from European institutional funds – and also some EU money to stimulate certain sorts of activity (especially that related to carbon-reduction projects and the knowledge economy). This new money then adds a further layer of complexity to the documentation required to complete a deal, as additional obligations for investors need to be recognized. 26

Developments in Legal Matters

These will not be legalistic problems – since most deals will be wri�en and construed under English law – so much as ones of custom and practice that will have to be incorporated into deal structuring. Where European money is concerned, of course, then there may be audit and control problems that have to be dealt with in structuring a deal to comply with European funding requirements.

THE PROFESSIONALS’ CUT Lawyers and accountants face a mixed picture as far as their participation in the venture capital business is concerned (and continuing to maintain the distinction between venture capital as we are talking about it and the big private equity deals). The marketplace is ge�ing more competitive – in different ways for all participants. Few early-stage deals now seem to involve any participation from the banks beyond the provision of standard commercial banking services – although more of this in Chapters 3 and 4, concerning the fund managers’ view of developments. So, in that respect the position of young companies requiring funding has clarified. All the money that is going to be involved is likely to be venture capital supplied with none of the complications brought about by the bankers’ insistence on charges and security conflicting with the entrepreneurs’ desire for maximum flexibility. (For more established businesses, those being bought out or seeking development capital rather than early-stage funding, then the banking sector is still an important participant in the structuring of finances, and legal documentation will continue to recognize this and to try to square the circle as before.) But for early-stage deals the professionals face a dilemma. The complexity of the documentation is diminishing in some respects (standardization of terms is pushing towards that), arguing for reduced costs, while at the same time commercial pressures for shorter time horizons are increasing the structural complexity of the documentation and, perversely, pushing hard at the professional costs involved in doing deals. The response of professional firms has been to adopt a more commercial a�itude to the recovery of fees by regarding the deal as a sort of investment in itself. While it would be incorrect to say that all or even many professional firms will cap their fees for early-stage investments, 27

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the more commercial firms are certainly thinking that way in the expectation that they will recover their fees later through some formula arrangement or more loosely through a continuing arrangement with successful companies – an echo of the portfolio view of the investors. Regionally, at least, the number of professional firms that have the range of skills and experience to do such deals competently is limited, and these are the players that are leading the way in developing more sophisticated charging regimes – so that their involvement with successful businesses becomes almost like a form of carried interest.

CONCLUSION The combined effect of all this is that for early-stage businesses with high potential then the marketplace is probably moving in their favour. More, be�er-experienced angels, the prevalence regionally of a depth of funding experience (although o�en highly localized) and competition for good deals among venture capitalists, coupled with a flexibility in respect of fee structures from professionals, may remove some of the obstacles to completing deals. On the other hand, valuation stances have toughened. In time that may alter as some of the pain from the last boom so�ens. But lessons hard learned are unlikely to be soon forgo�en, and the scrutiny of venture capital funds’ performance by ultimate investors, which drives the VCs themselves to adopt hard valuation regimes, is unlikely to go away.

28

3

The future revisited II: developments in regional funding

Rich, adj: holding in trust and subject to an accounting the property of the indolent, the incompetent, the unthri�y, the envious and the luckless. (Ambrose Bierce, The Devil’s Dictionary)

 The effects of the dotcom bust on regional financing  The trends in investing  The change in fund characteristics It’s probably fair to say that, ordinarily, the view from any one region or any one industrial sector is going to be biased and particular, not necessarily indicative of the whole economic picture. But in venture capital, insights about regional performance and trends can lead to 29

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valid perceptions about the whole economy – particularly in the wake of the flux of funds’ fortunes a�er the dotcom boom. The dotcom boom again. Repetitive though it may seem to be to keep returning to the issue, it is difficult to comment on the major developments in venture capital at present without making some form of reference to the single most significant event in venture capital over the past 20 years. It colours so much of what is happening now. Investment a�itudes, the availability of funds and the readiness of investors to invest are all shaped by reference to what happened to the dotcoms. Investors adopt strategies that they think will avoid the mistakes of the past or choose to pursue paths that they hope will repeat the success of the early investments that were made in the sector: it should not be forgo�en that the dotcom boom arose in full magnitude because some investments in dotcom businesses made stupendous returns, which then encouraged a gold-rush frenzy that, in some cases, cast good judgement aside. But in venture investment everyone is always looking for the next big trend to ride, and being in the vanguard of those who spot it can lead to very large returns. Although in truth, it’s probably best to be the second one to spot the opportunity, rather than the first. Most venture investors would be pleased to let someone else do the hard work in pioneering marketplaces, potential demand and the problems of due diligence and exploit the ground once it’s been prospected. The trends identified here relate to a region that has fairly unique characteristics – it encompasses the commercial fringes of London, the agricultural expanses of East Anglia and the high-tech specializations of Cambridge, a university that has a world-leading capability in certain technology areas. So some of the features identified may not have direct applicability outside the eastern region of England. The points made also tend to concentrate (because of the character of the region) on technology-based investments. Even allowing for these biases, the pa�erns probably give some broad indications of the sort of trends that are developing across the whole of the country. And when coupled with the perceptions of a London-based manager of a mid-sized fund (in Chapter 4) then they probably identify at least some of the preoccupations that are affecting venture fund managers nationwide. Over the past five years or so there have been three significant trends in funding activity. On the deal side are the growth of clean technology as a source of funding proposals, and the fall and revival of internet and media technologies as areas of interest to VCs, while on

30

Developments in Regional Funding

the structural side there has been a major consolidation of funds, as the background to all funding activity.

NEW SOURCES OF PROPOSALS Over the past five years or so there has been a shi� of popular and commercial consciousness to an awareness of the physical consequences of global warming. Should the warming trend proceed without respite then the east of England will be a major casualty. The British Isles have been slowly tipping down to the east over millennia, and much of the land in the easternmost counties lies only a li�le above sea level. The east of England has literally a lot to lose if sea levels rise globally. It is perhaps partly for this reason that funds in the east of England over that same five-year period have seen the practical manifestation of a supposedly comparatively rare event according to economic theory: the availability of supply bringing about a development of demand. (However, perhaps it’s not quite so rare when the item in supply is money and the demand side of the equation is represented by investment proposals.) Over the past five years, businesses involving the use of some new form of carbon-reducing technology have been strongly represented in the numbers of proposals presented to venture funds in the east of England. Specialist money has been set aside by some fund managers to invest in the technology; and existing non-specialist funds, a�empting to catch the technology wave, have probably stretched the definitions of their own investment parameters in order to participate. Unsurprisingly, some proposals may also have stretched definitions about what is ‘new technology’, what is ‘carbon-reducing’ and – most significantly – what is commercially viable to try to a�ract money that is keen to find a home. The way that investment interest is developing in funding carbon-reduction technology has at least some of the characteristics of the dotcom boom. That boom developed because of the perceived growth of the use of the internet as a trading medium and the explosive growth in valuations of businesses that grew up to serve that trend. When the bubble burst, so many fund managers and investors had their fingers burned that investment funds for internet and media technologies dried up overnight. Now that the marketplace has se�led down and the more frivolous potential usages of the net have been shown to be 31

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commercially unfeasible, there is some revival of interest in internet and media technology as prospective investments. The market has grown up to the extent that the potential for these products can now be validly monetized – and consequently investors can place more realistic valuations on potential investments. The characteristics of the internet and media technology proposals this time round are different from those of the first incarnation. The current crop of proposals are ‘so� innovations’ – incremental developments – rather than the generational leaps that typified the first surge of investment. However, the investor’s job is no easier than it was the first time in trying to pick which of the technologies will be the market leader; the task still remains one of predicting which technological development is exactly right as opposed to being just close enough to appear right before the event.

THE STRUCTURAL SIDE The influence of the dotcom boom is inescapable in understanding how the market for funds has developed. As a result of what happened to funds a�er the boom, there have been three major changes: 1. The smaller funds have o�en disappeared and the bigger funds have consolidated. 2. The number of active investors has diminished rapidly. 3. There is less first-hand fund-raising by (new) investment managers. There are now perhaps 10 VC funds in the front rank nationally, with a further 20 or 30 in the second rank. The regional VC funds – whose establishment, some have always maintained, was made under questionable commercial logic – were revealed a�er four or five years of operation as having been spread too thinly with regard to deal capability, deal follow-through and geographic ‘manoeuvrability’. The constraints that they were placed under have severely impaired their activity to do what was anticipated of them. Seed funds and angel groupings remain congregated at the regional level where proximity to existing and potential investments is an important factor. In the case of the east of England the effect of the Cambridge Cluster is so pronounced that there is a big gap between Cambridge and the next locus of activity – probably Colchester or even Ipswich, further east. A similar effect is 32

Developments in Regional Funding

probably true for the area surrounding Oxford, although this is mitigated by the effects of concentration of developing businesses along the Thames Valley corridor. The response of many funds to this clustering and regionality has been to try to extend their deal flow by linking with business angels – trusted individuals and established groups – outside their immediate region. This has given rise to the phenomenon known, slightly oddly, as ‘cross-country’ funding. These associations have had the effect of improving deal flow and the calibre of deals that fund managers receive but not necessarily making funding any more easy to achieve for businesses. Managers’ impressions are that, while the number of good start-ups has not changed (still at a low number, in other words), the number of proposals overall being put forward has probably dropped and quality has not improved above the level of five or six years ago, despite greater sophistication on the part of some entrepreneurs. And not all companies that have managed to secure funding from an angel will automatically find that this guarantees access to further funds. Some funds are far from being ‘angel friendly’: some managers contend that only a third of angels will contribute anything at all beyond their cash and only a very few – 5 or 10 per cent – add anything of real value; the rest are merely a waste of time or contribute negatively. This perception may be partly explained by two factors: first, the angels suffered later in the cycle than did funds, in the collapse of the boom. The angels’ problems arose when they went for additional funding a�er the funds’ cash flow had dried up. At that point the angels’ resources were probably at their limits too, and their room for manoeuvre would be extremely limited. Second, few angels go in for high-tech deals: those that do probably know their way around; those that don’t probably flounder and make a bad situation worse. Despite this critical contention, there are sufficient business angels with experience of multiple investments that have developed successfully for there to be some evidence that there are the beginnings of a virtuous circle developing. There are now a small but growing number of serial entrepreneurs experienced in taking small businesses to development stage, and in response to this small pools of capital are developing for early-stage proposals located around the main regional centres. But seed money is still hard to raise, as all investors are seeking to arrange their investments in such a way as to minimize the duration of their holdings at any one stage of development. However, what has been happening in the past year is that there have been some 33

Venture Capital Funding

satisfactory local exits by specialist investors in companies that they have funded over the past 18 months. These exits have been tradebased and largely unreported. However encouraging this may be in the short term, it is as yet too early for it to have had much impact on general levels of confidence among investment funds. The internal rates of return (IRRs) for most fund managers are still depressed and remain disappointing. The difference in the returns made by the best- and worst-performing funds will have widened in the years since the collapse of the dotcom boom. The current record of the regional funds, still si�ing on (unrealized) losses, is probably very poor, and it will take a lot to li� them out of that position. Industry sources speculate that few regional funds will be in a position to generate overall positive levels of return. In this respect, the apocryphal problem of the funding gap may be moving out of being a contestable presumption into becoming economic fact. Bank funding – never much help for early-stage businesses – is almost non-existent for start-ups (outside normal commercial services), and the successors to the Small Firms Loan Guarantee scheme remain unused and unusable. In the eastern region some VC-supported, exceptional proposals may get pre-profit funding, sometimes even pre-cash break-even. But pre-revenue deals are completely out of court for all the banks. It would appear that the combination of these three developments – an expanding cohort of serial entrepreneurs, continued absence of bank support for early-stage deals, and continuing pickiness on the part of a smaller number of active funds – has led to many entrepreneurs adapting to these circumstances by relying on their own resources until what would otherwise have been second- or even third-round funding. If they can survive through to this stage then they may begin to benefit from the dearth of good deals available to investors. Valuations are competitive among funds for good deals, and the market for funding flips to being a sellers’ market for good established businesses. Excellent businesses have few problems finding funding. At this level, too, there is more help available for businesses. Many fund managers shy away from working with intermediaries, believing that the employment of an intermediary affects a deal adversely in two ways: it pares margin out of the business (and the deal) and it probably says something about the overall competence of the company management. But for businesses that have proved their ability to get to a stage where they require semi-development funding then the use 34

Developments in Regional Funding

of an intermediary may be beneficial – not least because the fund managers recognize that good intermediaries cannot afford to waste their time with poor potential deals. It is at this point too that the company begins to be able to properly afford competent professional support. Once more there is evidence that this is now increasingly available at the regional level: the cost base of the large London firms of lawyers and accountants is too high for them to be able to compete effectively on small deals, and the active regional firms are developing template processes and documentation to enable them to specialize in and reduce their cost base further. In addition, more innovative charging styles and collaborative working with funds have led to be�er relationships between professionals, VCs and companies. The market is beginning to sort out and mature. There is far less of the ‘us and them’ a�itudes that typified relationships between the parties to a venture deal even three years ago. So, if we are to extract some general points from the experience of one region, what might those be? First, it is evident that the number of active funders in the marketplace is diminished. Second, the appetite for good deals remains strong among those funders that are le�. Third, there are the beginnings of a virtuous environment of funders, active angels and professionals who will probably smooth out the excesses of the marketplace that led to the boom and bust that accompanied the first generation of dotcoms.

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4

The future revisited III: the view from the City

Palm, n: this noble vegetable exudes a kind of invisible gum which may be detected by applying to the bark a piece of gold or silver. The metal will adhere with remarkable tenacity. The fruit of the itching palm is so bi�er and unsatisfying that a considerable percentage of it is sometimes given away in what is known as ‘benefactions’. (Ambrose Bierce, The Devil’s Dictionary)

 Changes in fund sizes and values  Changes to government policy  Changes in the availability of debt The large-scale factors that affect regional venture funds will also affect London-based ones. The trends identified in Chapter 2, dealing with developments in legal ma�ers, and Chapter 3, dealing with 37

Venture Capital Funding

developments in regional funds, will have points of commonality with developments in London-based funds. All of the venture capital business has been affected by the consolidation of funds, and all venture funds have been affected by the shi� to common terms and the convergence to semi-standard documentation. The dotcom bust had the effect of winnowing out the weaker players and forcing a reduction in deal costs. The significant issues that affect regional funds tend to congregate around the types and size of deal: the proposals that are prominent in the deal flow of regional funds will be affected by regional economic specializations; deals will probably be smaller and possibly involve younger companies than for London-based funds. The cost base of the London funds is higher (partly because they are bigger) and so they probably need to look at more mature, larger businesses for investment purposes. London-based funds do not invest solely in the metropolitan area, of course, but spread their nets nationally. They tend – by and large – to be bigger than regional funds, in that they have more money under management, probably more staff and probably be�er access to additional capital, and they probably see a larger number of deals every year. London funds may also tend to specialize in types of deal rather than considering anything as a potential deal, as many of the regional funds have to do. Some London funds may be general practitioners, but some will have been able to move into niche markets: development capital; specialist sectors (not necessarily glamorous ones); buy-outs up to a certain size; syndication specializations. The option of specializing like this is open to only a very few regional funds. These specializations allow some of the London funds to be not quite so hungry for deal flow as the regional funds. Some of the London funds will have deliberately established criteria that would put a regional fund out of business in short order. For instance, some of the be�er-established funds have raised their threshold projected rate of return (in order to consider doing a deal) to 50 per cent plus (which means that the business will be able to double in size inside two years). Very few regional funds would see a deal flow that consistently offered doable deals at that rate of return. Funds in this happy position are able to look for businesses that, if not able to produce the anticipated high level of capital growth through some market setback, are still able to service the investment at very high rates of interest, because, once the investment has been made, they will be able to throw off cash at a very high rate. These 38

The View from the City

businesses are mature, solid concerns probably with a substantial trading record or able to dominate a market segment through some particular characteristic. While businesses in this position may choose to approach a regional fund, their cash requirements will probably exceed that which a regional fund could mobilize. Not all funds based in London are like this, of course – many will be almost exact counterparts of the regional funds but just bigger. The point is that by being bigger some of them will have the chance to develop specializations not available to the regionals, and this will give them slightly different perspectives on what is problematical. But the uniting factor between provinces and centre is that, like their regional cousins, all the London funds probably still have in the backs of their minds the need to minimize their risk by cultivating strategies to exit to another buyer as quickly as possible – to pass the parcel on rapidly so that they do not get caught when the music stops. Given that some of the London-based funds will have the very special investing requirements mentioned above, what are the factors that have been significant over the past three years or so? Inevitably, we return to the effects of the dotcom bust. The big-to-very-big funds have probably become more specialist. Those at the bo�om end of this pack will have tried to move up the ladder of deal size to where substantial returns are probably more easily forecast (overall). The best area for effecting this from the funds’ point of view is either through management buy-outs or by taking companies out of the public arena altogether. The Boots, EMI, Sainsbury’s and QinetiQ deals are all of this type. The intense controversy raised by some of these deals – and reviewed briefly in the Introduction to this book – has aggravated the confusion in the public perception between venture capital and private equity, as the repercussions of some of the larger private equity deals began to make headlines in the silly season for news in the summer of 2007. The high-tech funds will still be seeking substantial capital growth since most of their investments are heavily dependent upon the promise of profits rather than the generation of cash, once the investment has been completed. In that respect their concerns will be the same as their regional counterparts’: unlike the very big private equity funds, they will be concerned about the cost of deals and the pricing of opportunities – and most of all about realizing some successful investments to enable them to raise more funds. The size of the funds being raised controls the outlook of the fund – and for the moment, at 39

Venture Capital Funding

least, big pots of money being commi�ed to high-tech funds are out as far as most investors in insurance companies and pension funds are concerned. The big differences over the past three to five years are these: 1. changes in the number of funds – and the amount of funding available but moving in different directions; 2. changes to government policy; 3. changes in the availability of debt – which has changed again in the past few months following the Northern Rock scandal. Overall the market has thinned out (in terms of participants), as in the regions, but the simple pressure of the need to invest insurance money and pension funds has still produced additional funds to this marketplace. The sums available for investment in venture capital deals – partly stimulated by the growth of private equity – have grown overall. (The statistics in Chapter 1 show this.) Government policy has been seeking to bring about changes in the operations of venture capital trusts – sometimes in terms of the ripplethrough from curbing the perceived excesses of the private equity market, but also through Treasury a�empts to control the shape of venture capital provision. In particular, the position of the venture capital trusts has been adversely affected by government manoeuvrings. It seems that it is government policy to push VCTs into doing progressively smaller deals by manipulating tax regimes and tinkering with investment rules. The trusts are resisting this, since they see no reason why they should be the instrument to plug the perceived equity gap (if it does exist). The upshot of these two effects is that some fund managers believe that the VCTs will become highly una�ractive as investment vehicles for the general public and that their numbers will thin dramatically over the next five years. As far as pricing of deals is concerned, the fallout of the dotcom bust has meant that funds specializing in development capital are even more concerned with P/E ratios than they were before – and overall both prospective P/Es and IRRs have shi�ed down over the past five years. This is partly because the availability of cheap debt meant that until recently prices being asked by companies disposing of businesses in development capital/buy-out deals (that is at the small end of the buy-out market) remained buoyant. Managers of the businesses being 40

The View from the City

bought out did not benefit from this, since it was the debt that took the slack in the pricing, but they did manage to improve their position with respect to the VCs (an interesting parallel to the experiences of the regional funds). The reduction in prices prompted by the paralysis of the debt market may lead to be�er deals for managers in the forthcoming period until debt confidence returns. The availability of comparatively cheap debt until recently had another adverse effect on deals in that it allowed some funds to reintroduce co-investment and carried interest terms to its executives on highly preferential terms. In the regions the banks have been obvious by their absence, but in London some bank-owned funds have been able to continue to mobilize cash from their parents. Those that had no relationship hardly felt the difference, since in the time of very cheap debt banks were falling over themselves to offer debt and were willing to accept ridiculously uncommercial terms – ‘covenant-lite’ as it became known. This easy availability of debt has led to a reliance on debt structuring in some deals to bring about satisfactory prospective returns (more debt bearing the commercial burden means potentially more valuable equity on realization). The consequence of this has been an overgearing of financial structures in some deals. The effects of this are yet to be fully felt but may well mean that some investments struggle to achieve their projected returns. The effects of this are unlikely to be simply overcome. Nor will they allow businesses to compensate for delayed sell-ons by generating an income return for their investors. Where capital growth is inhibited through a disproportionate debt burden retarding profit performance, there is also likely to be an adverse effect on free cash flow, so development capital/buy-out deals undertaken by traditional venture funds may well be seriously affected by the complicated deal structures that depended on the availability and the effect of cheap debt. By a further irony, it is this area of the marketplace, the development capital/buy-out opportunity up to around £15 million deal size, that has been the type of deal most sought a�er by the venture capital trusts. It o�en offered the prospect of a double win for the investors (and would then be of interest to traditional funds) or, more o�en, provided solid prospects of income even though the chances of large capital growth were small, making it ideal for VCTs. However, if the VCTs are forced through government policy to contemplate moving downmarket, they will be precluded from participating in the lower-expectation deals that arise from the restructuring 41

Venture Capital Funding

of frustrated sales (brought about by over-ambitious gearing). So it is not difficult to see that it could be this area that is likely to be the equity gap of the future – too small for the very big funds to bother with, too large for the regionals to cope with and too pedestrian in terms of prospective returns for generalist funds to enter. Government policy may be shi�ing the equity gap into a different place in the market. At the level of the deals that are being done by the London-based funds, the far more complicated tax position faced by investors – both professionals and management – has tended to push deal fees up. This has been prompted by the complications of tax law and the overengineering of structures to accommodate carry and co-investment. It has happened even though there have been pressures the other way – like standard documentation, pressure from the VCs themselves on the professionals to reduce their costs in return for continuing business, and competition for deals among VCs. The bulk of this increase has been in tax advice and the cost of incorporating the effects of this advice into legal documents. The unwieldy commercial arrangements brought about by complicated and over-engineered deal structures will also inhibit recovery efforts if and when they are needed. In summary, it is easy to be gloomy about the prospects for venture capital in the readjustment period a�er the excesses of cheap debt. Many of the mid-sized deals that were constructed at the height of the availability of easy money will begin to feel the crippling effects of over-gearing if interest rates more realistically reflect perceptions of risk in the short term and if consumer demand slows. There may also be a problem in the offing in respect of a new equity gap if the VCTs decline in number or are forced to reduce their willingness to engage with businesses seeking development funding at more pedestrian levels of growth than are a�ractive to private equity.

42

5

Why do you want funding?

Opportunity, n: a favourable occasion for grasping a disappointment. (Ambrose Bierce, The Devil’s Dictionary)

 What venture capital is and is not  The basic question  Types of VCs  Timing of approaches  Post-investment considerations  Exit routes  The four main purposes of venture money Previous chapters laid out some of the factors that form the background to embarking on a quest for venture capital for a business. This chapter tries to illuminate what venture capital is and what it is not and to define some of the basic characteristics of the marketplace. 43

Venture Capital Funding

DEFINING WHAT VENTURE CAPITAL IS – AND IS NOT Both the marketplace for funds and the venture capital business tend to define themselves by what they are rather than by any dictionary definition. The actors know what they do and how they do it. Essentially, and as far as this book is concerned, venture capital can be defined as an investment in an unquoted company for one or a combination of purposes. These purposes usually fall into three major categories:  initiation of trading (start-up);  change of market position (development capital); or  change of ownership (buy-out). The purpose of the investment is to make a substantial rate of return to both the investor and the entrepreneur(s) within a reasonably closely defined period of time, typically three to five years, by enhancing the capital value of the business in which the investment is made. Stating some of the things that venture capital is not will also help to define it. Venture capital is not:  secured – there is no guarantee of recovery of the investment in the event of failure of the business;  time limited – while there is a horizon (typically three to five years) for the calculation of the rate of return available to the investor, there is considerable uncertainty as to that being achieved;  certain – the investment is always at the risk of market forces and managerial capability;  liquid – once in, it is very difficult to get the money out again readily;  suitable for a ‘core’ investment policy – venture money is capable of high rewards but is not intended for the provision of basic and safe returns. The factor linking all these last five characteristics is that venture capital is risky. As we shall see, this means that the investors adopt certain strategies in making investments. Knowing what the root of 44

Why Do You Want Funding?

these strategies is will help to shape the approach that the entrepreneur should adopt.

THE BASIC QUESTION Simple though it may seem, there is one very basic question that if answered properly gives the key to the whole exercise of raising money for a business. It may at first seem like something of a redundant question to ask ‘Why do you want outside funding for your business?’, because the answer is, fairly obviously, ‘Because I haven’t got the money myself.’ But if you go on to think a li�le more about the reasoning behind the question then a slightly more elaborate answer will help in the search for funding. The real intention behind the question is to elicit the purpose to which the investment money is going to be put. If you can provide a cogent answer to this for your business then you are a long way down the road of achieving a satisfactory reason for an investor to make an investment. The four reasons for this are simple and powerful. Knowing the purpose for which you want the money will control:  the type of VC that you should approach;  the timing of your approach and the timing of the entry of the cash;  the way that you will run your business a�er the injection; and  the exit route that you expect to achieve. These four factors are really at the heart of any excursion into raising venture capital. We will go on to look at them in greater detail in just a while when we consider the types of business that can normally achieve funding. But before you embark on the (possibly long and probably arduous) quest for outside finance you should ask yourself an even simpler question: ‘Do I really want outside cash at all?’ This is not so stupid as it may seem. And, before you answer the question, consider some advice from someone who has been through the process. Mike Southon started a consultancy that he sold to one of the very biggest worldwide computer and accountancy consultancies only five years later, and has been involved in several start-ups since. His advice is to use the following sources of finance to develop your business, and he lists them in priority order as: 45

Venture Capital Funding

1. 2. 3. 4. 5. 6. 7. 8. 9. 10.

your own money; grants and so� loans; revenue from the business; a mentor; a friend; your bank; revenue with the enticement of future equity; business angels; VCs; gentlemen in dark glasses. (Mike Southon and Chris West, 2003, The Beermat Experience, Prentice Hall, London)

He regards inviting VCs into one’s business as equivalent to agreeing to a Faustian pact – in other words, selling one’s soul to the devil. We shall see why he thinks this in Chapter 13 when we deal with the legal stages of a venture capital investment. However, since Mike Southon also lists his services as helping to secure venture funding for young businesses on the same website where you can buy his book, he is obviously exaggerating to make a point when he lists VCs as one notch above loan sharks as a source of finance. (Given recent and continuing experience with the willingness of banks to lend – even to each other – he might want to reconsider his advice about them, too.) But, as with all good exaggerations, there is a kernel of truth at the bo�om of what he suggests. Enticing venture capital into a business is not a one-off process that, when completed, can be sidelined to the main purpose of the business. Once in, VCs are likely to be more than a li�le intrusive in a considerable number of ways – determining business strategy, ve�ing the appointment and dismissal of senior employees, controlling capital expenditure, controlling salary levels, being picky about corporate and statutory regulation details, and so on. The list will be extensive – as Chapter 14 will show – and there will be more than a marginal element of corporate adjustment in accommodating their requirements. And that goes without any consideration of the rate of growth that they will expect for their investment to turn out satisfactorily. In order for a business to be of definite interest to a VC it is probably going to have to exhibit a potential growth rate of about 25 per cent per annum compound. In other words, at that rate of growth, a business is going to have to double in size by the end of the fourth year. Can you manage that – in both senses of the word? 46

Why Do You Want Funding?

First, can you actually physically cope with that degree of extension of your management abilities and, second, is your business capable of that sort of speed of growth? There are comparatively few businesses that have the market potential to do that – and of those still fewer with the managerial capacity to cope with such change. No wonder Southon says that taking a VC on board may be a Faustian pact. But there are two counterpoints to the Southon view. First, venture capital has helped to make a very large number of what were otherwise pedestrian or even stumbling businesses into worthwhile industrial and commercial concerns; and second, a large number of the owners of those businesses have become very wealthy in the process. So if the prospect of having to cope with this culture shock doesn’t put you off, then keep reading (and I hope you will).

THE FOUR MAIN PURPOSES Going back to the question that was posed at the very outset of this chapter – ‘Why do you want outside finance?’ – there are essentially four main purposes for raising venture capital. Any reason other than these is simply a variation on the main theme. The principal purposes are:  to start a new business;  to develop an existing business;  to change the shareholding structure of an existing business;  to rescue a business. These four purposes equate roughly to the life cycle of a typical business: birth, growth, maturity and some form of exit – although hopefully not a corporate death. Consequently they encompass most of the opportunities that will present themselves to most entrepreneurs. But what is also important to recognize is that they all represent step changes of some form in the life of a business. In other words, they are not simple changes in the pre-existing strategy that the business has been working to, but fundamental changes in the organization of the business that will bring about fundamentally different outcomes to what previously existed. Such fundamental changes in expectation can 47

Venture Capital Funding

be expected to bring about greatly enhanced returns to the business, if they are properly executed. The corollary of this is that you don’t pursue venture capital unless you are contemplating a step change. If your business needs some form of transient funding to accommodate changes in trading volume, then go and get yourself a bigger overdra� or talk to an invoice discounter or factoring business. If you need to fund a large piece of machinery then get a term loan. If you need to move premises then get a mortgage. None of those purposes is suitable for venture capital funding (although I ought to qualify that by saying that, if the size of the expansion of premises you are contemplating is very large and brought about by a merger, then venture funding might just be appropriate). And it will probably not be worth your while trying to find a VC who will put in less than £250,000; you might find a business angel (or business angel syndicate) who will do that for you if your case is good enough but most of the large funds won’t stir themselves for opportunities of less than half a million. The managers of the regional venture capital funds (see Chapter 3) – which were specifically set up to plug the perceived ‘equity gap’ regionally – began to mu�er almost as soon as they were set up that, with caps on the size of investment they could make, their territories offered thin returns and they would be be�er able to make the expected turn on their (public) money if they were allowed to move upstream to where the larger opportunities exist. Experience has borne out their concerns. The equity gap, like the poor, is always going to be with us – although it may exist in different positions in the market – see, for instance, the comments in Chapter 4 about the effects of government policy on venture capital trusts. But back to our analogy of the life cycle of a business. Just as each of the different stages in the business life cycle brings about different problems and opportunities, so each is of a very different nature from the others in terms of the risks, problems, rewards and outcomes that accompany it. And, not least, the issues that surround each of the purposes need to be carefully considered by the entrepreneur before embarking on the pursuit of venture capital. The effect on the business cannot be considered in isolation but has also to be viewed in the light of the changes that will occur as a consequence of financial development. To throw into contrast the different approaches that are demanded of both the entrepreneur and his or her potential backers in bringing these changes about, we need to look at them in a li�le more detail

48

Why Do You Want Funding?

and consider the funding characteristics of each in terms of the four consequential categories we introduced. To recap, those are:  the type of funder who will be interested;  the timing of the approach;  post-investment consequences;  likely exit route.

START-UP This is the area from which true venture capital sprang – and from which most generalist VCs are now migrating. However, the most recent figures (see statistics from the BVCA published in full on their website, www.bvca.co.uk) indicate that some very large amounts of money are still being commi�ed to start-ups. But by and large this area is now principally the hunting ground of business angels, specialist university-based funds or technology fund specialists; in March ’08 3i announced it was withdrawing from this market. Funding will almost certainly be ‘staged’ – predicated on the achievement of ‘milestones’ established in the business plan – and the amount of equity that the entrepreneurs can be expected to retain is likely to be on the low side, in order to protect the funders from the heavy element of risk in taking on – presumably – largely untried management or unproven markets or risky technology. It will also have to protect them against the impact of the almost inevitable second-round funding where their holdings will be severely diluted by new participants. Prospective rates of return (RoRs) will have to be high, in consequence. And following the dotcom bust everyone will want to minimize the length of time for which they hold an early-stage investment.

Type of venture capitalist to be approached From what has just been described it should be plain that if you are contemplating a start-up then you have two choices. You are either going to have to use your own money (or that of the three Fs – friends, family and fools) or probably more likely going to have to approach a specialist. And all of the following is also dependent on 49

Venture Capital Funding

the assumption that when the term ‘you’ is used it is being used in the plural and, further, to a multiple of persons – in other words, not just two people. Very, very few professional investments are ever made in lone inventors. Investors want to see a team of managers that will be able to cope with the growth of the business that they are hoping for. So if you are going it alone then you will have to recognize that your choice condemns you to a perpetual small size in the eyes of most investors and that you will likely have to rely on the three Fs for your development money. The main market for investment funds has moved on from the start-up area, leaving it to specific types of VC to trawl. These types of funder fall into two main groups. If you are involved in venture capital in a university environment then there is probably a specialist in your university whose task it is to liaise with industry-specialized VCs to develop funding relationships and alert them to potential opportunities within university departments. Each university, if it does operate this system, will have specific rules about whether the university will hold a stake in ventures started up by academic researchers and what size that stake should be. These need to be considered carefully before an approach to a VC is made through such a route (although if you have made the discovery or built the venture in university time using university materials and funding then you may not have much choice). Most universities now have an enlightened view about this, recognizing that some portion of a large cake is be�er than none at all. Their expertise in helping to develop such ventures is not to be dismissed lightly. The rules about stakes and assistance are usually published or well known by senior researchers. If you are operating outside a university then you are probably going to find the most a�entive audience among the several specialist investment fora that have set up either commercially or through regional economic assistance organizations – the old Business Links. These can usually be easily found by searching on the internet. They specialize in introducing potential businesses to potential funders – in the shape of business angels – and will give some technical assistance to the businesses or proto-businesses that approach them in return for a fee. The businesses are the clients of the investment forum managers – not of the business angels (who may also have to pay some form of fee to be associated with the forum) and so there is usually some scrutiny done by the staff of the forum to improve the presentations of the best client companies and advice about how to develop and present a cogent case to potential investors. 50

Why Do You Want Funding?

The usual format for these investment clubs is that there is a monthly meeting of investors at a local hotel where four or five potential investments are given 10 or 15 minutes (at most) to present to the assembled funders, who then might choose to approach the presenters either individually or in syndicates. (These mini-presentations are called ‘elevator pitches’ because the first such approaches supposedly took place in a li� where the entrepreneur had trapped the investor and used the time it took a li� to go up or down the entire height of the building to make a case.) You can see that the forum is effectively a sort of financial dating agency, where opportunity meets angel (rather than boy meets girl). The outcome is hopefully the same – a consummated relationship. Another similarity with the dating agency is that, in each case, the introducing party retires immediately a�er making the introduction so as to avoid being a gooseberry and cramping the style of the two main parties.

Timing of the approach Usually for a start-up, the sooner approaches are made to VCs the be�er. But beware talking to investors before you have properly protected any intellectual property on which your business is going to depend. You cannot approach an investor with an investment proposal and maintain your credibility if you are going to tell the investor that your idea will revolutionize industry X but that you are unable to reveal precisely how. If you are working in a university then this problem should not pose too many difficulties since the liaison officer will already have taken this into account and undertaken the necessary steps to protect patentable processes and ideas. In a commercial environment this is less easy – patent protection costs money. Defending patents costs lots of money. In either case, university or non-university, it is necessary to have some basic ideas about the next two factors.

Running the business post-investment The one overriding trouble with start-ups for most investors is that they do not contain a full suit of management skills in the hand that 51

Venture Capital Funding

is being dealt. Most VCs will want to add commercial skills to a startup opportunity to make up any managerial deficit they feel they have identified. This may be hard for some teams to swallow – not least because it may involve some further erosion of the stake that they collectively hold or impinge on the way that they want to exploit the market commercially. Business angels get over this problem by combining their money with a requirement that they take an active role in the business – combining cash with so-called ‘sweat equity’. Most sensible entrepreneurs will readily embrace this offer if they find a compatible partner.

Knowing how to get out – the expected exit Only one thing causes more trouble than ge�ing money into a business – and that is ge�ing it out. Start-ups pose particular problems because there are so many unknowns about how the business will develop. Professional investors assume that one of their possible exits will be to see their holding heavily diluted by further injections of cash required from other investors to see the business plan brought to fruition. This supposition is borne out of hard experience. You can count start-ups that have got to a successful exit on the initial injection of cash on the fingers of one hand. Business angels must operate on this assumption – on the near certainty that their pockets will not be deep enough to fund the level of expansion that a small start-up requires to make it a decent business. If this is going to be the case, it helps explain the high levels of equity that start-ups o�en have to concede to incoming investors.

BUSINESS DEVELOPMENT ‘Development capital’, as this part of the market has come to be known, is an area where venture capital funders probably begin to feel fairly comfortable: there is a market that they can analyse, management that they can scrutinize and a company with a record of profitability that can be assessed. The ‘hurdle rate’ is probably much lower because some of the uncertainties about the business will have been mapped out and the likelihood of second-round funding can be be�er judged.

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Ratchets may well be employed in the structure of the funding to allow some flexibility for equity dri� to one party or the other. There are many funds that compete in this marketplace – although fewer than there once were thanks to the consolidation of the numbers of funds. This has the effect of reducing the price of capital to what are likely to be viewed by the entrepreneur as more reasonable levels. In terms of stakes that have to be conceded to the incoming investor, this should translate directly into more equity for the management team. However, while the relationships between investor and investee have equalized over the past few years, the availability of cheap debt until recently still gave the investor the whip hand. The absence of this availability is unlikely to translate into an immediate advantage to the management team. More likely it will make marginal deals more difficult to complete again. Good companies will find investment money.

Type of investor Business angels are still active in this part of the market but probably as syndicates rather than as individuals, mobilizing collectively larger amounts of cash. They will thus take on many of the characteristics of ‘normal’ funders, probably nominating one of their number to act as non-executive director or rapporteur – but still perhaps with a greater degree of participation than might be expected from a fund-based non-executive. Development capital is such a popular area with venture fund managers that many even incorporate it into their fund names. But not all will have the same risk appetite for development deals, and there is undoubtedly some segregation of the market by size and by industry type. Most funds will indicate in their literature and on their websites the areas in which they feel most comfortable and, generally speaking, the larger the fund the more sectors it will look at.

Timing of the approach Speed is of less absolute significance for the development capital deal. Cash pressures are unlikely to be quite as significant as for start-ups. As the businesses operate probably in a more mature market, in many ways managerial calibre is of greater significance than pure market 53

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considerations. The coherency of the business plan will also count highly – and the quality of the management of the company will be strongly evident in this.

Running the business post-investment Well-rounded management teams will include subject and functional specialists to whom the VC will be able to introduce li�le of additional value. The one area where there might be some managerial lightness will be in the area of what might be called ‘corporate wisdom’, and it is o�en here that VCs will seek to make some changes. This is usually done by selecting a new chairman for the business (from the stable of individuals who circulate among the venture capital community) to complement the seat on the board that will come with the ‘monitoring rights’ for their investment. The right to appoint the chairman will probably be put forward as a stipulation in the offer le�er. Development capital businesses are being prepared for sale from the moment that the VC’s investment hits the bank account – o�en before. Good development capital opportunities are, in fact, businesses that happen to be currently private but are being run like public ones. This applies not simply to the range of skills and the capabilities of the senior staff but also to the regulatory standards that are employed in the company. The idea is that a public flotation of the shares or a private sale to another business will be made that much easier if such standards are adhered to – and of course that the resulting price will be that much higher, since a ‘control premium’ will be fully justified by the company’s financial and operational history.

The expected exit Well-run development capital businesses leave investor options open for either flotation or sale but it is unusual for these options to be equally likely outcomes. Since the exit is much higher in the chronological list of priorities than for the start-up business (not surprisingly, since the hard early work of growing has largely been done), the preferred outcome will usually form a concrete part of the management’s plans. For the potential investor not to be able to recognize it as being in place as the investigation of the proposal becomes more detailed may well be an obstacle to investment. The need for management to give an 54

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unambiguous signal that they are clear about the commercial strategy for the business is of critical importance in trapping the interest of the potential investor. The VC can be persuaded (or not) about the case and either pursue the investment or not, but to leave the case unmade will not encourage any pursuit at all. The area where problems o�en arise, though, is where development capital is sought by one company to enable a purchase of another. Buying into one company is difficult enough for VCs to convince themselves to do, but buying into one as a route to buying into a second is probably a step too far for most. The problems of integrating the different cultures of two apparently similar businesses are o�en a mouthful even for experienced management teams, never mind when they are also coping with the strangeness of taking on board an investor. Consequently such deals offer the types of problems that are usually met in the next category as well as the problems that are normally associated with assessing development capital deals.

SHAREHOLDER CHANGE If ‘shareholder change’ means the sale of a subsidiary to management then this is probably now the area where most VCs feel at home. If it means simply buying out a recalcitrant problem to make life easier for the incumbent management then there are going to be fewer takers. But in each case the larger the numbers being talked about – paradoxically – the larger the likely number of interested funds. MBOs have become the favoured variant of venture capital for many of the larger funds – a fact a�ested to by the heavy preponderance of investment in that area. MBOs a�racted considerable notoriety in the summer of 2007 – o�en because of misreporting or misunderstanding. In the larger buy-outs, the senior management levels are o�en populated with executives who have been selected according to the rigours of big company criteria. The senior staff of major subsidiaries (prime candidate companies for buy-outs) will be at or just below board-level calibre for plcs: seasoned, qualified and experienced managers. They will be used to operating in major markets and with big-company disciplines. The businesses that they run will have long financial records that can be disentangled from head office overheads to demonstrate commercial a�ractiveness. There will be nice clean audit reports coming from long audit records. 55

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Most MBO opportunities also come with the blessing of the selling company, so there is a willingness to do a deal from the outset (although the beginnings of a trend of the contested take-out may have been seen in the Sainsbury’s bid). Critically, the interests of the VC and the managers are almost completely allied while the bulk of the deal is being done: both want to flush out the lowest possible price for the deal. This is in marked contrast to the normal situation in a development capital opportunity, where managers are trying to bid up the price of their company while the VCs are trying to push it down. Not surprisingly, MBOs are juicy plums for most VCs. By contrast, using money to winkle out a recalcitrant shareholder looks a bit of a thin reason for investing. Only if the business is capable of some spectacular growth under a rejuvenation of management is this likely to be an enticing opportunity for most investors.

Type of investor The biggest funds devote much effort and much cash to cultivating this sector of the market. The amounts of money that can be mobilized by any one of the largest funds are now tens of times larger than the biggest deals that were being done by syndicates of investors only 15 years ago. If a big buy-out is what you are pursuing then you will find no shortage of potential takers for the right type of deal.

Timing of the approach It is less easy to be specific about this area: some funds like to work very closely with potential management teams. Others like to get started only when the bulk of the permissions to try to arrange a buy-out have been granted to managers by the parent company. Clandestine arrangements are probably not very a�ractive to most funds – although it happens even with the largest deals. I can remember, when I worked for the Coal Board Pension Fund, being escorted from the premises by security staff (together with a large number of other potential investors) when the first buy-out of Land Rover was proposed by the incumbent managers, without having checked with the board first. The big benefit of this type of opportunity is that there is usually no shortage of good advisers to help managers put a deal together. But it is also necessary to point out that good advice can be costly – and 56

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if the deal falls over at the last minute it can be very embarrassing for the managers, who may find themselves in the unenviable position of being without jobs and with big professional bills to cover.

Likely exit Only a few years ago there would have been no doubt that the most likely exit route for a big MBO would be another flotation. Now there is a tendency for large companies to think twice about the administrative and regulatory burdens of listing on a public exchange. Consequently private sales and cash-flow deals have become more popular as the longer-term prospect for buy-outs rather than entry to a public stock market. This has deep implications for structuring deals and the relative a�ractiveness of various types of management investment. The choice of investment vehicle, the use of offshore and discretionary trusts and whether to use loans, equity or preference shares and so on are much more complicated than they used to be and depend very much on good professional advice. Many such deals are now tax-driven in terms of their structure, rather than being commercially transparent as they would have been for flotation purposes.

RESCUE You have to have fairly strong nerves to do this kind of deal either as a manager or as an investor. There are specialist fund managers in recovery situations – and they o�en follow one or two talented individual managers who specialize in doing recovery work. A good generalist fund manager will not turn down any potential opportunity without studying it thoroughly. But if you are contemplating taking this sort of opportunity to a VC then you have to put yourself in the VC’s place and ask yourself why someone should invest in a proven difficult case when he or she can probably experience less grief in a much simpler proposal for the prospects of a similar rate of return – at least at face value. The only possible correct answer is because there is a prospect of a stupendous return for some otherwise unrecognized technical reason.

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People, and particularly investors, being what they are, they will remain sceptical about these technical reasons. Because of this, recovery deals are just about the hardest to sell to investors. Even most business angels, o�en more adventurous both by disposition and by reason of practical experience than most VCs, tend to fight shy of recoveries. The problem of credibility is not only concerned with the commercial history of the business but also means an almost guaranteed requirement will be that the management should suffer wholesale replacement, since they were the ones who got the business into trouble in the first place. From the investors’ point of view, there is the double bind that anyone associated with the previous regime will be tainted, and fresh incomers may not understand what really caused the problems that brought about the demise of the previous management group.

Type of investor This will almost certainly be a specialist – therefore both easy and difficult to find in consequence: easy because specialists stand out and difficult because there aren’t many of them. Specialist associations like the Turnaround Management Association (UK) will know of likely investors in these areas.

Timing of the approach This is critically important. Get in too early and not all the commercial problems will have become apparent. Get in too late and you may well be flogging a dead horse. VCs are very well aware of this and also that, as their industry folklore has it, ‘lemons ripen before plums’. The due diligence requirements for these sorts of opportunities will be severe – costly and probably extended. Even to get to that stage you are going to have to present a very good case.

Likely exit If the corporate undertakers can be avoided – corporate failure is statistically the likeliest outcome – then probably a trade sale will be the preferred route. Most venture investors will be unwilling to tempt fate with a long involvement with a company with a dicey history – 58

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and a poor record of profitability will not contribute much towards a sturdy initial recommendation in a public stock market. So that’s completed our brief Cook’s tour of the investment landscape. In summary, start-ups aren’t flavour of the month – this month or any other month; development capital is a be�er bet for funding; buy-outs are the likeliest to get capital; rescue situations have to be potentially very, very profitable to get a hearing, because of the risks involved. Are there any other general points we need to introduce to thoroughly fla�en any residual interest in raising capital? Well, yes. Just a few.

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6

Know your enemy: the venture capitalists considered

Freebooter, n: A conqueror in a small way of businesses, whose annexations lack the sanctifying merit of magnitude. (Ambrose Bierce, The Devil’s Dictionary)

 The background factors  The myth of patient money  Pressures on the VC  Types of venture capital fund – fund size and structure  How these factors affect fund behaviour  From fund to individual: who are the VCs?  How VCs make their money

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While Chapter 5 started off by posing the question ‘Why do you want the money?’, this chapter takes a look at the problem from the other side and asks ‘Why should they want to give it to you?’ The simple answer to that question is profit. VCs can make a lot of money out of buying into young or developing businesses, helping them to grow and then selling out. The statistics in Chapter 1, compiled from information released by the BVCA, showed where VCs have been placing their money in recent years. VCs provide the wherewithal for the company to grow, possibly adding some managerial help and some administrative discipline. But their overriding intention is to leave just before the peak of the company’s growth parabola – at the point where a li�le more growth can be anticipated but, in truth, where the fastest rate of growth has already been experienced. So don’t ever forget that critical clause – they want to sell out. They don’t want to stay with you for ever. Venture capital funding is a marriage of commercial minds, with a built-in divorce about halfway before the seven-year itch starts to set in. This should be appreciated from the outset. VCs are not long-term investors. This is in direct contradiction of what they try to emphasize as part of their sales pitch to the businesses that they deal with. They are be�er described as serial medium-term investors. In fact, unlike many pension funds that are genuinely long-term holders, the three to five years for which venture funds typically hold their investments are barely two-thirds of one economic cycle.

THE MYTH OF PATIENT MONEY A myth that has grown up is that money put into a business by way of equity is ‘patient money’. The myth appears to have grown up through a misapprehension, like most myths, and appears to rest on a mistaken contrast of equity with loans. Because loans are repayable on demand and need constant a�ention in the form of interest payments, they are felt to be demanding and undesirable as a means of stimulating business growth. The implication is, as I understand it, that equity is patient because it is ready to wait for its return. That, unfortunately, is not true. And it is certainly not the case where venture capital is concerned. Successful venture capital investment is built on three things, and patience is not included. The three factors that I perceive to be 62

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important are risk minimization, opportunism and a good dollop of luck. None of those things is particularly well acquainted with ‘the long term’. To explain those characteristics further, we shall see throughout this book that one of the key factors to any venture capital deal is the minimization of risk. This is what VCs strive a�er in arranging the structures of their deals – and also in the duration for which they are willing to stick with a deal. It is a reasonable supposition that any investment that is longer in duration than any comparable investment is exposed to greater risk. This is simply because the passage of time conveys with it the development of risks unknown and unexperienced in the shorter investment. Hence VCs will stay with a company up to the point where the top of the growth parabola can be seen and no longer. Of course, they might be mistaken about where the top of the curve is exactly, but where they perceive it to be is the operative factor in their decisions. The second characteristic I have identified – opportunism – has received a bad press in recent years and is now o�en associated with some sort of reprehensible behaviour or lack of morals. This is unfortunate, since in its pure form, shorn of connotations, all it means is taking advantage of opportunities that are offered. To my mind every good business manager should be an opportunist – seeing and exploiting opportunities is what business is all about. VCs are certainly opportunists and ought to wear the badge of opportunism with pride. It is one of the methods by which they seek to minimize the risks to which they are exposed – taking advantage of opportunities to release investments at the points where the potential risks become greater than they are happy with for the rewards that they are likely to reap or, conversely, where the rewards become less than they are satisfied with for the risks that they are currently running. The third characteristic – luck – is implicit in all business ventures. While it is reasonably easy to distinguish the good business from the bad or the good manager from the mediocre, in both businesses and managers it is only shades of luck that separate the good from the outstanding. No business can claim to get the exploitation of every opportunity right every time, and the record of venture capital funds and individual investors shows that they certainly do not. Given the amount of effort and intellectual energy expended in investigating and doing deals, the only reason that can explain such failures, overall, is bad luck.

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PRESSURES ON THE VENTURE CAPITALIST These three factors explain why venture capital investors are highly impatient people (as a class). Individually, of course, VCs are sophisticated individuals who behave as befits normal commercial behaviour. We are not talking about barging to the front of queues in post offices or the use of the briefcase as an instrument of violence in a tube crush. Individually, perhaps the most frequent clue to impatience that I have seen is the tapping of fingers noisily during very long meetings. But collectively, as far as their professional existence is concerned, VCs are anxious to see returns on their investments, eager to move on to the next deal, and have a short fuse for extended explanations when things do not turn out as anticipated. In short, they want their money to perform and are prepared to act in such a way that they reduce the risk of that not happening. While they are unable to ask for their investments back in the same way that bankers can demand repayment of loans, we shall see that VCs are quite capable of effecting changes in a business. This is done purely to try to bring about a turn of events that will favour the outcome they were anticipating when they went into the deal. Far from exhibiting the characteristics of patient investors, who are willing to let events transpire and sort themselves out (o�en because they have no option to do anything else over the short run), venture capital equity is highly impatient money. And furthermore, venture capital money will carry with it the right to take managerial action over the short run, because VCs deal in the immediacy of business in real time and taking action to rectify problems is part of the process of a�empting to minimize risk. Nearly all the actions that venture capital investors take resolve eventually to an obsession with risk and its minimization. It is not too far from the truth to say that most businesses are like unexploded bombs – something is ticking away inside the structure of the business just waiting to go off and wreck the whole thing. If you hold on to an unexploded bomb for long enough then you are going to be around when it does go off. That explains why VCs like to make their investments, develop the company fairly fast and then get out while the growth path is still pointing upwards. This tendency has been reinforced in recent years: they want to get out well before that ticking stops. But the pressures are not all the same for all VCs. Different types of VC will be affected by different influences, depending on where 64

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they stand in the capital marketplace. We need to look at them not as a homogeneous, indistinguishable group but as a heterogeneous set of individuals in order to make sense of their behaviour.

FACTORS AND ISSUES AFFECTING VENTURE CAPITAL FUND POLICIES The root of the pressure to which venture capital fund managers are subject, though, is that all the money with which they are dealing is someone’s savings. And savings, if they are to be of any use, require that a return be made on them. Money that isn’t working is just idle paper. It can be made to work in a variety of ways and in our economy works mostly by being invested in companies – either directly or through the medium of the stock market. The big players in the stock markets are the pension funds and banks. The managers of these funds are constantly seeking out opportunities to invest the funds placed with them to achieve returns that will exceed those of their competitors and therefore a�ract more customers’ funds from which they will derive more profit themselves. The problem for the pension fund managers is that, with be�er-regulated markets and faster transmission of information to all parts of the market, it is becoming increasingly difficult for large pension funds to make consistently be�er returns than their competitors. Venture capital funds can help them do this. The VCs’ aim is to achieve a much-be�er-than-average rate of return on the savings that they are entrusted with by using their judgement and operating in a marketplace where direct action on the investment is possible. The benefit for the investors is, of course, that if the VCs do their job well then the investors make a very fancy return, with luck, on the money that they have entrusted to the venture capital funds. And this rate of return will be far be�er than they make on their normal investments. Even though the proportion of total funds that the big investors place in the venture capital market is small, the rate of return that can be achieved is very good. This makes it a�ractive – particularly when achieving above-average returns in the large markets becomes increasingly difficult.

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FUND SIZE AND STRUCTURE We have looked at some of the main forms of venture capital fund in Chapter 5, identifying the sectoral interests that they might have. There is no need to rehearse those features here. We are now going to examine:  the structure of funds and how it affects investment stances;  how the size of the funds under management affects the way that they are managed; and  the consequences for the investee company of the position that individual funds occupy in the life cycle of their portfolios. As far as the outsider seeking funds is concerned, there are really no visible differences between the funds – no external distinguishing features. However, the characteristics of the funds may alter the way that fund managers are able to or wish to behave in respect of investments.

Structure 1: individuals Individuals operating in the venture capital business are almost always one of three types – deal brokers, consultants or business angels. Only the last of these is of any real interest from a funding point of view. Deal brokers have now almost disappeared from the market, with the increasing sophistication and growing maturity of funds (the British Business Angels Association, BBAA, for instance, used to operate a marriage-brokerage ‘Bestmatch’ service, but turned it off in 2003 because of decreasing interest), and consultants generally offer expensive services that are o�en paid for with equity in order to get a foot in the door of developing businesses. Their value is limited to any well-managed business. In short, if you are well managed you don’t need them, and if you do need them then you should probably not be applying for venture capital – yet (or at least not until you have digested the information in this book). The interesting ones from the funding point of view are the business angels. These are individuals who are (or are supposed to be) ‘sophisticated investors’ – that is they are able to understand and 66

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evaluate investment opportunities by themselves, without relying upon the expert guidance of an intermediary. There is no exam for being a sophisticated investor; business angels merely have to selfcertify (the rules were changed in 2005) to confirm:  that they have been a member of a business angels network for at least six months; or  that they have made at least one investment in an unlisted security over the past two years; or  that they have worked in a professional capacity in the provision of finance to small or medium-size businesses in the last two years or in the provision of private equity; or  that they are or have been a director of a company with a turnover of at least £1 million. They are thus individuals of ‘high net worth’ – that is, they can afford to lose the value of their investments, if the worst comes to the worst, without being financially crippled in consequence. The amounts that investors will want to invest are therefore heavily dependent on individual circumstances: some investors may have a pot that they want to spread around and may limit themselves to, say, a couple of investments of £50,000 each. Others may be willing to go nap on one investment if it looks good enough. In situations where individual investors can’t – or are unwilling to for reasons of prudence – put all the cash into an opportunity then they can ‘syndicate’ the deal (see pages 76–77 ). The rather acid description that I have given does not do most angels justice. While there are dile�antes among their ranks, in general business angels are individuals who have gathered their resources the hard way, through building up businesses themselves, and are now willing to speculate with them in order to accumulate more. Unlike venture capital fund managers, they are risking their own money and not somebody else’s. If things go wrong they are the ones to suffer directly – and in the pocket. A loss in any one investment may be regre�ed by fund managers but it is not likely to make their eyes water. They will have adopted a portfolio approach to investing their funds so that the expectation of some loss is covered by the expectation of very high profits in other deals. Business angels are in the front line of losses when things go wrong, for each and every loss.

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One of the most significant primary characteristics of business angels for very young businesses is that, first, they will apply not only their cash but also ‘sweat equity’ to a business – they will probably require as part of the investment some form of quasi-executive post and will want to work in the business for a couple of days a week – and, second, they may (but only may) require a lower rate of return from their investments than a professional venture fund manager. (This qualified ‘may’ depends very much upon the intention of the business – going for rapid growth is perhaps riskier and might require a higher rate of return, or going for gentler growth might mean that it is una�ractive to a traditional VC and be�er suited to an angel.) The invaluable quality that the good ones bring with them is commercial experience. Business angels (the name is borrowed from the theatre – ‘angels’ is the collective term given to backers of a show) should be the first port of call for raising funds for all but the mature business. Raising business angel finance will usually set future fund-raising on a firm platform, if the investment is successful for the angels. Finding an angel is best accomplished through one of the investment fora that are now established across the entire country. Two of the most active are Beer and Partners and the Great Eastern Investment Forum. The BBAA has details of other groups, which can be obtained from their website. The BBAA is an umbrella organization – operating on a notfor-profit basis and backed by all the major UK clearing banks, the London Stock Exchange and the Department for Business, Enterprise and Regulatory Reform – which, among its other services, operates a website where businesses seeking finance can be put in touch with potential backers. While individuals may invest somewhere between £10,000 and £250,000 in any one investment, businesses requiring larger sums may also raise money using syndicates of angel investors (o�en behind one lead investor or ‘archangel’). See the section ‘Structure 6: syndicates and consortia’ (page 76) for more information specific to the way syndicates operate. Contact details of the BBAA can be found in Appendix 2. Business angels are also able to set off the value of their investments against income and capital gains taxes under the Enterprise Investment Scheme, provided certain conditions are met. This effectively reduces the cost of the investment, which may allow them, again, to accept slightly lower rates of return than those at which managed venture capital funds find the deal acceptable. Tax rates change every year, though, so proper advice is essential. 68

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Structure 2: partnerships Many venture capital funds – of all types and sizes – are organized on the basis of a limited partnership (since the Limited Liability Partnerships Act 2000) or some other form of limited duration trust. Few partnership funds run for more than 10 years. That means that VCs will want to see the money they have under management, ‘in’ (invested) and ‘out’ (realized) within about a five-year (maximum) horizon so that they can report good results to their backers, have funds to reinvest and follow through on promising cases and still have some funds le� to invest while they raise another fund. This life cycle of fundraising, duration of investment and further fund-raising conditions the style of investment and the readiness to make investments and to embrace risk. It also means that the venture funds and the people who run them – just like the management of their investments – are under continual scrutiny. The consequence of this is that stakes are high for them too, since poor returns on the funds will mean that they are not entrusted with more money when the time comes for the next fund-raising ‘round’ and consequently, with no fresh funds to manage, the fund managers will lose their jobs. Because of this, many fund managers raise funds on an ‘overlapping’ basis if they can, so that they are continually able to draw down cash to fund new investments. This will be evident if the fund documentation talks about funds with different names or with different calendar designations. It is worth asking about this in discussions with the fund managers, since it is possible to conceive of a situation where they may no longer have cash to follow through on existing investments (which were originally funded out of what is now a mature fund) even though the total amount of money under management may not change dramatically. New funds may have replaced ones that are due to wind up and release profits (or losses) to the investors, so keeping overall levels of money managed high even though individual funds may be winding down. All funds have the same basic investment processes, but the details may slightly alter depending on the particular structure of the fund. Appreciating the steps in this process is a necessary prerequisite of looking at how the individual fund structures can affect investment styles. Chapter 7 deals with what happens in each of the detailed stages of the investment process, but in essence it follows a path like this: 69

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1. 2. 3. 4. 5. 6. 7. 8. 9.

approach by the company; initial appraisal by the fund managers; meetings with management; detailed examination of the proposal through interviews and visits; offer le�er; accountants’ investigation; submission of the proposal to the investment commi�ee and approval; legal stages; closing.

Variations to these steps are largely around the margin: some funds may put preliminary details of proposals to their investment commi�ees before issuing an offer le�er; others may have a fixed operational requirement concerning which issues have to be covered before an offer le�er is issued. Most funds have ‘Monday morning meetings’ where new investment proposals are discussed and progress with existing cases is reported on. These meetings, which are deceptively casually run to the outsider’s eye, are where much of the tone of the investment policies is set. By a filtering process of discussion and sharing experiences, the operational participants – the people who actually do the deals – absorb what can and cannot be done in investment terms. The investment commi�ees, which are much more formally run, are probably much less significant for most funds in se�ing the priorities of investment policies – they are more concerned with making sure that the details of the priorities have been observed. Most investment commi�ees meet regularly – some may even meet on demand – to approve investment proposals submi�ed by the investment managers for both new and follow-on financings. The operation of investment commi�ees will be considered in Chapter 11. The dynamics of the internal structures of the larger partnerships mean that there are usually a few partners who control the investment policy of the funds that they manage and a larger number of associates or investment managers (who are employees and not partners) who do the detailed work of the investments. The partners will probably sit on the investment commi�ee, which decides whether investments should be done or not, along with a few independent non-executives with business and/or financial backgrounds.

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If you get a partner interested in your proposal then it should not fail at the investment commi�ee stage (or there is something seriously wrong with the partnership). It shouldn’t fail either if handled by an experienced manager – because there should be discussion about deals all along the way as they proceed through the stages of a deal – but the terms may be modified a�er the proposal has been through the investment commi�ee’s hands. Because the investment partners are the ones running the fund there should be a very clear understanding between them, and between the partners as a group and the managers, about what will be acceptable in terms of investment strategy. Established funds will have recognized areas that they have to consider when thinking of completing an investment, so unless your proposal is very unusual then it shouldn’t prove too problematic for investigating and structuring purposes. In general, the larger the fund, the more likely it is that the range of businesses that the fund is willing to invest in will be broad. Funds that specialize in specific sectors tend to be smaller – principally because of the limited amount of money that investors in the fund are willing to risk in any one sector. The portfolio approach to investment – limiting the prospect of overall failure through spreading risk over a number of sectors – promotes the existence of large funds with only modest sectoral limitations. Functional specialists – like buy-out funds and development funds – are large for the same reason. Larger funds are also less likely to be affected by fund termination problems because of their generally higher rates of success. Large funds – to paraphrase David Nobbs’s archetypal senior industrialist, CJ – ‘didn’t get where they are today’ by being timid and unsuccessful. The chances are that, consequently, they will have fewer problems in a�racting money for subsequent funds and so they can keep up a good flow of deal completions. By contrast, the smaller funds sometimes suffer from the partners’ a�ention being drawn away to raising funds from their investors and also from rationing of funds for new investments once they invest something close to half of the total amount that they have under management. Beyond that halfway point, the managers are o�en as much concerned with nurturing their existing portfolio to produce the best possible returns as they are with making new investments.

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Structure 3: captive and semi-captive funds Captive funds are those owned by banks or pension funds that use their own money without the need for raising money from other investors. Their supply of money is effectively limitless as far as the outside world is concerned, and they do not suffer from many of the problems of phasing of new investments against follow-on funding and fund-raising that other funds do. They are usually free to enter any sector and undertake any type of deal – although given their size they probably tend to specialize in big development or buy-out deals where the sums required are large. Most of the large funds used to be like this, but over the past 15 years or so the large industrial pension fund subsidiaries have developed as managers of other people’s money too – Hermes (BT), Cinven (the old Coal Board fund) and Electra (out of Cable & Wireless). The large banks are still interested in this area. Basic processes for investigating and then approving an investment are the same as in any other fund – although subject to local idiosyncrasies of style. By and large, banks do not require investments to bank with their high street counterparts – both because the fund managers have fought internal ba�les for their independence to be free of such requirements and also for the very good reason that the banks want to spread the risk if big deals do go down. However, where there are large syndicated deals where a banking captive takes the lead, then there may be some pressure for clearing bank services to be provided by the sister bank. Semi-captive funds are captives that also manage other funds’ money on the basis of a pooled fund arrangement. From the outsider’s point of view, they are identical to captives, with no distinction being made by the manager about the origin of the funds.

Structure 4: independent funds – 3i and ECI, VCTs, and funds of funds A whole book could be wri�en about 3i – in fact one was some years ago to celebrate 3i’s 50th birthday – and for many years the company was the British venture capital business in its entirety. As a consequence of this, many of the individuals who now run the larger funds are graduates of the 3i way of doing things. Overall, 3i has been 72

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very successful and is an unsung major contributor to reshaping the British economy from metal bending to predominantly a knowledge economy. The procedures that other venture capital businesses use are largely a result of the procedures developed inside 3i, leavened with a sprinkling of transatlantic jargon. Originally called Industrial and Commercial Finance Corporation (ICFC) and then Investors in Industry (a�er it amalgamated with its sister organization Finance for Industry), before assuming its current rubric, 3i stands ready to supply funds for suitable investments in every section of the market, and although it abandoned a specialist high-tech start-up unit some years ago it is still very active in the field of technology exploitation. It was and remains a powerful participant in the so-called Cambridge Phenomenon, for instance. Most of the limiting considerations about fund life, partnership issues, subordinate managers, and disposal and follow-through concerns that affect other funds do not apply to 3i. However, as a quoted company since 1994 it now has to follow the disciplines of raising money through the stock market, and some treasury matching of deals being done against deals being realized is now obvious in its strategy. Although it was never related by direct parentage, Equity Capital for Industry (ECI) was o�en seen as the sibling of 3i. The two businesses had a similar ethos and were staffed by individuals of similar background and investment style. Similar sorts of consideration about the characteristics of one apply to the other – there is no problem about availability of funds, they are both extremely catholic in their investment tastes and their internal processes are similar. Like 3i, ECI has seeded much of the present British venture capital business with former members of its staff. Equity Capital for Industry was originally established by the clearing banks as their answer to 3i (when 3i was still ICFC), and the two businesses carried much of the responsibility for venture capital in Britain through the 1970s and 1980s, together with the Coal Industry Nominees’ Industrial Investment (CINII) – which became Cinven – and big funds like Candover and Electra. Equity Capital for Industry transmogrified in due course into ECI Ventures and then into ECI Partners. Venture capital trusts (VCTs) are funds that have a publicly quoted price. They are managed funds that private investors can buy into just as with a unit trust or a capital bond. They make investments in exactly the same way as any other venture investor, but their trust vehicle prices are based on the value of the assets that they control (through 73

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their investments) as declared by the fund managers at regular intervals. Recent changes in government policy may have made life more difficult for the VCTs. With the growth of the venture capital business, another type of vehicle – the fund of funds – has grown up. This enables pension fund managers to invest indirectly into funds by placing their money with another fund that then allocates that money to separate investment managers. By the nature of the vehicle, the fund of funds never comes into contact with investments directly, and proposals to invest cannot be made to the fund of funds by companies.

Structure 5: public–private partnerships The perception that a funding gap exists and that the geographic basis of much of venture capital was too metropolitan in its bias led to the creation of the regional venture capital funds (the RVCFs) in 2001/02. These funds use the skills of managers developed in the private sector to control funds of about £20 million each, spread through all of the nine English and Welsh economic planning regions. Public money contributed by the Treasury was pledged to each fund provided the managers could raise at least matching amounts from the private sector. Public money also comes out last in any realization of assets from an investment. In recent years the RVCFs have been hard hit by the fallout of the dotcom bust. The future of many of them is uncertain, so the information set out below, about what they were allowed to invest in, is mostly for the purposes of illustration.

Size of business The business had to comply with the European Union’s definition of a small and medium-sized enterprise (SME). Currently, this is defined as a business with fewer than 250 employees that has either a turnover less than 40 million euros or a balance sheet total less than 27 million euros.

Ownership It must not be owned: 74

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 wholly by another company;  25 per cent or more by another enterprise;  jointly by several enterprises not meeting the above SME definition. Some of its equity can be owned by business angels, or other individuals not connected with the directors or other shareholders. It can already have had venture capital funding either from seedcorn funds or from other VCs; however, if this is the case, the amount the RVCF can invest will be restricted.

Sectors There are a number of sectors in which the RVCFs could not invest:  land and property development, dealing and investment;  provision of debt and equity finance and financial services in general;  accountancy and legal services;  hotels;  nursing and residential care homes;  international motor transport;  agriculture;  forestry and timber production;  horticulture. The birth of the funds was not easy, with funding o�en proving hard to a�ract. Serious controversy surrounded the selection of managers for one fund. While £20 million (the rough average raised) seems like a lot of money, it does not go very far when it has to be spread around investments to be made by a fund with a projected 10-year life and has also to support a management fee for the fund managers for that time. Although some of the funds did relatively well in terms of deal flow – at least one fund pioneered a form of initial business plan appraisal 75

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that might be called ‘Venture Capital Lite’, using online techniques of business plan presentation to help it to si� through the 60 or so proposals that it received every month – they had only limited possibilities of follow-on funding for businesses that developed strongly. They were limited to an investment of £250,000, with a follow-on maximum of £250,000. If two or more funds collaborated on an investment they would still have to abide by the £250,000 ceilings collectively. While this should have proved no real bar to the future funding of those businesses – larger funds could come in from elsewhere – followon funding might be more protracted and therefore more painful for the businesses involved. Some managers began to grumble about the constraints that were placed upon the funds in terms of financial targets to be achieved almost from the off, about the relatively modest size of each fund and about the practical proscription about certain deal types (because of funding limits), and these concerns were exacerbated by the effects of the dotcom bust.

Structure 6: syndicates and consortia Syndicates of investors get together when a deal is too big for one investor to take on alone. Sometimes this means not simply that the cash amount is too large for one investor, but that the investor is unwilling to take all the risks of the deal and wants to spread the load. Professional investors frequently arrange syndicates among likeminded partners because they have a feel for what their investment commi�ees will be happy with in terms of the amount of risk that any one deal should represent. Business angels combine into syndicates for both these reasons: individually, they cannot raise sufficient cash to do the deal alone; and it would not be prudent for them to do so even if the cash was available. Sometimes, among business angels particularly, complicated deals are syndicated so that the burden of investigation can also be shared and judgements about commercial viability pooled. Syndicates usually appoint a lead investor who will act as the single point of contact for the company in order to minimize the administration of the necessary commercial and financial investigations and the legal negotiations. Completion meetings are o�en a�ended by all the members of the syndicate – and, what is worse, by all their lawyers too.

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The problems syndicates face are obviously those of trying to get individuals to agree on ma�ers that will be of concern when things start to go wrong. This means that the legal stages of any syndicated deal are likely to be more difficult than they would be under a single investor, as particular and individual problems about legal wording have to be overcome to produce agreement. The problems shi� in emphasis when more cash is required for a business. If the cash is required for rescue then they can become quite shrill, as some investors may not be willing to risk sending good money a�er what has turned out to be bad. In situations where further cash is required to fund beneficial growth, the problems centre around the differing capacities of investors to find the cash – this is usually a problem of angel syndicates rather than professionally managed funds, where cash resources are usually deeper. However, the RVCFs suffered from this problem at times as we have seen. The chances are that the lead investor will also act as a rapporteur for the syndicate once the deal is completed, taking the normal board monitoring position and reporting back to the group as and when appropriate. Normally the legal agreements will also give syndicate members the right to a�end board meetings and possibly even to appoint their own nominees to the board if things start to go wrong – such as forecasts not being met, additional cash required and so on. Although there is no strict distinction between syndicates and consortia as far as funding is concerned, a consortium is a more permanent arrangement between investors acting in collaboration; syndicates tend to come together on an ad hoc basis, although in large deals the members will probably all have done deals together before. So consortia are beginning to spring up to handle the international deals that are now being seen across European boundaries on a regular basis. Such transnational deals require the presence of a supervisory leader amongst the funders who can control the deal locally and then act as lead monitor a�er the deal is completed. In such a situation it pays greatly to work with someone whose style and strengths you can appreciate through having done collaborative work with him or her before. Consortia suffer from exactly the same problems as syndicates, with the added problem of cultural and legal differences in those formed around partners from different countries.

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SIZE OF FUNDS In general, two things happen as funds get larger: first, they gravitate towards larger deals; and second, their readiness to assume risk may alter. As funds get larger the economics of running them changes. It becomes impractical to chase a�er lots of li�le deals of £250,000 a throw when you are running a fund with hundreds of millions of pounds under management. Monitoring the investments would be impractical, inappropriate amounts of time would be spent in completing deals, and li�le time would be spent in stewarding them. The principal problem in running a very large fund is to get lots of money out of the door and into companies where it is going to make a good return. This leads directly to the conclusion that large deals have to be done by large funds – in other words, large funds arise because of the increasing size of deals that the market throws up, and once the large funds are in place to deal with them they have to continue doing large deals. The time it takes to do a deal is largely independent of the size of investment – small deals take as long to do as big ones. It is obviously in the interest of the manager of the large fund to concentrate on large deals – especially since large deals tend to be in large management buy-outs or substantial development capital opportunities where the risks are potentially lower. This reduction of risk by movement upmarket tends to condition the a�itudes of both the investment managers and the investment commi�ees when the time comes to review investment policies. The fact that they have moved into a region of the market where there is less risk of individual deals going wrong may well mean that they become unwilling to accept the risks that are present in doing smaller, more volatile deals – even though an objective calculation of the risks that they could afford to take across the whole population (if it was still calibrated to what they were doing when they tackled smaller deals) might suggest that the occasional smaller deal (higher risk but perhaps higher return) would be acceptable. Conversely, some managers might say that the cushion of large deals allows them the ability to speculate in smaller businesses, where rewards can sometimes be exceptional. Some funds actively pursue such a policy, se�ing up a specialist division to deal with deals under a certain size that have exceptional promise or actively monitoring 78

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certain sectors that seem to be good bets for a future presence but cannot support large deals at the moment. This might be a concise description of the strategy that 3i has adopted, for instance. In general terms, though, it is fair to say that the larger the fund the larger the deal that the managers will want to do and the less will be their appetite for high-risk small businesses. This tendency has of course reinforced the belief in the existence of a funding gap.

LIFE CYCLE The influence that the life cycle of a fund has on individual fund behaviour has already been touched on. Managers will probably want their deals to ‘realize’ in a timely fashion as the fund nears the end of its life and may become less willing to pump money into investments that are underperforming as the money that they have under management reduces. The larger funds, with their substantial investment records, are less subject to this effect than the small and middling funds, which have to proceed in completing individual investments with one eye always on the perspective of the shareholders in their funds. All funds, regardless of size, o�en perceive their own interest to lie in a quick realization of a deal even though that may not be identical to the entrepreneur’s ambitions. Investment managers will always be trying to gauge the point in the life cycle of the investment where they will be best served by realizing their investment. Although selling earlier than anticipated to a third party may not produce the rate of return that was originally predicted, investment managers are very sensitive about their reputations among their peers and will be far more anxious to avoid the opprobrium of a failed deal than the (unprovable) criticism that they realized a deal slightly too early. Funds, being opportunist in their a�itude to the investment world, work on the principle that a bird in the hand is worth two in the bush. Their overriding concern is to work always to reduce their risks in any one deal. At some point that may mean accepting a realistic price for its purchase from a third party, even if the price is not quite as much as was anticipated at the outset of the investment. From the VC’s point of view, many entrepreneurs – despite their ambitions to the contrary at the time they initiate a deal with a VC – become a�ached to the business they run and continually see be�er and be�er prospects for 79

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it, blinding them to the need to assess realistically the likely benefits of continuing. However, all funds are subject, to some extent, to fashions (read ‘manias’) in investing. Individual funds may not go so far as to restrict funds to any one investment purely on the grounds of redirecting them to in-vogue sectors but, certainly as a group overall, funds will ‘weight’ their investment stance towards what they perceive as developing areas of the economy. The dotcom boom was a prime instance of this. The da�est of ideas stood a chance of being funded if it based itself on the precepts of the ‘new economy’. This sudden preoccupation with funding opportunities based on internet trading proposals had the effect of crowding out, collectively, sturdier (but temporarily less exciting) prospects from the old economy. Undoubtedly, some good investment opportunities emanating from the old economy were discarded in favour of flashier deals that fi�ed be�er with the prevailing tendency that regarded anything connected with the web as being a sure thing. Less sudden changes can also affect a fund during its life cycle. If quoted stock markets make a fundamental movement in the value of a particular market sector, perhaps over a period of two or so years, then this will also affect the type of investments venture funds are willing to do over their lives. Over 10 years or so – the life of the average fund based on a partnership arrangement – these changes could be substantial. Trends in the composition of UK listed companies in the leisure sector are a case in point. The large groups in this sector have nothing like the same structural composition among their subsidiaries as they had five years ago. This tendency also goes some way to explaining the difficulty that venture funds have in completing successful and prolonged investment forays into the high-tech field. The typescript for this book is being wri�en on a computer that no longer accepts (directly, at least) two of the forms of recordable mass-storage media that were most popular only three years ago. In a fund of normal duration, any investment in a start-up that had sought funds to build a factory to supply the strong demand that existed at the time for those forms of recordable media would have been an absolute loss by now. VCs have as much difficulty as anyone else in keeping up to date with changes in technology, despite the advice that they can draw on from all sorts of sources and that they tap into during the period of investigating proposals. You do not have to look very far into the public record to find details of some of the problems with high-tech 80

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investments – the dotcom boom provides plenty of examples not only of market misapprehension but also of technological ignorance. Above all, in operating a fund with a limited cycle of life, managers have to be careful not to be caught flat-footed at a crucial period – for instance, when they are about to enter a period of raising further funds – by the well-publicized failure of an investment that formed a cornerstone of their investment strategy. Consequently the appetite for risks that the fund may have displayed at a point two or three years into its existence may have been only very brief and may not be repeated.

HORSES FOR COURSES The implication of these factors for businesses pu�ing forward proposals for investment is that they should seek to find out as much as possible about the funds that they would like to approach before commi�ing effort to preparing a detailed presentation. Horses have to be chosen for courses. This means that it is no use, for instance, approaching funds that are aimed at areas distant from the proposal. These areas, as should have been discernible from the details of the factors that affect funds’ strategies dealt with above, are as follows:  the size of the deal;  the market sector; and  the uniqueness of the opportunity. It would be futile, for instance, to approach a very large fund used to doing multimillion-pound buy-outs and cross-border deals – like Cinven or Apax Partners, to name two – with a proposal to invest £250,000 for the modernization and development of a clothing manufacturing business based in the Midlands. Three factors would be against anything happening: first, the size of the deal would be too small; second, the sector would probably be of only limited interest; and third, the opportunity would probably be insufficiently distinctive for the fund’s interest to be engaged. There are lots of clothing businesses in the Midlands, and for a fund to become interested the proposal has to suggest something pre�y radical is going to arise as a consequence of the investment. Simple modernization and 81

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development of a business are unlikely to offer the calibre of return a big fund would expect to see. The natural first port of call for such a proposal would be a locally based source – perhaps a business angel whose local or specialist market knowledge about the possibilities that such a deal might bring about would make it an a�ractive proposition. Perhaps for a slightly different proposal – involving the rationalization of a local sub-sector of productive capacity through the modernization of one business, which would result in the eventual acquisition of others – then a local fund might be an appropriate first call. If a requirement for considerable follow-on funding could be foreseen then a larger development capital fund might be a suitable fund to approach. The progression of types of fund that might be suitable funding partners becomes clearer as the purpose to which the funding will be put is be�er defined.

FROM THE FUND TO THE INDIVIDUAL – BACKGROUND AND EXPERIENCE Venture capital fund managers mostly fall into one of four or five types, in no particular order of priority:  ex-3i staff;  ex-bankers;  MBAs;  those qualified by experience (QBE). There are four categories there. The fi�h is that all the types listed above can also be accountants, who as individuals are the largest single population of venture fund managers. The fourth category of managers, those qualified by experience – experienced business executives who have found themselves involved in the running of funds almost by accident rather than as a planned career move – is increasingly thin on the ground as the old guard of pension fund managers, who led the British venture capital business in its infancy, comes to retire. Also comparatively sparsely sprinkled 82

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through the ranks of venture fund executives you will find a few scientists, some engineers and possibly some lawyers. Increasingly, funds will recruit only from the ranks of individuals who have some business experience – both to cut their own ‘educational bills’ as they support staff until they have the experience to evaluate an opportunity or complete a deal, and to ensure that the people that they entrust with doing deals are seasoned and mature individuals. Business angels are a separate bunch – mostly successful entrepreneurs or sometimes well-paid and retired or semi-retired corporate people who are now able to indulge their craving for adrenalin rushes by investing directly into businesses. Among the larger funds, the partners and senior managers will have many years of experience, will have a�ended many completion meetings and will be very able board members. Moving down the pecking order in large funds there will be progressively less experience in all these areas. However, in the smaller funds there is likely to be a more even distribution of experience among the staff, as everyone takes a hand in performing all the tasks required – initial appraisal, investigation, negotiation, completion and monitoring. Some funds – 3i in particular – have a policy of farming out nonexecutive directorships to third parties. This is done to allow the fund managers to concentrate on doing deals. Other funds take the view that everyone’s interests are be�er served if the executive doing the deal stays with it throughout its time in the venture fund’s portfolio – the company has a face familiar to it at board meetings and the investment executive gets valuable experience in monitoring, which feeds back into the next deal. Smaller funds may also find the nonexecutive fees a valuable source of income, which will support the beneficial experiential effects of having one individual look a�er the investment from appraisal to disposal.

FUND REMUNERATION Venture capital fund managers running a limited life fund take their pay by appropriating a small percentage of the total assets under management as a management fee. They also usually receive an incentive payment by sharing in the profits that the funds make. Sometimes this occurs as individual investments are realized and sometimes at the conclusion of the fund when the overall return can be to�ed up. 83

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The former case favours the managers substantially, as they get to keep part of the profits of each deal (assuming that profits are made) both earlier and without ne�ing off losses on some investments against profits on others. This participative return may or may not require the managers to invest their own money into the fund or to ‘co-invest’ as part of the cash received by the individual.

Investment by fund managers When UK venture funds were in their comparative infancy in the early to mid-1980s, opinions about whether to allow managers to participate were very varied. One school of thought said that managers’ minds are concentrated if they invest their own cash, and investment returns are likely to be be�er. Another school of thought suggested that coinvestment produces inescapable conflicts of interest that may result in good money being thrown a�er bad as managers use the greater resources of the funds’ money to rescue deals that they would kill if they had nothing of their own invested. A third school said that giving the manager a free ride is wrong and that there ought to be some cash outlay on the manager’s part. Still others tried to get over the conflict-of-interest problem by requiring the managers’ money to be invested blind in all the deals that the fund undertook, while some allowed managers to cherry-pick according to their ability to invest. ‘Carried interest’, as the practice is known, became something of a nightmare to sort out and caused quite a few problems between fund mangers and investors and occasionally some resentment among invested companies, which o�en thought that they were being forced into deal structures principally for the benefit of the managers’ ‘carry’. The regular haemorrhage of staff from 3i (which did not initially have a carried interest scheme and then ran one in only a small part of the business – which caused some internal resentment) was partly brought about by the business taking the decision to shed staff who did not fit, and partly by an exodus of ambitious staff seeking the crock of gold represented by the ‘carried interest’ available to partners in the many private funds that were starting up. Now, while the precise impact of the rules for each fund will vary, the arrangements that were most ostentatiously generous to managers have been smoothed out. The managers of most venture funds will

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benefit to some extent from the increase in value that they achieve for investors, but not to the levels that once existed for some funds. Business angels of course have no such side benefits – unless you count the tax breaks that they get. All the money that they are pu�ing in is theirs from the outset – real and at risk.

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7

The mechanics of doing the deal

Debt, n: an ingenious substitute for the chain and the whip of the slave-driver. (Ambrose Bierce, The Devil’s Dictionary)

 The process step by step  The business plan  A�racting a funder  The three Ms  Employing professional advisers  Selecting an investor  Deal negotiation and evaluation  The negotiation in detail  The preliminary offer 87

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Investment funds all have slightly different ‘house styles’ – particular ways of doing things that they regard as the correct way. There will be slightly different processes and procedures for each stage of the investment, according to which investment house does the deal. But some features are going to be broadly similar, and this chapter sets out the way that a typical investment process will probably run. It will also, first, give some insight into the things that the investor wants to see; second, set out what actually constitutes the process of the investment as conducted by the investor; and last, give an indication of the timescales involved. But, whatever happens, taking on an outside investor is going to be a bit like being in bed with an elephant – it is going to take most of the bedclothes.

STAGES OF THE PROCESS In broad terms, the critical path for the deal will be as set out below: 1. determination by the potential investee that cash is required for expansion, development, buying out existing shareholders or whatever; 2. preparation of a business plan and funding proposal; 3. initial approach to an investor; 4. investors’ preliminary (probably desk-based) consideration followed by investigation (meetings and visits); 5. preliminary (indicative) offer le�er – now known almost universally as the ‘term sheet’; 6. discussion of terms internally by the applicant; 7. acceptance of the indicative offer; 8. ‘due diligence’; 9. study of results of due diligence, and indicative offer confirmed or modified; 10. investment commi�ee proposal (VC), and indicative terms approved, modified or rejected; 11. issue of full offer le�er (subject to legal stages) by VC; 12. formal acceptance of terms (subject to legal stages) by investee; 13. legal stages, which are, first, meetings between the VC and the VC’s lawyer to dra� the legal agreement, then meetings between the company and its lawyers to consider its reply, and finally a series of meetings between both parties to hammer out the differences 88

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between what has been offered and what will be accepted and agreed; 14. completion meeting – held at the offices of the VC’s lawyers; 15. new investor joins the company (and probably the board); 16. everyone lives happily ever a�er. The time taken to complete the deal could be anywhere between three weeks (which is about the fastest I have known a relatively straightforward competitive deal take) and well over six months. The principal choke points in terms of the time taken are: 1. finding an investor who will take on the deal; 2. the due diligence stage; and 3. the legal stages – which can be as long as the bloody-minded choose to make them. Entrepreneurs will have to take into account the variability of timing when they prepare their business plans. There is no point in preparing a business plan that requires its crucial component to be executed in three weeks’ time if the investors cannot be galvanized to complete the deal for at least three months.

THE BUSINESS PLAN The business plan is the primary tool by which investors are a�racted to a business. As such it is more than simply a cash-flow statement, balance sheet or profitability statement; it also has to describe the business and the management philosophy behind the business. It must also indicate to the investors how they are likely to obtain an exit. (Some venture capital funds are now using ‘electronic filing’ of preliminary business plans, and these are skeletal in comparison with traditional submissions. This practice is not yet widely used, but may become more prevalent.) The usual headings for a complete business plan are as follows, although the exact structure is a ma�er of style rather than substance:  a short description of the business – including the purpose of the investment and the likely exit route for the investor – in summary;

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 a brief history of the business;  the current marketplace and trading conditions;  competitor analysis;  prospects and plans for the future – descriptive analysis crossreferenced with figures as an appendix, including how the investors (all of them) can expect to realize the value of their investment;  funds utilization (in detail);  senior and key personnel (including brief biographies as an appendix);  figures (best confined to an appendix): three years’ past performance summarized and against budget; the current year’s performance and budget; expectations for the next three years broken down by budget; cash flow; profit and loss; balance sheet. All this should be disaggregated into reasonable detail – for instance, by operating company or division if the company has them, or even by subsidiary company if the business has a group structure. The plans should also give a range of likely outcomes depending on variability of key market conditions – these are sometimes called ‘sensitivity scenarios’. The maximum length for a business plan intended to secure an investment negotiation should be about 20 pages, excluding appendices. One thing that entrepreneurs should not be tempted into doing is writing reams of description. It is far be�er just to pick out the salient points – making sure that all of them are covered – and leave some more information to be communicated during discussions and the ‘due diligence’ stages. The key point here is about the psychology of doing deals. Most investors will be put off by the sheer size of the task of absorbing huge tomes of documentation with vast spreadsheets of financial information; they will want to be able to know that the basics of the business can be communicated quickly. They cannot afford to devote the energy required to all the details of the business at the outset. They want to be able to judge quickly if it is worth their while to pursue the deal further. With lots of other potential deals clamouring for a�ention (any one of which just might be the deal of the century, which if they do not reach it fast enough someone else will snaffle), they cannot afford to spend long hours reading through a business plan. 90

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The next most difficult thing to do, once you have completed the business plan, is to find an investment house that will take it seriously and devote time to giving it the a�ention that it deserves. This is not meant as a gratuitous insult to venture capital houses – so many proposals come in to the big houses that they have to be ruthless in their initial si�s through what they think they might take on. If they behaved any differently they would be accused of taking an inordinate amount of time in considering proposals before rejecting them – which they sometimes do, anyway. What this rapid si� means is that proposals that apparently do not fit their criteria immediately will get discarded quickly. Remember also that the chances are that in a big investment house the initial si�s will be done by the more junior members of staff, who may not have the experience to recognize a good proposal immediately when it pops up. So you have to make your proposal stand out in some way. Coloured paper, jazzy covers and outrageous typefaces are unlikely to work. You have to sell your business by making the investor want to read more straight away. It is probably best to send your business plan to the venture capital house, with a covering le�er, a�er an initial phone call, so that you can find a named individual to deal with.

ATTRACTING A FUNDER The key features of the business plan that will a�ract a funder are:  Clarity of purpose (and presentation) – knowing what you want to do with the business and being able to describe it clearly.  The three Ms: –

Management capabilities.

–

Market a�ractiveness.

–

Mathematics, or a suitable rate of return within a suitable period of time; IRRs of less than 25 per cent are unlikely to prove very a�ractive. This means that your business (and the investor’s share of it) has to double in value every three years – a pre�y stiff test that not many businesses can meet.

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 Suitability to the investor’s portfolio requirements. Some of these features you can determine, but you cannot tell whether investors in the development capital field have a portfolio balance within their fund between the food processing and plant hire sectors.  Reasonableness – in terms both of the likelihood of the plans being achieved and of a fallback outcome in the event that the initial targets are not met.  Flexibility – the adaptability of the proposal to a range of investment instruments.

EMPLOYING PROFESSIONAL ADVISERS By all means employ advisers for their technical contribution to the proposal that you want to send to the VCs, but limit them to exactly that, a technical contribution, at least initially, and resist all blandishments to do otherwise. Outside lawyers and accountants have their proper place in the funding process, but be wary of employing them too early, because:  costs will sky-rocket (certainly);  time taken to do things will extend (probably);  tempers will shorten and harmony between the management team will unravel (possibly). The professionals will want to impose their ideas on the structure of the deal, which may be wrong as far as the investor is concerned: all investors have their own ideas about how to do deals. However, that having been said, many funds do now rely upon firms of accountants, particularly, to pre-package deals to some extent. Venture houses with an established relationship with accounting firms will know that the initial assessments, which they will otherwise have to perform themselves, will have been completed satisfactorily and so they can proceed on the basis that the proposal is likely to be a sensible one. But beware of giving the deal over entirely to a packager. Investors will want to hear you – not a professional mouthpiece – speak about your business if they are to gain a proper appreciation of the potential for the investment. 92

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And there is one very important point to be observed in engaging an accounting firm to help you with the deal. Under no circumstances think that you can substitute an outside accountant for a finance director. You may think that it may not be absolutely necessary to have a finance director (although most venture capital houses will want the comfort of one), but unless your business is very small (that is, at the start-up stage) then it is very unlikely that you will see a completed investment without one. You will probably find it best to use your accountants or firm’s lawyers to guide you to a suitable range and number of potential investors whom you might approach. Beyond that, you may find that it is best to approach the fund a�er an initial introduction to the proposal has been made: do that with them accompanying you and then proceed by yourself until the time that you need technical advice on tax ma�ers or other financial implications. You must be very careful not to lose control of the deal: don’t let the professionals a�empt to hijack the deal and do it for you.

SELECTING A POTENTIAL INVESTOR Realistically, deals are usually done with the investor who offers the best terms. As far as most companies are concerned, this usually means the greatest amount of money for the least amount of equity. But there are other factors that should enter into the consideration. By a�racting outside finance to your business you are doing more than preparing for future growth in the value of your business – you are taking on a very powerful outside shareholder who will want to exercise a very substantial degree of control over your business and will expect that it is run in a very specific way. Failure to achieve these objectives (or agreed alterations to them) will result in sanctions being exercised – and these will be only to your detriment. It is of great importance that you and your fellow managers recognize this and consequently that you select a funding agent with whom you share, in considerable detail, both an overall objective and a similar outlook on what might be described as the ‘character’ of the investment. This means:  selecting a funder who has some experience of the sector you are working in; 93

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 selecting someone who at least professes a fairly robust a�itude towards the legitimacy of business plan forecasts;  if you anticipate further rounds of funding, selecting someone who can either supply this or will take a constructive a�itude to having his or her investment diluted;  ensuring that there is a degree of personal empathy between you and the investor (or the investor’s representative);  understanding from the outset the intentions and aspirations of the investor – which will be different from yours;  understanding that there is no overall congruence of views between you and the investor about how things might be done;  being clear (mutually) as to the timing of any eventual exit and the need for an opportunistic a�itude to realization before the initial target date. Disregard any protestations on the part of investors that they are long-term players who will place no pressure on you to realize the investment before you really want to. All such statements should be accompanied by the disclaimer that this will hold good only if no a�ractive offer comes along within five days of completion and all targets are achieved on time, on budget and without further funding calls. As well as all these considerations, there is another good reason for selecting carefully the venture capital house you approach. If you do not take your proposal to funders who are competent to deal with it, then they will reject it. Having your proposal turned down will be a blow to your morale. It will also waste your time and get your deal the reputation of being tainted since it will have already been turned down once by the time it gets to an investor who does want to handle it. One of the first questions most VCs will ask is whether the deal has been seen by any other venture capital investor: among other things they will be trying to benchmark the degree of interest in the proposal as a means of filtering their own workload. The venture capital grapevine is very effective, and reputations are jealously guarded – word of what deals are being done gets around very quickly. No one likes being thought of as a fool for taking on a duff deal and, in addition, the herd instinct is very prevalent among venture capital investors, as it is among all investors. Once your deal 94

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or proposal enters the system you should act as if others will rapidly learn about it – either locally or nationally (depending on the size of the deal). You will waste your time and nibble away at your standing as an effective manager in the VCs’ eyes by taking your proposal to the wrong funding source. The information about who is interested in what types of deal and industrial sectors is quite easy to find. Established venture capital houses in the UK belong to a trade association called the British Venture Capital Association, which publishes a handbook of members. Specific funding interests, deal size thresholds, recent and notable past deals and industrial specializations are all identified. By looking through this you should be able to identify some venture capital funds that are interested in your business area or type of deal. If the amount of funding that you are seeking is less than the threshold level of the BVCA members, you will have to try for business angel funding or one of the smaller regional funds, which are more catholic in their tastes – since they cannot afford to be picky industrially if they specialize regionally, they do not specialize. Nor do they have the cost base that means that they have to specialize, so they are usually very flexible in their preferences. Business angels are now increasingly organizing themselves into networks, o�en affiliated to Business Links or local universities, where they collaborate on deals. Such arrangements offer the advantages of shi�ing alliances between members to cater for different types of deal and risk profile. One of the considerable advantages of raising money through local deal doers is that they are generally well known to the local business community. Where you know someone who already has a venture capital investor on board, then seek out that person’s advice about the skills that the angel has brought to bear and the process of doing the deal. If you have the time and the expertise you can also use local newspaper archives to help you get some sort of feel for the investment style and preferences of local business angel networks. Most regional newspapers have now put their back issues on the internet, so a halfday spent trawling through the archives may pay dividends when it comes to approaching an angel. Nor should you be coy about asking the angels about their particular expertise and experiences – entering into venture funding is a partnership of sorts, a�er all is said and done, and it would be a dereliction of your duty to your business if you did not want to investigate the provenance of a new business partner. Astute angels 95

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will be looking for such an enquiry and will probably see the lack of such questioning as a failure of perception and the normal shrewdness that they would expect to see in business people who intend to take such a large step.

DEAL NEGOTIATION AND INITIAL VALUATION The investigatory process A good venture capital house will respond to your initial information pack within a week, but it is unlikely that you will see completion inside two months unless the deal is very perishable or very exciting. The corollary of this is that you must not wait until your need for the money becomes desperate before you enter the process. A likely timetable will go roughly like this: 1. Send in the proposal (it may be wise to ask for receipt of delivery). 2. (Wait.) 3. Initial interview with the investor. 4. (Wait.) 5. If successful, an initial visit to the business by the prospective investor for the purpose of physical site inspections, ‘tyre kicking’ and senior staff introductions. 6. (Wait.) 7. A second visit to explain the detail further – usually to go over financials or elaborate on areas not completely covered or understood in the preliminary interviews. 8. (Wait.) 9. A possible third visit – picking up further detail. 10. (Wait.) 11. Possibly an illustrative deal without prejudice to the investors’ position, or a polite refusal. 12. You reply – but only a�er consulting your professional advisers about the impact of the terms on each member of your team and the business overall. (Points to note: you should employ only one set of lawyers; costs start to rack up a�er this point; and this is the point at which very robust and flexible planning is required to ensure that the business keeps running on track.) 96

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13. Wait while the investors consider your suggestions – and probably ignore them. 14. Possibly two or maybe even three months will have elapsed by this time.

The negotiation process in detail Part of the investigation process in determining the a�ractiveness of the deal will be concerned with the broad terms of the deal that you would like to secure. You should have an idea of the structure of the investment that you would like to see coming into your business and you should be ready to discuss this with the VC – but only at an appropriate opportunity: most VCs will want to be in the driving seat as far as structuring the deal is concerned. You must go into the deal-doing process with an idea of what your business is worth and a feeling for the amount of dilution of your own holdings you are prepared to accept. But you must also be prepared to be flexible. It is very unlikely that your valuation of your business and the VC’s will meet straight away (if ever). This is especially the case with early-stage deals or where subsequent rounds of funding are obviously going to be required. The VC will be thinking both ‘dilution’ and ‘realization’, with suitable caveats for both processes and a fall-back valuation in the event that the market does not pan out as expected and/or targets are missed. Not surprisingly, the VC’s perception of the risk–reward profile is probably going to be quite different from yours. The final point of consideration is always the amount of equity you have to give away to get the money that you need. Individually, investors – funds or angels – will shy away from taking majority positions in companies, since they do not want to become owners of subsidiaries. The use of preference shares by venture funds, instead of ordinaries, helps them do this of course. By not owning ordinaries they avoid the accounting burdens of ownership. Collectively groups of investors (‘syndicates’) may be happy to move over the 50 per cent mark (on conversion for funds or in ordinary holdings for angels). If it is a fair bet that the company will need additional funding before you move to a realization of the investment, think very carefully about the headroom that you may need, on top of the share of the company being carved out now, to allow another round of funding to proceed.

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THE PRELIMINARY OFFER The terms of the preliminary offer will not be fixed: they will be subject (as a minimum) to what are called ‘conditions precedent’, as follows:  ‘Due diligence’ – to cover, as a minimum: –

working capital verification (at some specified future date);

– tax computations; – review of accounts, both statutory and annual up-to-date; – review of forecasts; – verification of physical assets and intellectual property; – investigation of any outstanding legal actions or county court judgments, records, etc.  A catch-all clause about the investee company having an obligation to reveal information material to an investment decision (thereby catching all shareholders as well as management).  Accountants’ investigation (see above under ‘Due diligence’). NB: the costs of this exercise will always be borne by the potential investee, and this will not be a negotiable point. You must allow for this in preparing your budgets for the exercise.  Investment commi�ee approval.  Other ‘conditions precedent’ – for instance, the negotiation of satisfactory bank finance, the resolution of any property issues, confirmation of ownership of intellectual property, and so on. The final offer le�er, which may be dispensed with entirely in favour of proceeding direct to legal stages, is unlikely to be offered before the investment commi�ee confirms approval for the deal. It will usually contain the following principal terms, much of which is repetition of the first term sheet; it can therefore be regarded as a revision and reissue of the term sheet:  the amount of the investment;  the purpose of the investment; 98

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 the vehicle by which the investment is to be accomplished;  the share of the company that the investment is to command;  the components of the investment – the amounts to be held in ordinary shares, convertibles, preference shares and so on;  the amounts to be invested collectively and separately by the existing managers of the business;  whether there is any form of ratchet mechanism that will redistribute shareholdings in the case of under- or overperformance;  board representation ma�ers;  costs to be borne by the investee – this will involve both accountants’ reports and legal costs;  anticipated realization dates and intentions;  interpretation of jurisdiction – this is particularly important where there are Sco�ish subsidiaries because of the differences between Sco�ish and English law over ma�ers of contract. The offer le�er or term sheet is usually in duplicate. One part is retained and one part is signed by the addressee (or the company’s responsible officer) and returned, signifying acceptance of the terms. There is usually a deadline a�er which the terms no longer hold good. Most VCs consider it extremely impolite for recipients of offers to exceed this deadline.

FEES Some years ago, some venture capital houses used to seek to lay off all their costs of investigation and deal doing on investee companies; it is still the practice for some European venture capital houses to charge a deal fee as well. In the UK, fees have begun to reappear and are mostly charged to defray the cost of commercial investigations commissioned from outsiders and to cover the cost of accountants’ investigations. Since you are paying for these you should be able to negotiate a cap for them and to be given a breakdown of how the total is built up. If you are dealing with a BVCA-affiliated member, there are codes of conduct that govern the way they deal with potential investees and charge fees. 99

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You can obtain these from the BVCA – see the BVCA handbook and the website. The amount of funding to be offered, together with the proportion of ordinary shares to become the property of the VC, gives the valuation of the business. Or it should do. But when deals involve a number of instruments (the reasons for this have been covered earlier), calculating the value of the company becomes more difficult. If you find it difficult to work out how much the business is being valued at, don’t be afraid to ask the VCs to lay out the method of valuation. You probably won’t be able to challenge the basis of the calculation, but it may help you to understand the platform that the VCs are working from. It will be very unlikely that you will get a renegotiation of the value of the business at this stage from a venture capital house, since the IRR calculations will have been performed fairly rigorously before the offer le�er is sent out. Portfolio managers will have had to meet guidelines for projected rates of return, which they are probably unlikely to want to go against, since it would jeopardize their chances of ge�ing approval from their investment commi�ees. They will also be holding back a li�le in anticipation of structural reversals during the detailed legal stages of the deal, so that they can ‘give away’ some concessions and avoid beaching otherwise commercially good deals on the rocks of legal inflexibility. Business angels have no such investment commi�ees to which they have to report, and the decision to invest is probably more intuitive. They can afford to be a li�le more liberal in their valuations, so you may get further there, but don’t push so hard as to turn the deal away if everything else fits. If you don’t like the deal you are offered full stop and you really think that you can a�ract a be�er deal, then look for another investor. If one party thinks you are good enough then the chances are that someone else will too. And remember the words from earlier in this chapter: since you are going to be in bed with an elephant you might as well make sure you get a friendly one.

‘DUE DILIGENCE’ This phrase will crop up very quickly a�er you embark on the search for venture capital. Originally occurring in a US legal judgment describing how professional investors should act, it has now become 100

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an (ungrammatical) shorthand for the process of checking and investigating all the details of a potential deal that has to be undertaken by the VCs and their agents. ‘Due diligence’ investigations will therefore encompass the following areas:  financial records of the target;  financial projections of the target;  market information;  competitor analysis;  physical assets – particularly where there is a heavy property component to the deal;  any outstanding obligations to pension funds not covered elsewhere – particularly a�er recent significant problems in some very prominent high-value deals;  intellectual property;  legal title to assets;  management suitability. Not all of this will be done before a preliminary offer le�er is issued. In fact the bulk of the investigation is done a�er the target is on the hook (having accepted an indicative offer) and is therefore liable for some of the costs of the investigation. Almost all of the investigation of legal title and intellectual property will be done during the legal stages – when the detail of the agreement is se�led. Much of the basic information on markets and management is provided by the potential investee. The amount of further work that is done depends largely on the size of the deal: more money at risk in larger deals probably means more investigation. Riskier (earlier-stage) deals will probably also require more a�ention to detail in order to get them past investment commi�ee scrutiny. Investors will o�en ask for a pending audit to be brought forward to provide further comfort on financial information. Alternatively, a mini-audit concentrating on working capital items may be requested. Both these actions will be undertaken at the expense of the investee company.

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8

Seeing the finishing line

Decide, v.i: to succumb to the preponderance of one set of influences over another set. (Ambrose Bierce, The Devil’s Dictionary)

 The purpose of including the exit – at the outset  The major types of exit reviewed  Factors to avoid in presenting the reasoning about a route out  The dark side – exits not to be mentioned in polite company Sticking a chapter about exiting from an investment in the middle of a book like this may seem a strange thing to do. Logic suggests that it surely should go at the end. But there is a sensible reason for apparently pu�ing the cart before the horse. In seeking outside funding, as in most areas of business, it pays to have an idea of where you want to get to before you start. Knowing what and where your objective is offers the easiest way to plan out a suitable path. 103

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For almost all investors the only objective of investing large(ish) amounts of money directly into companies that will be run by other people is to make a return on the deal far be�er than they can make in the stock market or the building society. The whole point about venture investing is that these deals offer very substantial rewards if you get it right. But these rewards are only available because the a�endant risks are higher. Investors in the stock market can usually find a buyer at some price for the shares they have bought, even if it means taking a bit of a bath on the original purchase price. If things appear to be going wrong in a quoted company or even if investors just get cold feet, there is usually a buyer somewhere who will take the shares on. Venture investors do not have that benefit. Once they are in, they are in; the investment has to work pre�y much according to plan or the investors will probably lose their money – most if not all of it.

STARS AND BARS To put this danger of loss into context, out of a portfolio of 10 investments, the average venture fund might see something like the following pa�ern in its investments:  One or two will collapse through bad management or bad luck.  Three or four will underperform badly so that they just hang on by the tips of their fingers.  A couple will perform just above expectations.  One or perhaps two will be real stars. These star performers have to support the losses that are likely to be made on the rest of the portfolio. Somebody once said that the trouble with the job market is that companies advertise for labour but then get people. By the same token, VCs set their caps at investing in winners – but more o�en than not they take on trouble. Chapter 6 identifies that, all other things being equal, investors will invest in an opportunity where they perceive there to be less likelihood of their money being lost. Venture investing – far from being about taking risks – is largely about structuring deals so that 104

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risks are minimized. While expert investors will make their own minds up about the risks that the investment will face, they may need some expert advice about how the investment will be realized. That is where the entrepreneur can exercise some leverage over the shape of the deal that is struck. It follows from this that one of the highest-priority features of a proposal that will commend an investment opportunity to a venture capital funder is a statement of how the entrepreneur thinks the business will achieve its realization. So much is this the case for some investors, such as business angels and early-stage specialists, that having a good idea of how the investment is going to be realized is almost a prerequisite of entering the deal. This is especially so if more money than is currently being negotiated will be required to see the maximum potential of the business exploited. This o�en happens in early-stage financing opportunities. For other venture funders, like sector specialists or those who concentrate on providing mezzanine finance, the identification of an exit route will be a useful way of understanding entrepreneurs’ intentions and gauging both their apparent commercial acumen and their financial sophistication.

THE MAJOR ROUTES OUT The structure of the business plan and what it should contain was dealt with in Chapter 7. But for the purposes of this chapter we need to make it very plain that, at some early point in the document, entrepreneurs should write into the business plan what they think the likely route for investors to get their money back will be. Normally the choice is limited to one of the following three options:  a sale to a third-party investor;  a flotation on some form of stock exchange; or  a purchase by a trade competitor. In deals involving very large businesses, which throw off lots of cash, it may be possible for an investor to get paid back out of cash flow if the structure of the deal is right. This might happen through some form of refinancing of, say, redeemable shares by a third-party bank 105

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or another investor. But these are comparatively unusual methods in the run of realizations. Most realizations are brought about through market-based transactions rather than through what might be called ‘internal’ pay-offs. The statement about the exit that is incorporated in the business plan should be made without the tone being too evangelical or dogmatic. It must be remembered that comments about the likely exit route are predictions and not facts. The suggestion of what the outcome might be is best seen as a contribution to the shaping of the deal that is to be done. It is not a forecast of what must happen, since the purpose of making the suggestion is not to dictate exactly how the investment is going to be structured but to help identify what issues need to be considered in developing a suitable format that will best serve the likely outcome.

THE P/E TRAP One thing that should certainly never be included in the discussion about a realization is any prediction of the price/earnings ratio (P/E) that the business will exit on. There are four powerful reasons for this:  First, it is not the job of the entrepreneur to predict P/Es that might be applied to determining the exit value: that is the job of the investor. The entrepreneur should concentrate on maximizing the value of the business.  Second, any rubbishy old business can be predicted to make an outstanding return if the exit P/E is high enough. This sort of dressing up of a poor proposal won’t fool an expert investor.  Third, VCs will have a be�er idea of what P/E might be applied anyway. If entrepreneurs have included what they think is a likely P/E in the business plan, which happens to be lower than the one that investors would have put in, then it is a brave investor who will pitch his or her own estimate higher. In consequence investors may discard the higher P/E they would have employed (to the detriment of the entrepreneur’s case) in the absence of the suggestion. If investors don’t do that then they might have to justify to their investment commi�ee why they think a higher P/E 106

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should be applied than that which the entrepreneur speculated. Few investment commi�ees will be able to follow that line of reasoning.  Last, any such prediction, whoever makes it, will almost certainly be wrong. There is not a human being on Earth who can accurately predict P/Es three years out. For the entrepreneur to try to do so will merely invite justified ridicule. Quite simply, company managers who try to look clever or sophisticated by predicting P/Es end up looking both stupid and cocksure, confirming to the potential investor his or her suspicion that they really don’t know what they are talking about. In comparison to the value achieved on an exit, it is certainly more reasonable to predict the likely route out. Aside from expert knowledge about how the developed business will fit into the structure of the sector – knowledge that entrepreneurs in an industry are likely to have – the managers of a business seeking to develop itself into something bigger and be�er may well know of a competitor or complementary business that would find the acquisition of such a company to be a�ractive. There are a number of other special situations, too, where applying a P/E ratio might be counterproductive but indicating the exit will be helpful. Sometimes venture capital investors beat an industrial investor to the punch in buying a business – so there is a disappointed bidder waiting in the wings for a deal to be offloaded in due course. Once the hard work of growing the business further has been accomplished with the venture money, the previous suitor still finds the target a�ractive. Sometimes a venture capital deal can outbid the potential a�ractiveness of a flotation (the Saga business was secured in mid-2004 by a consortium of venture investors in this way). The large VC funds can offer a quick cash-on-the-nail deal instead of the protracted managerial agony of a flotation, with its endless verification meetings and protracted legal and accounting investigations. Purchases like that are usually taken with a view to a later and even bigger flotation, of course. But outside either of these possibilities there is usually li�le concrete reason to believe that any of the outcomes listed at the start of the chapter are anything more than aspirations. Business is a game of chance. Sometimes the odds can be lessened but it is not a game of certainties. So it is best not to be too dogmatic about the likely exit route. The most likely should be identified as exactly that – the most likely, not a certainty. 107

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REASONS TO BE HELPFUL, PART 1 Only three exit routes were listed above because, generally speaking, they are the only ways that a (successful) realization can be obtained. But there are a few others that might crop up. Aside from the cash buyback, which was dealt with as a structured possibility, there are two or three possible subclasses of sale. First, a management buy-out of the first investor might be possible in a deal of limited size. Or, second, a sale to another professional investor at a profit for all concerned is sometimes a possibility for deals from modest to medium size. Last, a share exchange in an acquisition by another company is a possibility for companies of all ranges of size. But these outcomes are likely to be too detailed to speculate upon at the stage that the first investment is being solicited. As a result of that, they should be discounted as deal-structuring possibilities towards which to work. The three broad categories first listed are likely to be the safest to incorporate in making suggestions about how the investment might be realized. Protestations of undying love aside, such as those that are made in completion meetings, the professional investor is looking for an opportunity to effect an early exit almost as soon as the investment has been made. This will be the case, particularly, with a development capital deal, where it is the imminent maturity of the business that makes the deal a�ractive to the VC in the first place. This fast track to a developing market will also make it a�ractive to someone else. Think of it this way – fast cars get lots of admiring glances; old clunkers do not. If the price is right, the professional investor will take the money and bale out – completely unsentimentally and perhaps almost as soon as the ink is dry on the completion cheque. Therefore for the investor to know that an entrepreneur has recognized that the business is only a way of creating wealth is a plus point when si�ing through which deals are worth pursuing. Quite bluntly, as far as the VC is concerned, it means that there will be so much less education to be done in encouraging an entrepreneur to think of the business as a means to an end rather than an end in itself – as must sometimes be done with entrepreneurs who have nurtured a pet business idea through thick and thin. The second good reason is that entrepreneurs pointing out the way that the deal might end, using the specialist industrial sector know108

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ledge that they might have, will place some of the initiative for the forthcoming detailed negotiations about deal structuring on their side. This credit balance may be short-lived – perhaps only very temporary – but if used properly it can be a useful foundation stone on which to consolidate further gains that will work to the benefit of the management team, as opposed to leaving all the initiative to the investor.

REASONS TO BE HELPFUL, PART 2 There are supplementary benefits to the business itself in thinking about the exit. First, it will help funders concentrate their ‘due diligence’ research on the likely exit areas. By knowing what the key commercial or technological points of a deal are, potential investors will know where to concentrate their investigative resources (necessarily limited by time, at the very least) in order to get the best payback in information. In making their minds up about what to look at, they will be probing the potential weak spots of the proposal. Pointing out where these are (and there are bound to be some) will help investors to eliminate uncertainties from their list of concerns, thereby helping to reduce the perceived risk in the deal and making the chances of a successful investment stronger. Second, it will mean that the time spent in investigating the deal is shorter and the cost will be reduced. As the company or the entrepreneur will have to pay for the investigation, this is a worthwhile consideration. Last, it may also help determine a shi� in the structure of the deal towards simplicity – perhaps for ease of unwinding at an early opportunity. Deals that may be anticipated to end in one particular way – a simple trade sale, say, at some reasonably well-defined point – may well be formulated in a way that is less complicated to unravel than those where the long haul has to be provided for, with performance ratchets (of which more in Chapter 12) or fall-back provisions for further funding and so on. Simpler deals are less difficult to negotiate and mean smaller legal fees. Simpler structures also reduce the investor’s perception of the risk a�ached to the deal. At the very least, entrepreneurs will do themselves no harm by indicating that the thought processes for an end game have been started 109

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early on in the process. I have already suggested that a completed game plan indicates to potential investors a degree of commercial savviness on the part of entrepreneurs. It shows that there is a strategic bent to the management’s thinking and that they are aware of the skills required to manage a business that will grow beyond its current size.

THE DARK SIDE It was pointed out at the beginning of this chapter that the average venture capital investor’s portfolio contains far more casualties than it does stars. And the exit routes that have been reviewed so far have all applied to situations where the investment has probably met with reasonable success. For completeness’s sake we ought to mention that other but very una�ractive exit routes do exist, of course. So-called ‘blow-out financing’ and liquidation (voluntary or forced) are the two main possibilities. But these are such highly unpalatable prospects that no one in his or her right mind would advocate them as even remote – still less likely – outcomes. So it hardly needs pointing out that it would not be appropriate to offer liquidation or receivership as acceptable exit routes to investors who are in the throes of agonizing over whether to lay out their money on an unproven speculation! And blow-out financing or more accurately refinancing (which we shall consider in Chapter 15) is hardly more a�ractive. It implies commercial failure on the part of the company, involving as it does, by definition, the virtual elimination of all the existing shareholders’ stakes. To incorporate it as a possible exit route indicates a mindset of failure on the part of the entrepreneurial team. Suggesting at the outset that the management have the intention to raise further funds to take out the investor now being courted, on highly unfavourable terms if things go wrong, will lead at the very least to suspicions of multiple agendas (and possibly multiple accounting!). Being taken out of the deal at a low price (even if not quite at blow-out levels) is a highly una�ractive proposal as an outcome for an investor and, in tactical terms, advancing it as an exit would be pre�y much equivalent to grabbing the starting pistol and shooting yourself in the foot at the start of an Olympic hundred metres. Put it this way: ‘Don’t move or the business plan gets it’ is not a rational negotiating strategy. 110

9

Dealing with existing shareholders (and stakeholders)

Money, n: A blessing that is of no advantage to us excepting when we part with it. (Ambrose Bierce, The Devil’s Dictionary)

 The effects of change  The best structure  Shareholders  Workers  Suppliers  Creditors  The bank 111

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The vast majority of opportunities that are presented to VCs involve existing businesses. Existing businesses have existing shareholders. And the chances are that the introduction of a new investor – in the form of a VC – will have fairly profound effects on the relationships that previously held between the shareholders. In the most extreme case of course – the management buy-out – the previous shareholders disappear entirely and are replaced by an entirely new set. Other forms of investment may involve some shareholders leaving, some shareholders having their rights curtailed, some shareholders being offered terms that they consider disadvantageous, or any combination of those. In general, it will always be best to do a deal that involves the smallest number of shareholders participating in the deal as possible. Much of this chapter will be devoted to explaining some of the problems with minority or ‘residual’ shareholders. The idea is to explain some of the pitfalls of doing deals with ragged shareholding structures, in the hope that prospective management teams will be persuaded to clean up those structures (or at least develop strategies to clean them up) before embarking on trying to raise external capital. The effort will almost certainly be worth it in terms of reduced complexity of negotiations and expenditure of energy during the deal itself.

THE EFFECTS OF CHANGE What shouldn’t be forgo�en is that a change of ownership can o�en have considerable effects on others connected with the business – stakeholders in the jargon – who have some form of interest in how the business is run and owned. So we shall also need to review some of the effects of those parties, too, to see how they might affect – and be affected by – a deal. The management of a rearrangement of share stakes will not usually be undertaken by the incoming VC; it is regarded as the province of the management shareholder(s) to sort out. There are, of course, variations to this rule – in a management buy-out, the purchasing VC may well take a strong position in developing the structure of the new investment vehicle and join with the prospective management in negotiating the change with the prospective sellers. Or where there is a residual stake being held in a business, it is also o�en the case that VCs can assist the negotiating position (since their 112

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own interests will be affected by the outcome) by making an injection conditional on the acceptance of certain shareholding structures. But even in cases where the management side’s collective shareholding is le� to them to sort out, the VC will exercise a veto position over the arrangements that are agreed between the members of the ‘other side’ to make sure that his or her own interests are not prejudiced by anything that they enter into or any side agreements that they conclude between themselves. So dealing with ‘residual’ shareholders usually has to be taken head on by entrepreneurs or management teams. There are a number of ways for such changes in shareholdings to be perceived by those affected by them. For instance, some existing shareholders might be pleased that new resources are being injected into the business (as in a development deal) and will be happy to see their shareholdings benefit from the effects of the cash that is being raised. Others may be dismayed at the draconian changes (as they see it) in the relative balance of power within the company that occur when the VCs take a stake. Some may try to resist the changes that the management team want to effect in the expectation that if they are sufficiently obstreperous then it will be worth the new investors taking them out at an enhanced price to get rid of potential aggravation. As for stakeholders, the workforce may regard the change in ownership as an unmitigated blessing – or fear it as the precursor of investor-enforced ‘rationalization’ that will cost them their jobs. Key suppliers will need to be informed of the change at an appropriate point – although their reactions are likely to be more dispassionate, provided that credit limits are still observed. Bankers may have a variety of reactions depending on the exact nature of the changes that are taking place.

THE BEST STRUCTURE Without a doubt the cleanest form of arrangement will be where it is only members of the management team who will own shares in the company (other than the VC) once the injection has gone in, since then there are no extraneous influences on how the deal is negotiated. Because of this it may be sensible, if possible, to buy out straggler minority shareholders before seeking venture capital, since this will clean up the situation to everyone’s benefit. Sometimes if there is cash 113

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in the business it can be used to purchase the shares of a dissident shareholder if the appropriate powers are contained in the company’s articles of association. That of course raises the question of why, if there is cash in the company, is the business seeking venture capital? The answer could be that the amount available to buy out a shareholder and the amount required to develop the business – perhaps to take advantage of a transient market opportunity – are very different. It may also not be possible for other reasons. In situations like those where a long-established family business seeks venture capital (although family businesses have their own special horrors for VCs: see Chapter 1), because the shareholdings may be widely spread, there may be too many shareholders to convince that they should sell out prior to an injection. Then, even though (perhaps because) the core group of managers may be non-family, it will prove extremely difficult to develop a consensus of opinion on what should be done. The exercise will have distinct similarities to trying to herd cats, in fact. In such situations it may be sensible to change the structure of the deal from what was originally contemplated to one that makes more sense from a financing point of view, in order to permit an easier investment by the incoming investor. For instance, changing a development capital deal where there are ‘residual’ shareholders, not connected with management, to a buy-out deal where the shares are all held by the management team will have the effect of cleaning up the shareholding structure at the same time as concentrating shareholdings in far fewer hands and making the deal easier to effect from the VC’s point of view. This might also have the beneficial effect of bolstering both the deal size and the prospective rate of return. More money would have to be applied to the deal to get rid of the existing shareholders but that would be balanced by pu�ing more shares into the pot from the ‘old’ shareholder and therefore making more potentially available for the new shareholder. In a deal where the rate of return might have been only marginally a�ractive previously, only a small additional slug of equity can have quite impressive beneficial effects on the rate of return if the rate of growth of the company is sturdy. We need to look at the potential reactions of shareholders and stakeholders in greater detail.

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SHAREHOLDERS As outlined above, remaining or ‘residual’ shareholders’ reactions usually fall into one of three categories once the prospect of venture capital injections is raised – support for the change; resigned hostility to the loss of rights; or active opposition. In a case where there are going to be minority shareholders le� in the business, their support has to be enlisted for the approach to VCs before the approach is made. If the support is not forthcoming, then there is no point in proceeding. It would be a fatal error for an investment proposal for a management team to try to induce a VC to enter a business without squaring existing shareholders to the changes that will occur. Once a VC found out that there was dissent about proceeding with an investment it would be very unlikely that the proposal would get much further. VCs are not in the business of trying to persuade people to take their money. Supportive minority shareholders should be kept informed of the progress of the discussions and negotiations with VCs, and should be introduced into the discussions at some (early) convenient point. The reason for this is that there is always a danger that trying to accommodate the preferences of one minority shareholder may well bring the deal crashing down. If that initially supportive shareholder is kept too remote from the deal then there will be lack of realism about what can be negotiated. The VC is very unlikely to adjust the terms offered to accommodate a proposal put by a minority shareholder. In terms of the future development of the company, that shareholder is going to be a very passive free rider as far as the deal is concerned. Consequently if someone holds out for be�er terms that suit his or her particular circumstances, this may well cripple the deal, since it will meet with intransigence. Everyone has to be ‘on side’ during the negotiating process, and there have to be only two voices in dialogue – the VC’s and the management side’s. Extra voices will just be so much noise that will eventually confuse the signal. Unfortunately, even though there may be initial support for the principle of an injection from minority shareholders this may be supplanted by hostility when the terms offered by the VCs are received. There is probably going to be a disparity between the expectations of the management team proposing the deal and the concrete terms offered by the VC, and this disparity will probably seem even wider to a residual shareholder. 115

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It is at this point that the deal gets placed in greatest jeopardy. VCs usually place time limits for their terms to be accepted, and if it takes a long time for a residual shareholder to be won round then the deadline may be breached. Worse still is the situation where the residual shareholders appear to accept the terms of the offer – however reluctantly – only to start to raise problems when the deal enters legal stages. The surest sign that this is going to happen is when residual shareholders appoint separate legal representatives to look a�er their interests during the legal stages. The only way to get round this (apart from buying out minority shareholdings at or before this stage) is for the management team to achieve an irrevocable undertaking that there will be no separate representation or a legally binding agreement that the terms that have been offered are acceptable. This means that the residual shareholder will abide by subsequent negotiations as a passive rider in the agreement. That may be a very difficult thing to do since, at some point in the future of the deal process, warranties and disclosures are going to have to be made (see Chapter 13). The legal stages of the deal always produce a lot of heat between management shareholders, so they will be even more difficult for a minority shareholder not connected with the day-to-day running of the business to swallow. In fact the management’s legal representative may well have to advise that there be separate representation for a minority just to deal with this point, notwithstanding ‘no separate negotiation’. But, even if it can be arranged, agreement on the terms of the deal at entry does not get rid of the problem. Exactly the same problems will reappear when there is the need for more cash (and consequently the prospect of dilution arises) or when the terms and timing of an exit are discussed. In short, the residual shareholder is a bit of a time bomb in a venture-backed business, si�ing in the corner and waiting to blow up in everyone’s face. If a deal can be arranged that eliminates the residual shareholder, it will be a be�er deal than one that has a ragged shareholding structure.

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OTHER STAKEHOLDERS The four parties that are going to be most affected by a change in the ownership of a business outside the shareholding group are the workforce, the suppliers, the creditors and the bank.

Workforce The workers’ rights are protected under the Transfer of Undertakings (Protection of Employment) Regulations (TUPE Regulations) in the event of there being a complete change in the ownership of the business. This occurs in a management buy-out where the previous employing company disappears to be replaced by Newco Ltd. The TUPE Regulations protect the terms of contracts of employment for workers whose jobs are transferred with the business. Business plans for a buy-out that include rapid and substantial cost savings through making changes in the employment cost base are based on a complete misunderstanding of the legal situation. Some recent large-scale deals have foundered because pension fund trustees were keen to protect the rights of the beneficiaries of the fund, and this area is likely to remain an area of problems. If there are potential difficulties that are known to the management of a business, they should be disclosed as soon as possible to avoid costly problems later. Other types of deal are less legally sensitive to changes in the structure of the business but, needless to say, good practice would require that the workforce be apprised of the situation as soon as is possible. The timing of this will be different for every business, depending on circumstances: size, number of locations, numbers of key employees and so on. But it is worth bearing in mind that the rumour mill will be working full time in any business where there are lots of meetings between the management and strangers, where accountants conduct detailed reviews of the business and where the management’s a�ention is suddenly occupied by an entirely different range of problems from the normal preoccupations. In the end, not many workers are likely to object to their employer being be�er funded, but VCs will probably be viewing the way that the funding situation is handled and communicated internally as one of the gauges of managerial ability on which they make their investment decisions. 117

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Suppliers Like the workers, the suppliers should benefit from an increase in the funds available to the company in most cases. However, it is very important to keep suppliers reasonably up to date as to what is happening inside the business, because part of the due diligence process undertaken by the incoming investor will be to talk to suppliers to understand key relationships – especially if there are a few critical suppliers. If such suppliers find out about the imminence of a funding deal from the VCs or their agents suddenly ringing up to ask about the customer, then harm will probably follow to the commercial relationship – not least through misunderstandings about the purpose of the VCs’ enquiries. There is a balance to be struck here, though. If for some reason the funding exercise does not come to fruition, then the supplier may well need to be reassured about the future. So a judicious sense of timing, and of the degree to which the plans are revealed to outsiders, is required. Suppliers are also usually creditors at some time, and the particular needs of creditors are dealt with below. When the due diligence process starts it is important for the management to liaise closely with the people conducting the investigations, to make sure that all suppliers that are going to be contacted have been told enough about the reasons for the enquiries (see also Chapter 11).

Creditors Another area for investigation in the due diligence process will be the creditors’ list, and so much the same considerations as were dealt with in the section above for suppliers apply to creditors. Due diligence processes and considerations are dealt with in Chapter 11, but it is important to point out here that although (perhaps because) creditors – like suppliers – should be beneficiaries from a cash injection into a business they need to be treated as an important factor in the process of raising funds. Creditors are a bit like shareholders in that they own a chunk of the company’s assets in the shape of its working capital (although by contrast with shareholders they own this part of the assets only on a temporary basis) and so they cannot be relegated to an outside role of no importance. They are, if you like, only minor players in the drama 118

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but have an important walk-on part that is crucial to the way that the plot ends. Although one of the purposes of raising development capital may be to clean up the creditors’ lists and put the company on a be�er footing with its creditors, it would be a foolhardy management that did not make strenuous efforts to push cash towards creditors to ensure that the lists are ‘clean’ before embarking on a fund-raising exercise. This should not be done in a sudden surge that looks – and is – artificial but, ideally, should be part of a controlled process extending over several months before the fund-raising process begins. The purpose is to bring the creditors’ list into line with the average for the industry of which the business is a part. There are a number of reasons for this. The first is that long-term suppliers (long-term suppliers are going to be long-term creditors) whose accounts have been properly handled are much likelier to give favourable reports about their relationships with the company when questioned during the due diligence investigations. Second, during the fund-raising process it is almost inevitable that the business seeking to raise funds will suffer a drop in levels of business activity as senior management’s eyes are taken off the ball temporarily. This may filter back to creditors’ payments; so making sure that the creditors are reasonably happy at the start of the process makes good sense. Third, taking the pressure off creditors’ lists before the process begins provides a cushion against some deterioration during the fundraising process so that management do not have to cope with making a deal with the investors and ba�ling with creditors at the same time. Fourth, a prudent approach to the creditors’ lists will mean that the negotiations with potential investors are conducted from a position of equilibrium. If the creditors’ lists look ‘unnatural’ in some way then the investor’s perception will be that the business is in some form of distress (‘creditor days’ are longer than the industry average), that there is financial fat to be trimmed by taking a more robust a�itude to suppliers, or that creditors have a stranglehold on the business in some way (the la�er two of which arise from creditors’ lists being unnaturally short and below the industry average). This last might suggest to the investor that there has been some trading hiccup in the past that probably ought to be investigated further. Last, by making sure that the creditors are happy when the fundraising exercise begins, the damage done by a failed search for funds can be minimized. 119

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The bank Almost certainly one of the key partners with any business, the bank needs to be kept informed of the intention to raise funds from the very outset. In the case of an independent business (that is, one that is not part of a group), the bank may very well have been the catalyst in prompting the search for external finance and so will expect to be kept informed of progress throughout. With the frequent changes in branch banking staff that are now commonplace, it is essential that a proper relationship is cultivated by the company’s management with a manager of the bank of sufficient seniority – that is, someone at a high enough level in the bank’s own management – to understand what is going on and to approve changes with the minimum of referral to higher levels. At some points during the funding process, speed of response will be of the essence. During the process of completing a fund-raising deal, the banking covenants governing any existing overdra�s may need to be revised, and future banking arrangements will almost certainly have to be reviewed. Bankers will be concerned that any security that they currently have over the assets of the business should not be compromised by any shareholding arrangements entered into as a consequence of the new funding. These issues will need to be dealt with by the company’s management in consultation with the bankers. It is not the province of the investor to make these arrangements.

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10

Building – and displaying – the management team

Accomplice, n: One associated with another in a crime having guilty knowledge and complicity, as in an a�orney who defends a criminal, knowing him guilty. (Ambrose Bierce, The Devil’s Dictionary)

 What can wreck a proposal  Four elements of a good management team  Post-investment  Dropping directors  Succession  ‘Key person’

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While it cannot be said that a good management team will rescue a bad proposal sufficiently to convince an investor to back it, it is certainly the case that the opposite is true. A poor management team will certainly sink a good proposal. Because of this, VCs spend a great deal of time in deliberating about management structures and the suitability of the individuals presented to them in the investment plan. The ability to place confidence in the management of a venture-backed business is a critical part of the process of deciding whether or not to proceed in making an investment. And the significance of being able to do this ranks, for the potential investor, almost as highly as the a�ractiveness of the information about the company’s likely development contained in the rest of the business plan. What many entrepreneurs fail to understand is that for the VC to repose confidence in the senior members of the management, the chief executive of the business has to display similar confidence in his or her team. And if the VC perceives that this confidence is not there or that it is misplaced, then it will severely prejudice the likelihood of an investment being completed. Nor does the assessment begin and end with the investigating executive – at least not where the investment is being undertaken by a venture fund. CVs of management form a substantial part of the pack of information that is formally presented to investment commi�ees – and these are not regarded as just so much filler material to bulk up the size of the investment folder. They are properly studied, in my experience long and hard, by investment commi�ees. Questions are asked about individuals’ competences, and proposers of investments will be expected not to present a case for investment if they have any reservations about the collective abilities or qualities of central members of the management. Because of the significance a�ached to the senior personnel involved in an investment, it is crucially important that entrepreneurs also devote time to the managerial aspects of the presentation of their case. In the end there is only one person who is in charge of a business, and potential investors assess that person’s ability partly by the shrewdness demonstrated in picking the right people to support him or her. The leaders of businesses place their own reputations ‘in play’ with investors as soon as they hold out a business as being suitable for backing by an outside investor, and the investor’s judgement about that suitability will be largely determined by the calibre of the management team.

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It is worth remembering when fielding a management team that you get one chance to make a first impression – you have to get it right the first time. Bloomfield’s First Law states that as someone rises higher in an organization it becomes more and more difficult to determine what he or she does. The VC will need to be le� with the emphatically unambiguous impression a�er the first meeting with the assembled senior managers that everyone is doing exactly what he or she is best fi�ed for. It is obviously too late to make changes to senior personnel when the flaws in someone’s ability have been exposed during the due diligence process. It is too late to move people around when the discussions have started between investors and the management team. It is even too late to start moving people around when the business plan has been sent out and been studied by potential investors. That means that the final management team ought to be in place before the proposal is even considered internally in the business. Not the least of the considerations that argue for this being done is that it will be very difficult to get people out of a managerial position without more than the usual acrimony when the prospect of large capital gains have been visualized by the managers. And acrimony costs money, aggravation and time – all things that can be ill afforded, especially by companies that are seeking to raise funding, not to dissipate it.

FOUR ELEMENTS OF A MANAGEMENT TEAM There are four elements to ensuring that the right people are in place for the business to be able to move forward and that it will be able to cope with the vagaries of the business environment:  first, ensuring that all the necessary functions are covered in the organization of the business;  second, ensuring that the functional positions are filled by the best people;  third, striving to achieve compatibility between individual post holders so that they work together effectively;  last, thinking about what will happen when the business moves from being a privately run company. 123

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We need to take each of these in turn to look at the problems involved.

Functional coverage It should be fairly obvious that for a business to run properly there should not be any gaps in the functional matrix represented by the skills of the core managers. However, in a business that has grown up with a continual shortage of resources – as do many businesses that seek venture capital – it is o�en the case that the full range of functional specializations is not properly covered. People o�en ‘double up’ posts. The engineering director serves as chief buyer or the operations manager does the detailed work of the production planner; the managing director manages the accounts with the help of an accounts clerk, and so on. This means that some posts are overlapped and some not properly covered. Jobs get done but not necessarily very well or at least not as well as they could be if there were proper functional specialists in place. If the system works – however roughly – there is a tendency to leave it alone. Custom and practice enable the business to ‘get by’. That may be adequate for a business that has no aspirations of growth. But ‘ge�ing by’ will not be enough for a VC, who will be concerned with ensuring that the money injected into the business is properly stewarded. More particularly, as far as the VC is concerned, the process of ‘ge�ing by’ will not be enough to see the business capable of developing successfully to its next stage – the whole purpose of seeking investment. Businesses that have been started largely by the efforts of one individual suffer from a similar problem – the inability of the founder to delegate responsibility to his or her colleagues. Le�ing go of a tight grip of the reins while still retaining control is a skill that not all managers can learn. The symptoms of this are usually fairly evident during the course of due diligence even though they may initially masquerade as tight managerial control: collegiate decision making ignored, too li�le delegation of functional responsibilities, too extensive a span of control for the top manager, minimal delegated power of spending to functional heads, insufficient a�ention paid to colleagues’ professional opinions and too much credence given to the opinions of trusted outsiders are all significant signs. These will be definite turn-offs for potential 124

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investors, who will want to see a properly functioning, properly led team of managers. There is a further consideration that should not be ignored. The process of growth will involve increased risk as new processes, or simply a different size of business operation, place strains on the old ways of doing things. Growing businesses face problems that they have not encountered before. When a new problem strikes a business, it is very much more difficult for an under-equipped management team, already struggling to cope with change, also to deal successfully with all the problems that suddenly begin to pile up. Unless there is a very disciplined approach on the part of the chief executive then there will be even more of a tendency for some things not to get done that should be done properly – urgently – and some lower-priority tasks to be given more a�ention by more people than they truly deserve. The success of the investment will be jeopardized. VCs know these problems, usually through bi�er experience. Poorly managed businesses rank very high on the alarm-bell scale for venture capital investments. Such an assessment will not be conducive to helping the VC reduce the perceived level of risk.

Presenting the best face of management Ideally, the people in the senior reaches of the business’s management will be the best that can be found – full stop. But VCs are sufficiently realistic to know that may not be the case in businesses seeking expansion capital, where cash is probably tight by definition. Most businesses will be staffed with people whom they can afford to a�ract. With luck the people will also be properly competent. VCs will be concerned about three things: first, that the people in place are capable of acqui�ing their responsibilities properly; second, that they can do this on a full-time basis; and last, that they can manage the growth of the business. A business plan that suggests that a parttime finance director will be sufficient to fill the post for the foreseeable future is unlikely to win the support of a VC; similar considerations will almost certainly hold for the other major functional responsibilities. And in a development of the problem considered above – where one founding shareholder has dominated the business – it may be more apparent to an outsider scrutinizing the business than to those inside the business that the person who holds the top position may in fact be more suited to being operations or technical director than managing 125

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director. It is a big man or woman who can admit that his or her skills may lie in another plane a�er having gone through all the sweat and agony of starting and developing a business. Being prepared to relinquish what is seen as the top seat to someone else is a further step that some people just cannot manage. The core problem with both of these facets of the senior staffing of a business, though, is one of chicken and egg. The obvious question arises: how does a business that needs cash for development or expansion find the wherewithal to employ people of the calibre necessary to reassure a VC? If the cash that could be used for expansion will only come when all the right people are in place, how are those people to be paid? The answer to that question is that it probably isn’t the right question to be asked. Chapter 5 suggested that venture capital should only be used for bringing about step changes in a company’s fortunes. Bluntly, it is unlikely that such changes could be brought about just by employing a finance director or a marketing director. There needs to be something else as well. The business should go a li�le bit further in its organic growth to generate the resources to put the necessary functional specialists in place. Then would be the time to seek out venture capital – to add the final ingredient to enable a new market to be tackled or a new product to be developed.

Compatibility issues There is nothing like money for ge�ing between the cracks in a relationship and making those cracks wider. It is a gross error to believe that the common desire to make an investment profitable will cement a management team composed of people who otherwise dislike each other. It may work during the time the investment is going to plan, but the bond will dissolve very quickly when the business hits a snag. Bloomfield’s Second Law shows that the latitude for recriminations and finding scapegoats will increase in direct proportion to the width between what should be happening according to the business plan and what is happening according to the monthly accounts. It may be be�er to se�le for a slightly less outstanding finance director if by employing someone too abrasive you are going to rub people up the wrong way. That is very definitely not a plea for employing second-raters. It is a plea to keep on looking until you find people that you can build into a cohesive team of managers. Very few developing 126

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businesses can accommodate people at senior levels who are always right in everything they do and say. It is usually very easy for an incoming investor to spot the symptoms of a dysfunctional management team when detailed discussions start as part of the process of due diligence. What is more significant is that bad relationships between senior staff will sour the whole process of the investment: legal stages will take longer as some members of the team begin to think differently about their personal liabilities under the warranties (see Chapter 13); this will cost money. The process of day-to-day working will be complicated in times of stress throughout the life of the investment, limiting the rate of growth; and the process of releasing the investment will be more complicated as individual managers assess their own personal positions as the prime consideration rather than think of the greater good of the shareholders collectively. Since many investments will also require capital to be invested by the directors and/or managers for them to receive a shareholding – particularly in situations where a previous dominant shareholder’s stake is to be diluted for incentive purposes or in a management buy-out – the different capacities of individuals to invest may also prompt potential dissension between board members. It is the job of the managing director to deal with these issues before they become problematic for the incoming investor. That may involve limiting the investment of some senior members of the management in order to allow others to get a small stake. Situations where members of the management borrow heavily to purchase a share stake are also to be avoided if possible. In the event of a cash crisis, far from concentrating the mind, such imprudent behaviour acts as a distraction. It is the job of the managing director to ascertain the capacity of each of his or her fellow investors to borrow and make sure that borrowing that does occur is done within sensible limits. Intrusive though this may seem at the time, it is a necessary action if the harmony of the management team is to be preserved when the going gets rough.

Development and capability The final factor that has to be borne in mind is the extent to which current holders of the major board positions are capable of growing with the company a�er it receives the injection of cash it is seeking. 127

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What we are talking about is step changes in levels of activity and subsequently dramatic changes in the level of sophistication of the skills required to run them. Where sympathetic colleagues in a private business may overlook minor failings in procedural rigour, in the harsher environment of the venture capital-backed company the emphasis will increasingly be placed on professionalism of a much higher standard. Only the able are likely to acquit themselves adequately in such conditions. This anticipated standard of expertise does not conflict with the point made earlier about few developing companies being staffed by people who are always right in everything they do and say. The standard of professional expertise that has to be expected of professionals in venture-backed businesses is not identical to the standards and qualities of judgement that have to be exercised. Judgements are always going to be variable and only patchily right. Everyone makes mistakes in employing their judgement about the way something will develop – a market, a product, interest rates. The investor will want to know that the people who are in charge of the business have the necessary skills and abilities to take it through to a successful conclusion without too many mishaps. Therefore, the managing director of a business seeking funding has to ensure that his or her colleagues have both the necessary professional competence to discharge their functional obligations not only now but in the future, too. They also have to possess the managerial capability to grow in their jobs as the business places increasing demands on them. Potential investors will rapidly latch on to those they think are weak managers, and this will tend to raise the risk level that they a�ach to the investment opportunity as a consequence. This identification of weakness may be right or wrong, since much of it depends on personal empathy (or otherwise), but has to be taken into account in presenting the case. In the circumstances where the managing director acknowledges he or she has a problem with one particular member of the managerial team it may not be necessary to ditch that person. A more subtle strategy would be to emphasize the blend of talents across the whole of the managerial group. For instance, if the putative finance director is technically excellent but possesses a diffident personality, then it might be acceptable to emphasize the essentially technical nature of the accounting function inside the business. But if the nature of the business is such that the finance director has to fight to control the 128

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allocation of resources between various parts of the business then you might have to think about finding someone tougher. It will be too late to try to rearrange the team once presentations are being made to potential investors. By this time there should be a rounded team capable of meeting most eventualities squarely and dealing with them competently as a group. Sensible investors will recognize that this quality is of a higher significance than having paragons in each functional post. If this case is presented properly it has great persuasive power, trumping the value of a managerial cohort formed of individually competent non-team players. In the eyes of most VCs, a good team that works well together with a blend of skills will always beat a group of perhaps separately be�er but less cohesive individualists. The last factor to be considered in this process is the change that will take place in the physical composition of the board once the injection of cash has been received. Few investments are made at a substantial level without there being a requirement for the investor to have a seat on the board for a nonexecutive director. Directors are not supposed to be partial – their absolute legal duty is to the good of the company not to one investor – but it is common practice now to appoint a representative to the board who will act as the investor’s conduit to the board. This person may be appointed as the chairman or may be some other individual who is perceived to have some special competence. It may be an employee of the venture capital fund or someone who has worked with the fund before or possibly just someone who has special sectoral or functional skills. Business angels of course usually take seats themselves as a condition of pu�ing their money into the business and then take an active part in running the business in a sort of semi-executive capacity. Board members of longer standing may feel that this newly appointed individual is in place to scrutinize their behaviour and report on it, and they may resent this. They are right to believe the former and wrong to indulge in the la�er. Board representatives will certainly keep the investment funds that appointed them up to date on developments in companies – usually on a monthly basis, at least. But investee companies usually benefit from the activities of good non-executives who, if they are doing their jobs properly, will require – diplomatically – all the executive board members properly to justify the development of strategy and policy, and will make their own contributions, too. The exercise of impartial scrutiny of ideas and proposals by someone who 129

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is not bound up in the day-to-day scrum of business activity can be a very valuable help to a company’s progress. In the event that the non-executive does not do his or her job properly or there are serious clashes of personalities between board members, then it is perfectly in order for the fund to be approached discreetly by the managing director or chair to advise it that things are not proceeding as they should and to seek a more compatible representative who fits be�er with the temper of the board. But this is not a power to be used without proper consideration, and normal disagreements are not a reasonable cause to exercise it. However, there are few investors who would jeopardize the effective operation of a board united against a representative non-executive director simply to stand on a point of principle.

DROPPING DIRECTORS All of this brings us neatly to one of the more difficult problems that a management team may have to face – how to get shot of an underperforming executive director. The short answer to this problem is to make sure that you don’t have to do so by choosing your fellow directors very carefully in the first place. The problem is not simply one of ge�ing rid of an underperformer and paying some form of compensation. The position about dropping members of the board is complicated in the circumstance of venturebacked companies by the fact that most legal agreements that control venture capital deals make employment by the company a condition for holding shares in the company. Directors of venture-backed businesses usually own shares in those businesses, and releasing people from the company means that they are going to suffer the loss of capital appreciation from losing their holding of a stake in the company. The alternative of le�ing them hold the shares when they are not contributing to the development of the company puts them in an unfair position in comparison to their remaining shareholder-directors, who remain with their wealth at risk and working hard. To get over the obvious unfairness of both of these courses of action – stripping people who have made a contribution of their shareholding or allowing them a continuing free ride – most legal agreements will incorporate some form of compromise clause that allows directors 130

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leaving the business to hang on to their shares a�er some qualifying period. Eighteen months a�er the investment has taken place seems to be a popular length of time; before that period they are required to sell their shares back to the company. As a variant on this there may be pre-emption rights that enable other directors to purchase the shares, or the shares might be held in some form of escrow account for the benefit of the removed director’s replacement. Whatever happens, removal from office is likely to be accompanied by other losses, too. The existence of such a sanction is obviously a very strong incentive for individuals to make sure that they perform their functions as expected. But it sometimes happens that employment has to be terminated for the good of the company. Where there is misconduct, the situation is very plain: bad behaviour merits the loss of the share stake – quite rightly. In less clear-cut circumstances, the unwinding of a shareholding by a dismissed employee can result in protracted unpleasantness that will greatly damage the company both in terms of distraction and in terms of legal costs. It is worth repeating the short answer to the problem: be very careful in whom you select as shareholder and/or director because the consequences of a mistake can be very serious. Bad directors can seriously jeopardize your wealth.

SUCCESSION Something that many management teams o�en leave until it is too late is the issue of managerial succession. Succession need not necessarily be brought about by ‘death in harness’ – although that is a distressingly frequent occurrence in venture capital-backed businesses. Businesses have to make changes for reasons as diverse as someone in the management team being caught fiddling expenses (you’d be surprised!), having affairs with colleagues and upse�ing the rest of the staff, or even falling under the proverbial No. 9 bus. The experienced potential investor will want to see evidence that some sort of succession plan has been thought of: not a detailed plan for every eventuality, but one for managerial strength and depth so that, should someone go, then the ranks could be quickly filled. Venture capital deals usually involve some form of key person insurance being taken out on the lives of the more senior members of staff so that there will be time and cash provided to find a replacement if 131

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there is ‘a series of unfortunate events’. But there should also be some contingency planning, so that those whose lives have been covered also devote some time to considering who might fill their places from within the organization and then make this known to the investor. The whole business should be done discreetly and as an adjunct to the management section of the business plan – not as the main feature of it.

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11

The key issues of discovery: the ‘due diligence’ process

Finance, n: The art or science of managing revenues and resources for the best advantage of the manager. The pronunciation of this word with the ‘i’ long and the accent on the first syllable is one of America’s most precious discoveries and possessions. (Ambrose Bierce, The Devil’s Dictionary)

 The overriding ‘key issue’  Reducing risk  ‘House styles’ – an illustration  The ‘due diligence’ process  The basics and key points explained  Detail of the process

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The issue of thoroughness of investigation has been given special significance in venture capital investments. The assumption is that venture investments are so risky in comparison with pu�ing money into a bank or with stock market investments that they need special a�ention. Only by treating all the issues that are exposed by the initial question about risk with appropriate ‘due diligence’ can the final evaluation be properly completed. The term ‘due diligence’ has come to be the shorthand for the process of investigation itself. This chapter is all about the due diligence process. It is a common misapprehension that investors make their judgements about whether to invest or not on the basis of the business plan they are presented with. They do not. What they make their judgements on is an evaluation of the wealth of information that they find out about the company and its business from asking further questions about the facts that are laid out in the business plan. In doing this they are seeking both further information and confirmatory information about the triple issues of management, mathematics and market. At the end of this process, all the individual questions that have been asked distil into one big question. The fundamental question, the key issue for the investor, is quite simply: ‘Is this deal going to make the rate of return that I need to achieve?’ If the answer is yes, then the deal goes ahead; if the answer is no, then as far as the professional investor is concerned it’s on to the next proposal. In the end, only the right answer to that crucial question will swing the decision one way or another. But that simple and fundamental question is obviously a summary one. It is the final interrogatory in a long chain of questions that have been designed to explore all the subsidiary information on which the business plan was based. This chain of exploration starts with a question that is very similar to the final question in its phrasing but, crucially, includes one specific element. The element of risk is the prime concern of every investor. The first question that starts off this long process is: ‘Is the likely reward that I am going to get if this proposal works out worth the risk that I am going to run if I invest my money?’ It opens up a spread of issues – all of which can be organized under one of the headings of management, mathematics and market – and each of which has to be explored thoroughly if the final question is to be given the weight it deserves.

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Some deals are so obviously good that investors have to look for negatives to persuade themselves not to do them, but these are – unsurprisingly – in a very small minority. Most deals involve a complex series of trade-offs of time against cash, and reward against exposure, that have to be resolved, ultimately, by the arbitration of rate-of-return calculations. But behind that bald and brutal process, there are lots of subsidiary factors concerning perceptions, personal ambitions and preferences (on both sides of the investment divide, those with the money and those seeking it), timing issues, risk profiles, sectoral expertise, past investment experiences and current portfolio dispositions. Some of the concerns of the potential investor will be apparent to the entrepreneur; some will remain hidden. This chapter will expand on some of them in detail.

‘HOUSE STYLE’ The ways that the investor goes about evaluating an opportunity, devising an investment structure and then completing and monitoring the investment all get packaged into a particular way of doing things that gradually assumes the trappings of a routine – a ‘house style’ in terms of investment funds. Some of these factors will be determined almost unconsciously as the result of past investment experience. The outcomes of these events – good and bad – form the background against which the investment opportunity is measured. Poor experiences in several investments in leisure businesses, for instance, might make funds reluctant to consider proposals from that sector in the future. Some funds might have a rule that they never invest in financial service businesses or, perhaps, businesses with overseas subsidiaries. If funds are not set up with charters that establish a specialization, then the investment fund managers are unlikely to impose one on themselves unless they have a very good reason for doing so. Such stances are increasingly unlikely as more and more funds become generalist and as businesses increasingly become international. What is common is a specialization by type of deal, as we have already seen – funds commonly stratify into early-stage specialists, development funds and management buyout specialists.

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What is much more usual is some form of preference for a deal structure that becomes a house style in doing deals. Funds might always use some form of investment ratchet to ‘give away’ some of their entitlement of equity as an incentive to high-performing managers or, instead, reverse ratchets, which take equity away from low performers (for greater detail on this mechanism, see Chapter 12). These o�enunelaborated operational rules will be borne out of the experience of individual managers and the experience of the fund or venture house that they are working for. Sometimes the rules might be explained, sometimes not. Sometimes they might result from a positive experience, sometimes from a very negative one. Unfortunately a proposal that falls foul of a particular prejudice at the first hurdle might never receive a full explanation as to why it was not proceeded with, even though it might be one purely specific to that investment house. Most rejection le�ers are couched in fairly broad terms – stock phrases like ‘not in line with portfolio requirements’, ‘fully invested in this sector’, ‘did not pass our initial requirements for investment’ – so as to prevent entrepreneurs quibbling with the detail of the rejection. The one area that can never be disregarded is that the primary objective of VCs will be to reduce their risk by trying to structure the investment in such a way that they are the last to get burned if things go wrong and the first to get out whichever way the investment goes – good or bad. But first they will be interested in discovering as much as they possibly can about the business. There are four principal reasons for doing this – two basic ones (which apply to all investors) and two administrative ones (which apply mostly to fund managers): 1. VCs want to make sure that they fully understand the risks involved in the business as well as the rewards and opportunities. 2. They want to be able to understand the way that the business works – and is likely to work once cash is put in – so that they can devise a structure for the business that makes sense given the risk profile they perceive. The two reasons above fall into the category of investment risk minimization. 3. They want to know sufficient about the business to be able to brief the professionals who will be working on their behalf – the

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reporting accountants about what particularly to investigate, and the lawyers about how to prepare the dra� agreements. 4. They want to make sure that, if there are any questions at the point where an investment commi�ee considers the proposal, they are able to answer them authoritatively. The last two reasons fall into the category of personal risk avoidance.

THE DUE DILIGENCE PROCESS The house style that results from particular ways of looking at investment opportunities will result in particular ways of investigating proposals depending on what each individual thinks are the most important factors that contribute to a successful investment. A li�le personal history may help illuminate this. During the time that I worked at the Coal Board Pension Fund’s CINII subsidiary (which later became Cinven), I tended to regard possible investments in manufacturing as highly a�ractive – both because that was where my personal interests lay and because the fund’s policy was to pursue such opportunities. If it was possible, a�er a quick read-through of the business plan (usually starting with the CVs of the senior managers) I would try to find out a bit about the industry by looking at some economic statistics and maybe some stockbrokers’ sector reports. If a�er doing that there was nothing that definitely turned me off the sector, and the business plan looked reasonable, then the next step would be to visit the company to look at the manufacturing plant. By doing this I could gain an impression of the way that the business was run so that I could then talk at greater length to the management about the detail of the business plan. That would let me ask informed questions – although I was usually careful not to seem too informed, since I wanted the management to tell me what they wanted to tell me, not to try to impose my own prejudices on the story that they could tell. Apart from everything else, if what they told me contradicted what I had already found out through my background reading and my tour, then I most definitely wanted to know that too. If all this added up over a series of meetings – each one of which might last an hour and a half to two hours and would cover a different aspect of the business plan: first the market, then the cash flow and 137

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profit forecasts and then the personnel and management team – and I felt that there was the prospect of a good investment, then I would make a preliminary report to the investment commi�ee. The assumption at CINII was that we wanted to do deals (finding cash to invest was not a problem, but finding good deals was) and so cash was usually forthcoming. It was at this point that we would discuss a deal structure informally with the management – based on preliminary calculations about profitability and projected P/E ratios – and if these went well we would appoint investigating accountants to review the business. I am not sure if my approach in going to this next step mirrored that of my colleagues, but in my commissioning brief I used to ask the investigating accountants to concern themselves with only three things. The first was the working capital requirements of the business as identified in the current year, the second was the projections for working capital as contained in the business plan, and the third was the tax calculations that the company had made in its business plan. I reckoned that a detailed examination of these three aspects of the company’s plan by outsiders who possessed technical skills that I did not would reveal all that I needed to know about the business that I could not find out by myself. In particular, I did not want the accountants to waste time and money reciting the details of the business’s history and structure to me – that was easily investigated and usually contained in the business plan. I reckoned I could ferret out any inconsistencies. Similarly, my own background meant that I was as least as well qualified to make a judgement about the management’s individual and collective strengths and weaknesses as the accountants. Lastly, I could evaluate the business plan against the market background – again as a consequence of my own experience and professional skills. What I wanted the specialists to concentrate on was whether the plans that the business had presented were 1) sound, coherent and complete, 2) flawed by some fundamental initial problem that predated the business plan, or 3) full of gaping holes, all in terms of the working capital of the business – the cash needed to fund suppliers, stock and customers. The reason that I chose to concentrate on this was that I always felt that what we were really trying to do was to provide businesses with working capital with which to develop. The cash we injected in development capital deals, in return for a stake in the business, would be used at root to fund changes in stock, debtors and creditors. So my 138

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own particular way of thinking about investment conditioned my approach to investigation and evaluation. I wanted to minimize my risk of having to be asked to put in more cash at some later date because the cash needs of one of the three legs of working capital – stock, customers or creditors – had been underestimated initially. The later problems that I had with investments usually revolved around one of those aspects, and so my accumulating experience developed and modified my approach to investing – in other words, the approach I adopted to reducing my risks. The strategy I had devised for minimizing the risk in assessing investment opportunities that I was presented with was to concentrate on a few critical aspects of the business’s operations. I had identified some aspects that I believed to be fundamental to the success of the investment, and I concluded that I needed to understand those in depth so that I could assess the likelihood of failure of what might otherwise seem to be a good risk. No doubt other VCs adopt similar strategies but may have different priorities in evaluating what makes a successful investment.

Investment fees One of the prickliest issues encountered in raising cash is the request that many funds make for fees to investigate the proposal. These can usually be negotiated and should certainly be capped by agreement of both parties. Accountants’ reports will certainly have to be paid for by the company seeking to raise the cash, and some firms ask for the costs of market and technology reviews to be underwri�en as well. These requests will usually be contained in the term sheet and, with confidentiality and exclusivity provisions, will be the only binding clauses in that document. The timing of the investor’s presentation of the term sheet to the company is a bit chicken-and-egg. Too early, and there will have been insufficient basic investigations to give the term sheet a sensible structure; much later, and the deal will have got under way with costs already incurred and no one responsible for them. However, management should note the following: very early presentation of term sheets will almost certainly result in the structure of the deal being substantially reworked – and this is always to the detriment of the company. It o�en says more about investors’ desire to trap the proposal and to cover their costs rather than any urgent desire to do this particular deal. 139

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THE PROCESS To demonstrate the range of issues that have to be dealt with during due diligence, we shall now go on an extended trip – not abbreviated as in the anecdotal example above – through the analytical process. As such, it will probably not be typical, since it will aim to identify as many as possible of the separate issues that could come up, whereas in practice many of these will be eliminated from any particular investigation, as individual investors place greater or lesser weight on some aspects. In addition, the sequence as described suggests that the process is strictly sequential, whereas some tasks will be completed concurrently, and there will be continual interruptions – in a large fund, at least – as completions and monitoring duties intrude into the working week. Some investors may also take some steps out of the sequence that is suggested here – for instance in looking at the technology before the market or perhaps looking at detailed management issues a�er visiting the factories. Some funds may commission an accountants’ review before the final review of the business plan so as to incorporate the findings in a summary review; others may wait until they have discussed the financial data so as to find out what further details they want to have examined in detail. Usually there is some basic research done before the issuing of a term sheet (see Chapter 7) when things start to get serious. But almost always the first step is a desk review.

STAGE 1: DESK REVIEW Issues covered There is no set procedure for desk reviews. In some funds, the first review of the proposal may well be undertaken by a junior member of the investment house – if it is a large fund that the proposal has been sent to – or equally all proposals may be reviewed in summary form by the senior member of the fund to ensure that good opportunities are not being missed. It doesn’t really ma�er – what is important is that the first review will be fairly cursory and that a number of features have to stand out if the proposal is to get any further:

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1. The preliminary estimate of the rate of return has to be a�ractive (this is not necessarily something within the control of the management team pu�ing the deal up, as we have already seen); preliminary rates of return are usually done on the backs of envelopes using a combination of pre-tax profits and modest P/E multiples. 2. The proposal should be complete: a complete business plan (not only the summary cash flow, estimated profit and loss and balance sheet), complete financial information, market appreciation, opportunity rationale, business history, complete CVs and a good summary that will a�ract further examination are essentials. 3. The technology – if there is a proprietary edge to it – should be robust. 4. It has to be appropriate to the requirements of the fund – it will be no good sending a biotech investment to a so�ware fund, for instance. In the case of a business angel being the targeted potential investor, the likelihood is that the introduction will come from some sort of presentation (if the business is entering a formal fund-raising process) at an investment forum. Such fora will (usually) be held in the evening, perhaps at a local hotel, where five or six businesses will get the chance to explain the basics of their proposition in a 5- to 10- or maybe 15minute presentation to a group of potential angels. The organizers of the event should have given the businesses some coaching in how to make a presentation of this brevity and how to pull out the major points to a�ract investors. A�er these brief introductions the angels are then free to approach the businesses individually to discuss ma�ers further. The investment forum will take no further part in the process, leaving it up to the parties to hammer out the terms themselves.

Commentary 1. In Chapter 5 we introduced the concept of the hurdle rate that venture capital opportunities have to clear before anyone is going to be interested in investing. Investors will expect to see something around a minimum potential 25 per cent per annum compound growth when they complete their initial calculations. That means the business doubles in size every five years. In fact, it is not too difficult to achieve that sort of rate of growth if a market is expanding fast, if there are plenty of efficiency gains that can be 141

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made in a business as it gets bigger and if the market recognizes the value of the company by ascribing an increasing multiple to the value of its earnings. Most venture investors will want to see a sequence of accounts from three years back to see if the projections can be derived logically from the history of the business, but a detailed review of past years’ accounts will probably wait until the formal due diligence process begins (a�er a preliminary approval from an investment commi�ee). 2. No one will waste any time looking at a proposal if it is not immediately apparent that it is complete and answers most of the initial questions that the investor will want to know – market opportunity, likely rewards, who’s going to be running the business and what experience they have. 3. Larger funds will have in-house experience that they will bring to bear on assessing technologies – but this will only be at a preliminary level initially. More detailed work will need the assistance of specialists, which will probably be done on a contractual detailed basis later. 4. The needs of the fund you approach will be determined by all sorts of things – not least of which will be the type of deal that they have most recently done. There is very li�le way of knowing what will a�ract a generalist fund at any given point. The tastes of specialist funds are more obviously ascertainable.

STAGE 2: MANAGEMENT CALLED IN TO DISCUSS THE PROPOSAL Issues covered If everything appears to make sense and hits the right bu�ons at the preliminary review, then the chances are that the next stage will be for the fund manager allocated the responsibility for the deal to ask the management team to come into the fund’s offices to talk over the proposal in general terms. This is not so much a truly exploratory meeting where the details of the proposal are discussed as an opportunity for the manager to study the individuals who will form the team. There are a number of things the fund manager will be looking for at this stage: evidence of cohesion among the team; evidence of

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leadership; evidence of knowledgeability concerning the marketplace; and unanimity of purpose in respect of the outcomes of the deal. The fund manager will also discuss the fund’s particular approach to deals of the type that is being presented. However, it has to be said that relatively few proposals get turfed out at this stage. If you have made it to the point where the fund wants to meet you then the chances are that they are serious about proceeding. That, of course, is no guarantee of a successful conclusion to the process. Much ground has yet to be covered. It is at this stage that due diligence as such really commences – a�er the decision has been taken to proceed in principle. Many funds will present companies with a term sheet at this stage (see Chapter 13) to enable them to demand some form of exclusivity, and to provide some form of fee underwriting for the expenses that are about to be incurred. Fees, if they are charged, should only cover the costs of externally provided advice – about things like technology or markets or legal affairs. The basic investigative costs should be borne by the VC.

Commentary The specific purposes of due diligence that the investigators will have in mind when they visit the company or review its activities can be summarized as follows (they all follow the general objective of reducing risk): 1. checking the financial valuation of the target by analysing the assumptions of the business plan; 2. discovering factors that may lead to a reduction in the price of the target; 3. identifying areas that need to be protected by specific warranties to be given by management; 4. discovering areas that may need the consent of others for the deal to be able to go ahead successfully (property rights or product licences, for instance); 5. identification of areas for improvement a�er the deal is completed.

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STAGE 3: COMPANY VISITS Issues covered Assuming that none of your management colleagues has two heads and/or particularly unpleasant social habits then the likelihood is that the fund manager will want to make a visit to the company shortly a�er the preliminary meeting. This visit (more likely visits in the plural) will include the factory (or factories) and any remote sites – for instance, R&D or distribution depots if separate from the factory. It is not very usual for approaches to be made to customers at this stage – unless the proposal is for a start-up where there is not much else to investigate apart from potential customers and technology. That comes later. The particular points that are likely to be covered at this stage will include the following: 1. the age, state, suitability and location of the physical fabric of the factory and offices; 2. the production plant and equipment – suitability, age, layout and technological generation; 3. ownership of the factory and plant; 4. production capacity considerations; 5. subcontract arrangements (if any); 6. key suppliers – location and dependency; 7. capital expenditure plans and surplus equipment (if any); 8. workforce – key workers, skill level, local availability, turnover rate, salary levels, unionization (if any), employment policies, and payment terms (hourly, piecework and bonus details); 9. regulatory requirements – health and safety considerations, hazardous material usage, discharge permits, and records of infractions of any of these; 10. stock levels; 11. quality control procedures; 12. costing methods. This list is obviously extensive (but may not be exhaustive) and it is likely to be covered over three or four sessions of increasingly detailed investigation of the business rather than in one big swoop. The likely detail of the investigation is dealt with below.

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Commentary 1. Investors should be concerned to find out about the suitability of the plant of the business that they are investing in. This will include: an examination of the physical state of the factory to see if it is in good repair; its physical suitability to the production process in terms of layout; the location of the place in terms of accessibility and ease of use; the scope for expansion. 2. A similar process of consideration will be applied to the production equipment and plant. How old is the production equipment? Is it technologically up to date? Will it need replacement to cope with the needs of the expanding business in a short time? 3. Are the factory and the plant owned outright or leased or mortgaged? Is the plant leased or on hire purchase? What are the terms of the property lease? Are there penalty clauses for early cessation? 4. Is the current level of production at or close to capacity? Has provision been made for expansion? Can the workforce, the plant and the factory itself cope with the expansion that the business plan anticipates? 5. Is any part of the production process subcontracted to another business (or another factory in the same group)? What are the risks of this? Is there any danger of disruption to production in consequence? 6. How far away are the key suppliers? Are they dependent on the business for their existence? Are they replaceable in the event of problems? How dependent on one or two key suppliers is the business being investigated? 7. What are the business’s capital expenditure plans with specific reference to the existing plant? Is there any surplus equipment available to defray these plans? Is there a market for surplus equipment? What is the rate of technological change of plant? 8. How far do the workers travel to get to the factory? What is the rate of turnover of staff? What is the rate of absenteeism? How many of the workers are key to the business? How old are the key workers? What are the key skills required and how long does training take? Is recruitment possible locally? On what basis is payment made to staff – through piecework, hourly rates or flat salary? Are bonuses paid? Is there a union in the factory or the group or some other form of collective bargaining arrangement? Is 145

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9.

10.

11.

12.

the management aware of forthcoming legislation regarding issues like pay rates, maternity leave provisions and staff consultation? Is there a dedicated personnel function? Is there a pension fund and is it fully funded? What particular regulations govern the operation of the factory and offices? Are appropriate insurance policies in place and are they up to date? What is the record of infractions? Does proper staff training take place to deal with emergencies? In touring the factory, alert investors will be looking at the levels of stock that are held and making their own assessment of the slickness of this aspect of the business. But in particular there are a number of issues that will need to be examined, including the following. What is the seasonality of stock holding? Can the available stockholding space cope with seasonal changes? What are prices of raw materials doing and do they change seasonally? What is the wastage rate of stock? How is stock control physically effected? What is physical security like? Is stock fully integrated into production accounting? If not, why not? What are the procedures for ensuring consistent (high) quality? Does the firm operate any formalized quality control procedures: ISO 9000 (of dubious value); AQAP (be�er); total quality management (TQM) (be�er still)? Who is responsible for the enforcement of quality control? How is costing performed? This is a question specifically for the operations manager – to see if he or she understands the theoretical basis of the control system. The answer should match the one given (later) by the finance director.

Coincident with this stage of the examination of the business, if there is a technology aspect to the proposal then the chances are that the fund manager or investor will be farming this out to specialists. Very few funds have the necessary expertise held in-house to enable them to adjudicate on ma�ers of advanced technology. In fact, in cases where the technology is very advanced, the management team may be asked to suggest suitable referees who can advise on the technology from among the ranks of academic researchers. If there is a piece of intellectual property involved at the centre of the deal, then patent agents may also be called in to comment on the registration of the patents. Questions will also be being asked about how the specific technology of the business fits in with market pa�erns and likely future 146

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developments. The investor is always thinking of how to reduce the risk associated with the investment, and in a technology-based opportunity this is particularly important.

STAGE 4: MARKET REVIEW Issues covered The best way of trying to find out about the market is to use comparative data from competitors’ published information and market reviews. Investors who are based in a large investment fund will probably have plentiful access to such data; business angels may be thrown back on their own resources or on verifying information provided by the company. If the deal being proposed is a development deal then the historical sales records of the business will give a good idea of both the likely type of customer and the pa�ern of trading – both annually and seasonally. Specific information that is likely to be requested or reviewed will include the following: 1. 2. 3. 4. 5. 6. 7. 8. 9. 10. 11. 12. 13. 14. 15.

the existing order book; the order backlog, if any; the rate of growth of the market; the size of the customer base – both now and anticipated; identification of major threats to the business’s sales strategy; information about how much custom is repeat business and how much is new; sales forecast construction; pricing policies; competitors’ offerings; profiles of major competitors – possibly with a SWOT analysis; information about the organization of the sales aim; detailed information about the sales strategy – possibly broken down by geographical area and/or market stratification; warranty periods; customer complaints received; credit terms offered.

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The reasoning behind these questions is fairly straightforward – the investor wants to know as much as possible about the detail of how the business is going to achieve its sales forecasts. It is absolutely crucial for the investor to determine whether the sales forecasts have been built up on sensible information or simply for the purpose of making the proposal an a�ractive one in financial terms. This means more than simply ensuring that the sales director was involved in the budgeting process. Ideally, individual sales managers will be able to display confidence in the realism of the forecasts, which may have to be broken down for verification at the product or sales area level. This has to be done with a degree of sensitivity, since it is not helpful to future relationships inside the company to suggest that the forecasts are acts of pure imagination. Skilled investors will be able to elicit the opinion of the sales force without apparently casting doubt on the ability of the sales director to forecast sales pa�erns. Whatever it takes, it has to be done. As far as the eventual success of the business is concerned, everything will rest on the robustness of the income line.

STAGE 5: CUSTOMER REVIEW AND SUPPLIER REVIEW Issues covered Investors are generally quite sensitive to the need to be discreet when investigating opportunities and will hold off alerting customers and competitors to the plans of the target company until necessary. Sometimes, of course, the need to ask questions will have to be tackled fairly early on – specific situations will dictate the run of events. Competitors are rarely asked about the subject company. It would be unethical to do so, and to expect a neutral answer would be unreasonable, if the background to the questioning were known. Questions are usually only asked of customers and suppliers when the target company has few customers and they are significantly important in the future plans of the company. Suppliers may well be asked questions when the company relies heavily on one or two for critical components or services. Credit reviews and reports will also be utilized to gain a rounded view of the risk that the investment runs from problems with, or in, a supplier. 148

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Generally speaking, VCs do not ask for the proposing company to defray the costs of such expenditure. If potential investors do intend to ask the target to underwrite expenditure of this nature then it should be done early on in the process so that the company can make a decision before the investigation has gone a long way and the company is commi�ed to negotiating with one investor.

STAGE 6: FINANCIAL AND CREDIT REVIEW Issues covered With the market, customer and operations reviews completed, the process of investigation now apparently goes back to the beginning. Usually a�er the investor has gained a greater understanding of the business through site visits and preliminary discussions with the management team, the process will revert to a detailed re-examination of the financial data. But the purpose of the exercise this time is different from the first time. Initially the business plan was checked to see if it made sense in isolation and if it offered a rate of return that was a�ractive – sufficiently a�ractive to warrant further examination but, again, in isolation from deeper understanding of the business. The purpose of the site visits and further discussions was to gain this further understanding and, bluntly, to see what holes could be poked in the supposition that the deal was a good one. The process of financial investigation may well have begun with a review of the last three years’ accounts (if they go back that far) to see what the pa�ern of the financial years was and how the business has progressed. Much information about present problems can be gained by a skilled analyst by looking at a sequence of accounts. This may well have been followed by a standard credit reference available from any of the major credit agencies. If this is checked out reasonably well, then the investigation will have proceeded without interruption. At some time during the site visits the investor should also have checked to see if the business has ever had any county court judgments (CCJs) made against it for non-payment of debts. These arise in all sorts of companies, including the big plcs, and if they show up they should be investigated thoroughly. CCJs will be recorded on

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the company’s credit reference or can be obtained from a separate Companies House search. With the permission of the target company, the clearing bank may have been approached for discussions about the past history of the accounts and the future a�itude of the bank towards the company with an additional investor on board. If additional facilities are required as part of a package of funds it may well be that the potential investor and the company approach the bank together, once the deal is se�led. However, in general, British banking custom does not permit the sort of probing (read ‘impudent’ if you are on the European side of the Atlantic) questions that US investors may well be used to asking about the banks that supply credit to businesses in the United States. The investor will almost certainly have discussed the company’s affairs with the auditors to see what skeletons may have been unearthed during previous audits. The company’s permission for this is required, of course, so it will not have been done without the company’s knowledge. Much useful information about the robustness or otherwise of a company’s systems can be gained during such conversations, and this will contribute further to the investor’s desire to reduce the concomitant risk. Shrewd investors will certainly have asked for access to previous management le�ers (completed at the conclusion of each audit) to see what recommendations the auditors have made about the company’s financial position and the operation of its systems. The purpose of the second review of the financial aspects of the business plan will be to understand how the physical operations and constraints of the business fit with the financial projections that have been made. The discussions this time will probably be mostly with the finance director of the business. The intention is not to trip anybody up, but to progress further down the road to securing the investor’s continual objective of minimizing risk. Investors will want to make sure that what they have learned in poking around in the business is reflected in the financial plans, and that they fully understand the reasoning for changes in the structure of the business plan. These changes should, of course, mirror changes in the business that will take place a�er the investment and during the step change that the injection is bringing about. If it has been properly prepared then the business plan will only be fully comprehensible in the light of the additional knowledge that the investor will have gained during the investigations. A sophisticated treatment of the numbers for a business that is undergoing a serious step change is unlikely to

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show an unflinchingly upward progression of the arithmetic. And one of the measures on which investors will rate a business plan is the sophistication of the treatment of the numbers – that is, they will expect sophistication, not unnecessary complexity. With the be�er understanding that the investor will have from the visits and detailed investigation of the business, the premises of the business plan can now be more thoroughly explored. Specific points that might be covered at this stage will be concerned principally with change: 1. Is there an increased demand for working capital as a consequence of expansion? And if so, what is the magnitude associated with volume changes and what amount is due to product change? 2. How will the plans for the changes in the business affect existing capacity and the mix of plant? 3. How will the cash that is being sought be used – precisely? Is there scope for phasing the injections of cash? 4. What additional marketing burdens will be placed on the business by the plans that are being contemplated? 5. Are the changes that are being contemplated reasonable in the light of the historical information prepared by the company? 6. Will gross margin change uniformly? Are straight increases in margin (if they appear, for instance) realistic in the face of having to build up capacity to a�ack new markets? And so on. If the discussions with the auditors revealed weaknesses in the accounting systems, then the investor will need to be reassured that these have been remedied. This will go beyond warm words and comforting smiles. It is likely that the investor will require a completion audit (see below) – especially if a large fund is involved – and there will be specific requests in the instruction le�er that goes to the auditors to ensure that the problems revealed by previous management le�ers have been tackled.

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STAGE 7: ACCOUNTANTS’ INVESTIGATION Issues covered Accountants’ investigations are almost always paid for by the proposing company – the only exception being where a parent company is disposing of a business and offers to pay for a completion audit as part of the deal. This is sometimes done as a gesture of goodwill to help the departing managers, sometimes to speed up the process of disposal. Because of the financial significance (in both senses – for the company’s proposal and the size of the exercise) of investigations, they are rarely taken now without a term sheet having been presented, agreed and signed, signifying that the company raising the cash will pick up the bill. Some investors – particularly those leading syndicates or where the time between the deal being proposed and completed is extended or where a subsidiary is being bought out – will also require a completion audit. The completion audit and the accountants’ review are not the same thing, and it may be that both exercises will be required in any case. However, it may be possible for the two to be combined if the investigation is relatively straightforward. Problems arise, of course, when the investigation part of the exercise discloses issues that have to be cleared before completion of the deal can take place. However, on the plus side, you can be almost sure at this stage that this is more or less the last of the acceptance hurdles to be jumped. If the accountants’ review is satisfactory, then the deal will almost certainly proceed to the legal stages. However, very few reviews ever come out completely clean. This is for three very good reasons: 1. The investigators want to appear to earn their crusts by finding something wrong in the forecasts. 2. There is usually something that can be criticized. 3. The investigating accountants will be very reluctant to pass a completely unqualified judgement since they will always fear for their liability if something goes wrong with the deal subsequently. Disclaimers will abound in any investigating report, and the terms of the remit will have to be very strictly defined before it goes ahead.

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The extent of the remit given to the investigating accountants will vary between investors and possibly even between individual managers within the same fund, as suggested earlier in this chapter. As a minimum, the accountants will be asked to verify the existing levels of working capital and to make such comments as they think fit on the business’s plans for the future. Some potential investors may want a review to be conducted that will approach the levels of diligence of an audit, in addition to a completion audit. This may then cover a good deal of historical and statutory information. The purpose of this is presumably to verify that the past record of the company has been as described. The content will more usually be dependent on the nature of the proposal being put forward – a start-up has li�le to audit, a�er all, but a complicated or fast-changing business may require a belt-and-braces approach. In general, larger deals tend to require more complicated investigations, and angels tend to be fairly robust in what they really want to find out, being more amenable to paring investigations down to the bones. Financially qualified angels may well feel comfortable with the level of due diligence that they are able to complete themselves; there is, a�er all, no law that says you have to have an investigation. It is unusual for the business’s auditors to be asked to conduct the investigation, since the incoming investor usually wants an unbiased third-party opinion, but it is sometimes acceptable for a partner from a different office of the same firm of accountants to conduct the review. The investigation, if commissioned by someone who knows what he or she is doing, should not be regarded as a substitute for the exercise of an investor’s judgement but should be a support to the process of making a judgement. The duration of the investigation is likely to be very short – and the amount of effort required by both the accountants and the company being investigated is consequently intense. The purpose is not to spend a leisurely time ge�ing to know the company but to blitz the task and get a report to the potential investor as quickly as possible. Investigations rarely go beyond a couple of weeks from commissioning to reporting. The accountants want to take a snapshot, not a home movie, and that is what the investor is also expecting. Discriminating investors will be able to pick out the important details of an investigating accountants’ report and concentrate on them with a view to modifying the structure of the deal – unless, of course, the report is so damning that it kills the proposal stone dead.

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Occasionally such an adverse report may be received that the deal does die there and then. The fallout from such a deal can be toxic – but it is not usually without warning. I once commissioned a report that revealed that inadequate stock checks for the annual audit had been performed in a business (which was very highly seasonal and dealt in very perishable stock) since the term of the current auditors began. This meant that it would have been three years before a completely clean record could be established for the accounts; not surprisingly, we withdrew from the deal forthwith. The senior partner of the auditing office landed in very hot water for that one, and the company, which knew all about the auditors’ practice of accepting their stock records without independent checking, suffered badly in reorganizing its accounts. At one stage it was touchand-go whether it would make it, since the clearing bank (which had a floating charge on certain fixed assets, debtors and stock) got very windy about the whole affair. The moral of the story is not to even think about seeking venture capital if you know there are huge clanking skeletons in your cupboard. The irony was that the report had been commissioned (against my be�er judgement) from a sister office of the firm of accountants that had been conducting the audit. Checking all the planks of a business plan can go on for ever and become a substitute for actually making a decision. It is sometimes the way that an investor who does not want to complete a deal can avoid being brought to the sticking point – there is always something more that needs checking. The management team cannot completely avoid this possibility, but should ensure that they ask for a detailed discussion about the due diligence at the outset of the process so as to establish a common (rough) timetable for doing the deal. To paraphrase Donald Rumsfeld, there will always be certain things that investors will not know they do not know until they come across them – which will extend a review of a proposal beyond the expected time – but experienced investors should have a very good idea of what the vulnerable parts of a proposal are and how they intend to assure themselves about the risk a�ached. The purpose of all this investigation – from the initial basic desk review to the completion of the expensive accountants’ report – is to help the investor understand the risks involved in pursuing the opportunity. The physical end of the process is the preparation of a report to the investment commi�ee, leading to an approval of funds to proceed. We now need to look briefly at the commi�ee.

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THE INVESTMENT COMMITTEE Business angels take decisions on their own about whether or not to invest their own money. The deal goes from presentation to investigation to negotiation to legal stages without interruption. This is not quite the case with investment funds: there is a break point at the stage where formal approval for the deal has to be obtained. Investment managers usually have to have their investments cleared by an investment commi�ee that will usually consist of senior executives of the fund (if the fund is modestly sized) together with a sprinkling of outside ‘wise men’ (and/or women) if the fund is substantial. These non-executives will be senior financiers (perhaps retired), senior business leaders and perhaps the odd academic (the adjective is used advisedly). The idea of having investment commi�ees is that the investing executive has to convince his or her colleagues that the deal is a sufficiently good one for them to want to give the go-ahead for the investment. The commi�ee reviews papers presented to it by the fund managers, who request both the approval of the investment and the release of funds to make the investment. The papers will be prepared to a set format (‘house style’) and will contain the following information:  a summary of the proposal;  the history of the business;  the CVs of the management;  a market report;  a major risks analysis;  the deal structure proposal – including details of syndication partners, if any, and details of management’s financial contribution, if any;  a calculation of the likely IRR of the deal on explicit assumptions;  detailed financial information;  a summary of the investigating accountants’ report. The sequence of this information and use of appendices to contain detail will be dependent upon the individual fund. Much use will be made of the information prepared by the company together with 155

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any expert reports on technology that have been commissioned. The papers are confidential and will not be disclosed to the company with which they deal. Investment commi�ees usually meet at regular intervals (in large organizations) and o�en consider several proposals together. In smaller organizations the meetings may be held as and when required – perhaps to consider individual proposals. Whatever their frequency or composition, investment commi�ees are not pushovers. Their powers of dismissal are real and are exercised. They do not automatically approve investments – few will be dismissed outright, but some investment proposals will be sent back to the manager for reworking of the investment structure to get a be�er return or to minimize a perceived risk. Sometimes this will mean that the deal that has been submi�ed by the investment manager will have to be renegotiated with the management of the business; sometimes it may mean that the commi�ee was unhappy with some aspect of the review and wants it to be investigated further. Once reworked, the review will then be resubmi�ed. If the commi�ee’s concerns have been met then the deal probably gets approval. With approval, the fund may or may not send out a formal offer le�er that repeats the terms on which the commi�ee has approved the deal, and this is usually countersigned by the company to signify that it has received and understood the structure of the deal. With both parties having signified that they have the capacity to proceed, it’s off to the races – or rather to the solicitors.

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12

The choice of investment vehicle: existing business or newco?

Corporation, n: an ingenious device for obtaining individual profit without individual responsibility. (Ambrose Bierce, The Devil’s Dictionary)

 Factors involved in determining the investment vehicle  Type of investment  Realization intentions  Trading record  Complexity  Tax  The impact of structure on the return to investors 157

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Following on from negotiations with the existing shareholders – and in fact sometimes part of that discussion – will be discussions and negotiations between the investors and the entrepreneurs over the choice of investment vehicle. In other words, will the investment be made in the company currently owned by the management or in another one specially created for the purpose – a ‘newco’? This may seem to be one of those dry-as-dust academic questions best le� to the lawyers – but in fact it can have significant impact on what happens a li�le further down the line when the investment comes to be realized, and so it is worth spending a li�le time considering the pros and cons of the various options. Not the least of the considerations about the type of investment vehicle will be the financial structure that results from the negotiations between the new investor and the management who are going to run the business. The financial structure chosen for the investment will have a significant impact on how much the investment is worth when it is realized. Needless to say, it will result substantially from the investors’ desire to minimize the risks that they run in the investment. Financial structures cannot be designed in isolation from considerations of the scale, type, purpose and likely outcome of the investment and are almost certainly going to be tailored to the special characteristics of each individual investment. There are preferred house styles – 3i used to have one particular style of investment that was reasonably easy to identify because of its inclusion of redeemable shares, which boost the value of the remaining equity – but the market is now very homogeneous in its choice of financial instruments, and so the differences mostly amount to variations around a theme. That is useful for us because it means that we can describe the basic types fairly simply. As far as making any proposals in the business plan is concerned, it is probably very unwise to take any pre-emptive decisions about structure before both the quantum and the specific arrangements for the money are agreed. But it is essential for the managers of the business to understand how the corporate structure can influence the financial structure. There are (at least) four major commercial factors, and one subsidiary one (tax), in deciding whether you are going to have a new company to play with or use an existing one. These are:  The investment type that is being made – broadly speaking, whether the investment falls into the classification of start-up or

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development capital, buy-out or recovery. Considerations of the existing shareholding structure might also impinge on this.  The intention of the parties in realizing the investment – again broadly, whether there is going to be a flotation or a trade sale, whether further acquisitions are going to be made, or whether there is already evidence that some form of additional financing will be required at some point down the path.  The trading record of the existing business – if it is consistent then that would argue perhaps for a different approach from one where the record has been patchy; if it is very variable (perhaps even because of something as trivial as head office charges that have been levied) then again that might argue for a different choice of investment vehicle from one where there had been a historically strong (perhaps even accelerating) record of stand-alone growth.  The complexity of the investment – whether there are multiple divisions, or a research and development business feeding marketing arms, and whether there are now, or are likely to be in the future, manufacturing and service functions serving the same or different customers – may affect the choice of vehicle.  Taxation considerations may very occasionally dictate the choice of vehicle in special cases. While tax efficiency for all involved is a laudable aim in the detail of an investment, it is probably not going to be a very good investment if the sole consideration in deciding a commercial structure is a desire to avoid some tax statute. There is a danger – which must be avoided – that the fiscal tail will wag the financial dog if taxation concerns are elevated above their rightful station. Sometimes problems are stored up in the ‘financial engineering’ that takes place to try to circumvent current complicated tax regimes and this will backfire in the long run. The combination and significance of these factors will have various influences on the way that the business is structured. Professional help will certainly be required to sort out the tangle of influences and to design the correct structure. Since all the turmoil of a legal agreement is being entered into then it might be best to roll the costs of reorganization into this process at the same time. Looking at the detail of the factors outlined above will illuminate some of the considerations that have to be borne in mind.

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TYPE OF INVESTMENT Development capital and start-up deals may well sit comfortably inside an existing company, but the chances are that a buy-out will require a new company to be created that can purchase either the assets or the business from the existing owners. Sales of divisions of larger businesses usually require the creation of a newco. A�empts by the seller to be helpful by shovelling the elements to be bought out into one company – possibly a previously dormant subsidiary – are unlikely to turn out to be so. It is far be�er to have the assets for sale identified but to leave the choice of vehicle to the time when the deal is ready to be done. The choice of buying either assets or the business is one of those situations where tax considerations can be pivotal in determining the structure of the investment vehicle. And in the case of the buyout the whole arrangement is complicated by the vendor also having tax interests that will probably need to be protected. It is o�en very much simpler to create a new share structure, which can then be used ‘clean’. With special consideration having to be given to the facts of each case, it is not really possible to generalize further about what sort of structure suits what sort of situation: the eventual choice will be decided by the circumstances, the current tax regime and professional advice.

REALIZATION CONSIDERATIONS Once you have considered what option you would like to follow in either continuing with the existing business or substituting a new one, you have to place the overlay of realization intentions over the decision. If you are going to try to float a business, then it needs a substantial trading record before it can be taken to public investors – at least three years of trading. Thoughtless elimination of an existing record even if it is not a terribly exciting one (such as occurs by employing a newco as the investment vehicle) could cost you dear in terms of extra time required to establish the record. A sale to a trade buyer does not carry such considerations, and if that is your aim then the trading record may not be so important. (But what happens if you and your investors change your minds?) If you can see that there is going to be more money 160

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required in the future to bring the business to its fully exploitable level (such as o�en happens with angel-backed deals, for instance) then you should choose a structure that will allow some room for shareholder expansion and does not require, at the extreme, blow-out financing to bring about change. This probably means a straight equity deal with no funny money tucked away into redeemable preference shares or convertibles. Start-ups are be�er served by such structures anyway – most business angels know this and shy away from structurally complicated deals.

TRADING RECORD If the business that the incoming financiers are investing in has a patchy trading record or is too closely associated with the business that it is being bought from, then it might be that the investors persuade the management of the a�raction of an entirely new company through which to make the investment. The timescale that the management suggests for the realization of the investment will also have a bearing on this – for instance, if the intention is to take the company to a flotation. But cu�ing ties with a dominating parent can also be a strategic move to establish a new identity and make customers and the investment community at large aware that the business is under new management, with its own plans and its own operating priorities. In the event of a purchase of a business to bring about its recovery it might seem sensible to cut away the past history of a failing company by creating a new trading vehicle. But it is likely to be practically impossible to do so unless some formal insolvency arrangement is contemplated – and even then the scope for doing so may be limited by both the law and creditor pressure. Buying out part of a failing business is usually best done with a newco that is set up clean and then buys the assets that it wants from the old business. Where there is merely a bad trading record, the options are more flexible and will be dependent on factors such as the amount of capital being injected, the changes being made in the management of the business, and changes in physical and organizational structure. But beware of je�isoning tax losses along with the old business.

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COMPLEXITY Buying a complicated business may well argue for a newco to be utilized so that it can form the holding company of a future new group structure. A complicated business is one that has lots of trading subsidiaries in different fields, owns a multitude of properties, has trading licences or operates internationally. Buying out an existing complicated business from a conglomerate parent and then restructuring can be a troublesome exercise; it might be be�er to grasp the ne�le now with a new and more commercially justifiable structure. But if you are going to do this then you have to be careful of the TUPE Regulations. You can’t buy something out with existing employee contracts and then make unilateral changes to those contracts – the law won’t allow you to. You also have to think carefully about the tax implications of what you intend to do. And the ba�ery of regulations grows. As of March 2005, TUPE has been joined by the Information and Consultation of Employees Regulations 2004, which provide that employees now have to be consulted in advance about changes in the structure or organization of the business that are likely to affect employment. Ma�ers covered by these regulations specifically include mergers and acquisitions and takeovers.

TAX Without contradicting what was stated earlier about tax considerations not being allowed to be the main factors in determining corporate structure, it is easy to see from the above that tax does play a significant part in determining the structure of investments. Almost every choice is qualified with the need to consider the tax implications of what is being proposed. Consequently, although the commercial factors are the ones that should be driving the deal, one of the marks of a sophisticated management team is not to neglect entirely the issue of tax-efficient structures. The investors will obviously have the major say in what the structure of the deal is going to be: even a ma�er as apparently straightforward as the choice between purchasing assets and purchasing the business will have tax ramifications for the deal. But the management team has to be aware of the tax implications of the deal for their own interests and must be prepared to speak out in order 162

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to have the proposed deal modified if they feel that the suggestions being made harm their interests. It is be�er to have disagreements about the structure of the deal before entering the legal stages than during them and even be�er to have such disagreements out in the open before the deal is finalized. It may be that the current owners of the business need to impose a certain structure on the deal to ensure that their own liabilities are minimized. This is o�en the case where the business is being purchased from one major shareholder who is approaching retirement age, for instance, and who wishes to take advantage of the tax provisions offered for this contingency. It is also at this point in the deal that managers should actively begin to plan to minimize the impact of personal taxation on the proceeds of the realization. Any particular arrangements that need to be made should be introduced into the discussion about the corporate structure at this point. Minimizing the impact of personal tax charges in the event of a realization can usually be achieved with some planning and provided that the necessary accommodations are identified in order to be made in the corporate structure early enough. This may not be possible later, when less manoeuvring room is available in deciding how the money goes in and in what form. For instance, the management may decide to use individual trust arrangements to protect some of their likely gains and, since trusts cannot in themselves be shareholders of a company, that prospect has to be dealt with soon a�er the start of serious negotiations between management and investors. Tax ma�ers should not really become deal breakers, and if dealt with soon enough are unlikely to be so. They only really become troublesome when someone neglects to warn all the other parties about a special concern and the deal trundles along under its own momentum with positions gradually becoming embedded and too complicated to disentangle. It should be obvious from this brief tour of some of the salient factors that the decision about how to approach the choice of investment vehicle is not one that should be taken in isolation of a review of the circumstances of the deal. Still less should it be taken in isolation by one party or another. Dogmatism on the part of the management team for one preferred route without initial consultation with the investor about the most suitable choice is a sure way of introducing angst into the negotiations. Negotiations that start in that way are unlikely to get 163

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very far. The deal structure that has to be se�led on eventually has to be the one that all parties can live with – not one that reflects only one party’s preferences. Equally, if investors press for one style of investment structure without preliminary consultation they should be challenged if the characteristics don’t meet the aspirations of the management team. It is usually possible for the investment to be tweaked in some way to accommodate modest individual requirements. And lastly, professional advisers who encourage their management clients to adopt one particular strategy for arcane reasons of tax or personal preference will be doing them no favours in the long run. The reason for this is that a requirement of one particular investment structure will limit the options available to the investors in determining the shape of the investment. This ambition on the part of incoming investors to design the investment structure is not a simple piece of ritual meddling but an obligation to try to find the structure that best suits their overriding intention to minimize the risk they face. Given this need and aside from the implicit difficulties of deciding on the desirability of the basic structure, it is probably foolhardy to take any pre-emptive decisions until heads of agreement have been se�led between the parties. In fact, trying to fix a structure that will cater for as-yet-unknown developmental changes in the business at this early stage might be taking a bridge too far. What should be borne in mind is that, whichever structure is chosen, it should be capable of accommodating the changes that the business is likely to experience up to the forecasting horizon. The three golden rules are: 1. Don’t take any decisions in isolation. 2. Don’t neglect to warn other parties of any special considerations that might apply to your plans. 3. Employ the best possible professional advice you can. What management teams o�en forget in the heat of raising the cash to do a deal (and running the business at the same time) is that they are investors too. While the deal is likely to be imposed by the VCs in the first instance as investors, the management are entitled to have a say in the structure of the deal. But the management themselves will have to make this known. If they want a certain twist to the deal incorporated into the structure, then they will have to argue it. From this it can be appreciated that there is a fourth rule implicit from the

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three above: you cannot expect anyone else to look a�er your interests in negotiating the structure of the eventual investment.

THE STRUCTURE OF THE DEAL AND THE RETURN TO THE INVESTOR Commercial considerations will affect the choice of deal structure, as the sections above have shown. But that is only part of the story. Internally to the deal, once the choice of vehicle has been made, investors will be anxious to adopt a financial structure for the business that secures their primary objective of reducing the risk to which their investment is exposed. There is not a lot that investors can do about market risk (and by entering the deal they are presumably content with the risk–reward ratio for that element of the deal). So investors will then move back to the part of the deal that is controllable – the way that the money actually goes into the business. Venture capital deals are equity investments. Investors put their money in as shares and become part owners of the business. There may be some loan stock added to balance the investment (see below) but this is usually much less than the amount of share capital. But not all shares are equal in their rights and obligations. VCs will make maximum use of this differential to do two things: first, make sure that they have only the minimum amount of their investment locked in as ordinary shares; and second, make sure that they are the first to get their money out of any deal. But in contradiction of these limiting requirements they will want to control the company too. Ordinarily, control in a limited company is exercised through the voting weight of ordinary shares, all of which are equal – more shares equal more votes equal more power to determine the company’s strategy in those ma�ers that can be decided by shareholders. But by limiting the amount of ordinary shares that they wish to hold for value reasons, VCs ostensibly limit the control that they can exercise. They get over this contradiction by employing different types of financial instrument to make their investments. In order to examine fully how they do this, we need to take a small digression to describe the various species of financial animal that inhabit the venture capital jungle.

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Financial instruments For completeness’s sake, let’s start at the beginning. The simplest of all the financial instruments is the loan. I lend you money for a fixed period; you pay me back at the end of the period (or ‘term’), or in instalments, and pay me interest all the while. Sometimes the loan repayments are modest and a large chunk is saved until the end – these loans are called ‘balloon loans’. Loans can come in lots of different guises, but essentially the principle (no pun intended) is always the same. The bankers get their money back at the end plus some interest. The loan is too simple for most VCs because it does not do what they want – it confers no rights of ownership, except perhaps in default (which they are not interested in) when it commands security. So VCs don’t make loans – they leave that to the bankers (but see the information on convertibles below). The consequence of demanding security, against which their loans are made, always puts bankers and VCs in opposite camps. Next rung up on the food chain is the ordinary share. This is the first of the financial instruments to have rights of ownership. Ordinary shares are permanent and live as long as the business does. They can be added to but not reduced in number – which makes them the ideal instrument for funding young businesses. More shares are added as the requirement for cash increases, and the rights of everyone remain the same, but the incoming shareholders dilute the voting power of existing shareholders. Ordinary shares usually have a right to a share of the distributable profits of the business, which are shared among equity holders. Ordinary shares also have the right to vote at meetings of shareholders – although the rights of ordinary shares in any particular circumstance will be determined by the terms set out in the company’s articles of association. These will be dealt with in detail in Chapter 13. Most VCs don’t like ordinary shares for their holdings, since they don’t offer enough scope for protecting the rights that they want to impose. They would rather have preferred shares, next one up in the family tree. The ordinary share’s bigger sibling is the preferred ordinary, which is entitled to a slice of the distributable profits before the ordinary shares. It gets its name because it is preferred in the ranking of entitlement to dividend. Voting rights may, or may not, be the same as for ordinary shares – again, depending on what the articles say. 166

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Top of the ordinary shares pecking order is the participating preferred ordinary (PPO) share, which gets a dividend equal to some identified percentage of the distributable profits – thus PPOs are usually called 3 per cent PPOs or 5 per cent PPOs, dependent upon their percentage entitlement. PPOs usually also have voting rights, which are again determined by the company’s articles. Sometimes the name is just kept at participating ordinary. So far, so good. These types of share are quite basic in the form of their rights and obligations. It is beyond this level that things start to get slightly more complicated, as the VCs start to play variations on themes. The chief variations are to do with convertibility rights, redemption rights and cumulative rights to dividends. ‘Convertible’ means that the shares change into something else on some trigger event; ‘redeemable’ means that the shares can be eliminated as a class from the company’s balance sheet (but only out of the proceeds of a new issue of shares); and ‘cumulative’ means that the shares have the right to catch up on any dividends that they may have missed in previous years when there wasn’t enough profit (and/or cash) to provide a dividend. The situation gets really quite complicated when the variations are multiple. Either of the preferred or participating classes can have any one or all of the additional rights of convertibility, redemption or cumulation applied to it. So it is quite possible to have convertible participating preferred ordinary shares (CPPOs) or redeemable convertible participating preferred ordinary shares (RCPPOs) or even cumulative redeemable convertible participating preferred ordinary shares (CRCPPOs). Having considered some of the major tweaks that can be added to simple share structures, let’s now revert to seeing how they are applied.

How the variations work The intention of these variations is always to give VCs some advantage. In the case of cumulation, the intention is to protect the ‘running yield’ that the instrument offers so that the investment is continually ‘performing’. This enables investors to reap some return from the profits that the business makes even if the capital appreciation that was hoped for is late in coming through. A patchy profit record will be salvaged – for investors at least – by the fact their dividends will be protected. 167

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Cumulative dividend shares are entitled to arrears of dividend before any current dividends can be paid. So ordinary shareholders have to wait before they get their dividends if cumulative dividend shares have missed a turn. The characteristic of participation is that it does much the same thing – it means that investors get a slice of the profits before everyone else – so if the business is appreciating only slowly in capital terms then the investors make their money through a continually escalating monetary amount, provided it is generating profits and cash. The twist here is that participation is based on the profits that the business achieves not the value of that class of shares. So pu�ing a comparatively minor amount of money into this type of instrument can have massive ramping effects on the rate of return in an investment where lots of cash is thrown off by the business. Convertibility is used to exchange one sort of shares for another. The purpose of this may be to swamp the other shareholders in the event of some difficulty with the company so that they can take both voting and managerial control. If the company is performing badly and the management owns more than 25 per cent of the capital of the business, then the investors may find it very difficult to effect changes that they want to see in the strategic direction of the business. Swamping an underperforming management with a flood of converted shares that suddenly become ordinary voting shares enables control to be exercised in the bluntest way. These conversion rights will also usually be accompanied by ‘board-packing’ rights, which will give the investors the right to appoint sufficient directors of their own choosing to outweigh the management directors on the board. This will then ensure not only that ma�ers put to shareholders are capable of being won on a shareholders’ vote but that the right ma�ers are put to shareholders and furthermore that they are then executed by the board. Convertibility may also be used simply to clean up a share structure at the moment a sale or flotation occurs, when one class of shares has had different rights to the others – typically, participation or preference will evaporate on conversion. So if these shares are made convertible then their additional rights disappear and they can be sold as ordinaries. More practically it may also be used – along with redemption – to change the proportion of ownership either in favour of the managers or in favour of the investors. This is done for one of two reasons. One is for ratcheting and the other for reasons of valuation. 168

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Ratchets are employed to provide an additional incentive to the management team. They are either positive in their effect (they give shares back to the management for either agreed performance or overperformance) or negative (they take shares away for underperformance). Convertibility is generally used for a negative ratchet, as it alters the balance of ownership in favour of the investor, while redemption is generally used for a positive ratchet, as it has the effect of removing shares that might constitute a proportion of ownership. However, where a ratchet is employed for this purpose the redeemable instrument will o�en be a loan, since (to simplify the situation slightly), under company law, redeemable shares can be redeemed only out of distributable reserves. In the absence of these – probably the case when the business is young – then the redemption can only take place from the proceeds of a fresh issue of shares. This defeats the object slightly, as far as giving shares to the management is concerned. So a positive ratchet will o�en be in the form of a convertible and redeemable loan – if it is not redeemed on time then the investor will have the option to convert it into shares at some agreed rate, which is usually provided for in the investment agreement. Redemption will usually take place at agreed windows (say, a�er a year or maybe 18 months from the date of investment and then at intervals of every six months therea�er), which places the burden on management to so arrange their business that they have generated the cash to take out the required chunk of the investor’s initial injection. Early redemption of substantial chunks of the investment also serves investors well. It reduces their overall risk profile by ge�ing some of their investment back into their hands early, and it boosts the rate of return of the investment as a whole, since the value of the investment is also calculated against time. Convertibility and redemption can also be used for valuation reasons. If the sum of money required by a business is large in comparison to its current value it will be very difficult for investors to put all their investment in as equity. A start-up requiring £1 million, for instance, will command an unreasonably high valuation that cannot be sustained if all the cash is put in as equity. Pu�ing more cash in to sustain the growth of the business in future will also be very difficult if the initial valuation is high; in fact initial overvaluation is one of the prime causes for blow-out financing in subsequent financing rounds. To get over these problems, investors can employ positive ratchets where they take more of the initial equity than they intend to end up with and then release some back to the management as the company 169

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develops according to plan. This is done by using a core of ordinary shares (which is the amount that the investor intends to end up with). These are bought at a comparatively modest price and using a slug of redeemables/convertibles to balance out the remaining required cash. The ordinary shares constitute the accounting valuation of the business for the purposes of the investment and for calculating the likely rate of return. The redeemables/convertibles can then be used to give back equity and act as a control mechanism in the event of nonperformance. In this way the investor can achieve all of the following:  make an investment at a reasonable equity price, yet still provide the total amount of cash required;  incentivize the management;  protect the investment against commercial reverses; and  reduce the impact of second-round funding at an adverse price, since the price and value of the redeemables can be isolated, with luck, from what happens to the price of the minimal quantity of ordinaries.

How and why deals are structured the way they are Given the details that have been explained above, it should begin to be apparent why investors choose to put their money into a business using instruments other than straight equity. The overriding consideration is one of risk avoidance. At the macro level, investors try to keep all their eggs out of one basket by adopting a portfolio approach to their investment strategy. The shrewd investor will place some of the total available investment funds into low-risk, high-yield situations, some into high-risk, low-yield situations and some in the middle. This strategy will also be pursued at the micro level if at all possible: in each venture investment there should ideally be a spread between high risk (pure equity) and a type of moderate-risk, interest-bearing instrument that is more insulated than the straight equity in the event of some commercial reversal. (Nearly all direct investments preclude the choice of a low-risk instrument.) If investors place all their investment in one type of instrument then they place it all in equal jeopardy. If anything goes wrong, everything 170

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goes wrong. By spli�ing the investment into different types of instrument, although it will all still be subject to the riskiness of the investment as a whole, it will be possible for investors to a�ach certain rights and obligations to different types of share and to protect some of their investment. This protection may be limited, but it is be�er to have some protection than none. The secondary consideration is that ordinary equity has to wait for an event such as a sale or flotation to achieve a realizable increase in value. If a different class of share, which has participation or preferred rights, is used in the investment then it may not enjoy all the capital appreciation of the ordinary shares but it has the potential to improve the overall rate of return by returning cash to the investor both earlier and faster than the ordinary shares can. Since the way that investment returns are calculated takes into account the time value of money, then a pound in the investor’s pocket in 18 months’ time is worth more than a pound in 36 months. Investors can of course waive their right to a participating dividend if the company needs more cash for an agreed reason – an acquisition or a physical expansion, for instance. Investors will have to calculate the cost or benefit of forgoing the interest or dividend on that part of the investment against the prospect of a higher capital value for the ordinary shares. It is in such cases that a�aching multiple rights to shares becomes very useful. The cost of participation rights forgone can be ameliorated by being able to exchange some of those shares into ordinaries that will benefit from the greater capital value of the company occasioned by the expansion. Lastly, by ascribing superior rights to separate classes of shares and keeping those superior rights to themselves, investors give themselves the power to take control of the available cash generated by the investment in the event of a failure of the company to make its commercial targets. There is also the sanction on the existing management to take complete managerial control by dominating the voting rights of the ordinary shares (via convertibility) and associated board-packing provisions. Finally, careful structuring enables different valuations to be placed on businesses.

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Preference for structuring Business angels are probably less likely to indulge in elaborately structured investments than managers of investment funds. This is for two principal reasons. First, business angels are unlikely to have the experience of having done the complicated deals that pu�ing successful structures in place requires. Complicated structures require complicated legal agreements, and lone investors may not have either the technical expertise or the legal grounding to work these through. Syndicates of angels operating at the development level may well include more sophisticated structured deals in their investment arrangements. They can afford to pay the lawyers collectively to do the groundwork; they may well be in a more complicated deal; and the larger amount of money involved (as there are more investors) usually means that there will be slightly different priorities for the investment. Second, at the start-up or early-stage levels where most angels tend to apply their skills, complication is a threat rather than a safeguard, so over-elaborate structures are to be avoided. Simple deals work best at this level, and the need for a complicated deal will probably indicate that the commercial nature of the opportunity is unsuitable for a lone investor. The risk of blow-out financing will not be reduced by introducing a complicated deal structure. If more money is required than can be provided by the individual, then a complicated structure is not going to lessen the risk. Conversely, the larger the deal the more likely there is to be a sophisticated structure. This will be done both in an a�empt to accommodate individual partners’ appetites for risk and to ensure that the investment is fully funded. Syndicated deals among investment funds where one partner has taken responsibility for the deal o�en involve the use of ‘strips’ of the deal being allocated to syndicate partners: everyone participating gets a ‘vertical’ strip of the total structure ranked according to risk and reward – some ordinary equity, some preferred shares, some redeemables and so on. Partners can then buy multiples of strips according to their preference for the deal. This arrangement also provides for fairness between the investing partners in terms of eventual return from the various instruments that are available in the deal.

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Other reasons for the structure In general terms, simpler deals are be�er deals. There is a uniformity of purpose and a greater degree of cohesion between the parties where interests are not split by different types of shareholding. But it is very unusual to find deals where there is no differentiation at all. And in many cases, some form of differentiation works well for the management side – o�en a differential pricing mechanism is introduced into a deal to enable managers to buy shares more cheaply than the incoming investors, for instance. So deals that are overly complicated are probably bad deals, and a structure that is devised solely as a means to accommodate a bad commercial proposition is not going to make it any be�er. If the deal looks like ge�ing unwieldy then the best thing to do is to go back to basics and try to think of a simpler method of accommodating the requirements that the parties are placing on the structure rather than on the opportunity. One of the methods of doing this is to try to involve another party in the deal. Though it may sound as though this is introducing further complications, it may help to break the logjam. In particular, some funds specialize in providing ‘quasi-equity’ that takes a good deal more risk than simple bank loans but doesn’t require all the rewards accorded to pure equity. This is sometimes called ‘mezzanine finance’ – since it fits in halfway between the two types of funding, pure equity and pure debt. It o�en takes the form of unsecured debt, which is paid off quite quickly but leaves an equity ‘kicker’ in the business for the lender. Although the investing and management parties will have to compromise to some extent over their holdings, using mezzanine finance can sometimes untwist the knots that deals otherwise get into.

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13

Legal stages: where the going gets tough

Lawyer, n: One skilled in circumvention of the law. (Ambrose Bierce, The Devil’s Dictionary) The first thing we do, let’s kill all the lawyers. (Shakespeare, Dick the Butcher in Henry VI, Part II)

 The stages of the legal process  Major features and documents  The term sheet  The disclosure le�er  Formal legal documentation

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THE PROCESS STEP BY STEP If you thought that ge�ing a VC to invest in your business was hard going then you may be in for something of a shock when it gets to the legal stages of doing a deal. This part of the process, where the governing terms are hammered out, is usually a long, hard slog. Much energy is expended in ge�ing to the position where each side feels comfortable with the form of the investment. I nearly wrote ‘happy with the form of the investment’, but that would be an overly generous description. It is not unusual for the relationship between the parties to change to something distinctly cooler a�er this point, and it is possible that there will be irreparable knocks to the rapport that has been built up unless care is taken by both parties to avoid them. This is especially the case if the lawyers are allowed to run (sometimes even rework) the deal. If this happens then there is a danger that the process will turn into a combat between professional arguers each determined to beat the opponent instead of a codification of the rules that will govern the conduct of each party towards the other. In these cases the most that entrepreneurs can hope to come out with is that some of the more egregious stipulations – those that work only in favour of the VCs – are knocked out of the deal in favour of ‘almost reasonable’ terms. The cost of this pyrrhic victory is that at the same time as defeating the worst proposals a big hole will have been blasted in entrepreneurs’ wallets by the fees – which they will almost certainly have to pick up for both parties. It shouldn’t be that way. Many entrepreneurs may have had to swallow hard in accepting the financial terms that were put forward in the preliminary offer le�er. The terms will usually have fallen short of the hopes of the management team, usually in terms of the disparity between the price the management think that the business should command and what the investor is willing to pay. This may have resulted in some loss of morale and a li�le less enthusiasm for doing the deal. But an offer that doesn’t quite meet expectations is be�er than no offer at all. Unfortunately, the deal isn’t done yet, and the course of completing the deal is likely to get worse before it gets be�er. Few people ever enjoy the legal stages of a deal. In all probability the first reaction of the management team on reading the first dra� of the legal documents will be that this is not the deal that they thought they had. In fact, they may think that they 176

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are entering a different deal altogether, especially if this is the first deal that they have done. The primary reason is this business of risk minimization again: the lawyers will be keen to extract more value out of the deal for their clients if there is the slightest hint of a wobble in the expected progress of the business. The lawyers reason that if the anticipated rate of return is going to be sacrificed by management ineptitude then the capital value must be protected by their prowess. This has led to more than a li�le inflation in the protective clauses that the lawyers like to incorporate. Like much of the developing practices of the venture capital business, these provisions are mere aping of US custom. Offer le�ers have become ‘term sheets’, avoiding the unpleasant connotations of a legally binding half of a contract; flotations have become initial public offerings (IPOs); chance and risk have been reduced in ‘down-round protection’ and ‘liquidation preferment’. Companies seeking venture capital might be forgiven for thinking that the VCs’ desire to reduce risk has become extended into a desire to eliminate risk – especially as money generally has moved upstream to the bigger (safer) deals. It is more than debatable whether these developments are beneficial. Inevitably the extended legal provisions work to the disadvantage of the management of venture-backed businesses, and they also make refinancing increasingly problematic. On the other hand, the term sheets may work to the benefit of both sides by reducing legal costs (if properly handled) by taking some of the contentious issues into the pre-legal stages before costly legal bills are racked up. Generally, though, it is difficult to see how some of the proposed changes benefit anyone but the investors. In particular, the clauses in the original investment agreement put in to protect previously injected money (see below) cannot be easily reconciled with the need to give new investors a reasonable chance of achieving success with a sensible funding structure. In these situations, the management is normally the loser – both financially, since their share price valuations are shot to hell, and physically, since they are forced to try to run the business on no cash while financiers haggle over numbers. (Being mercenaries, the lawyers will oppose these clauses just as vituperatively when they work against their clients’ interests, if they represent the investee companies, as they will be evangelical in promoting them for the VCs.) The first piece of advice that should be given to management teams in respect of the legal stages is ‘Get yourself the best lawyer that you can afford.’ Under no circumstances should you anticipate that the firm of lawyers who have always done the company’s conveyancing will be 177

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able to cope with the grind of a venture capital negotiation. The last thing that you want in a venture capital deal is your lawyers learning how to do it as they go along. Make sure you use a lawyer who learned at some other mug’s expense. The lawyers preparing the documents (the investor’s lawyers) will have reduced what appeared to be an acceptable deal into a hostile document that places much more emphasis on the obligations of the management than on those of the VCs. Legal language is always daunting, but the frightening thing is that this reaction is – in essence – correct. The lawyers will have been employed to protect their client’s interest and, particularly, to reduce their client’s risk in the event that the exercise goes pear-shaped at some point in the future. In terms of the ever-present goal of reducing risk, the legal documents are the last ditch. It is no wonder that they are toughly wri�en in consequence. As we have seen, the primary consideration of any VC is one of risk minimization. Lawyers become paranoid about this overriding preoccupation, especially the very good (and therefore expensive) lawyers employed by VCs. Nowhere is this paranoia be�er expressed than in the legal documentation that surrounds a venture capital deal. The process of agreeing terms is one of a�rition. Legal point a�er legal point is advanced in ba�alions of words and squadrons of paragraphs, claiming why the deal has to be this particular way or contain that particular clause. These advances are then discussed and either repulsed or conceded. Counter-a�acks are mounted as proposals for change are suggested. These are ba�ed back, amended and usually incorporated in some modified form. The use of the language of armies is deliberate: the process can seem like a small war at times. It can o�en take three or more weeks to complete this process – and therefore the deal – if it is allowed to drag on. But there are exceptions. One of the biggest failures of the dotcom boom was a company called Clickmango, which had pretensions to run an online health and beauty business. (Great name, rubbish concept.) Clickmango’s legal documents were constructed, negotiated and signed in eight days. In other words, the whole deal worth £3 million was done, from start to finish, in less time than it usually takes for the desk review to be completed. Unfortunately, Clickmango collapsed within three months of opening its virtual shop – despite the fact that the terms of the legal agreement were held to be very good, coming from a well-established and respected venture fund. All that goes to prove is that very good, even fast-negotiated legals will not save 178

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rubbish businesses. By contrast, bad legals can definitely damage good businesses as the increasingly bad-tempered skirmishing between the lawyers, the management and the VCs wears down previous reserves of good will. Legal stages are not nice for any management team that simply wants to get on and do the job. This is the way that the process works.

THE PROCESS As with much of venture capital investment there is no consistency of format or content to the documents that are exchanged between the investor and the company. Just as each investment fund has its own house style, so each fund is likely to have a pet set of lawyers that looks a�er its deals. And each firm of lawyers has its own particular wrinkles that it wants to see incorporated in deals to protect its clients’ interests. The situation has regularized to some extent with the adoption of more consistent US-style ‘term sheets’ that have partially replaced the offer le�ers that used to be issued by funds. For simplicity’s sake the term ‘offer le�er’ has been used in this book up to this point (because I think that it more accurately describes what the document is), but from now on ‘term sheet’ will be used for consistency with current practice. However, the use of term sheets is still far from universal, and when they are used they can still be very variable in content. Regardless of individual peccadilloes, all term sheets or offer le�ers have the characteristics that they describe the basics of the investment that will be completed by full legal stages and that they are not legally binding as ‘offers’ in the legal sense. Investments of early-stage money, by angels for instance, may well never use term sheets or offers. Term sheets are usually issued at the point when the deal has received the preliminary approval of the investment commi�ee. To get to that point, though, the deal will have been partially negotiated already. The investment manager and the company will have discussed the structure of a deal in principle, and this will have been incorporated in the preliminary documents that the manager submi�ed to the senior fund managers or maybe even in an informal discussion with members of the investment commi�ee.

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In recognition of the fact that many venture capital-backed companies experience more than one round of financing, the first investment round is now referred to as Series A. The layperson might well wonder why this is; doesn’t the term ‘first-round funding’ serve just as well? This terminological exactitude is useful, though, when shares belonging to different funding rounds need to be described. Two types of shares that have otherwise identical characteristics can be identified by reference to the round they were created in – series A prefs (preference shares) will be immediately distinguishable from series B (second-round) prefs and so on. New term sheets and new legal agreements may be used in subsequent financing rounds, of course, to identify the particular features of investments made a�er the first. However, the description of the events and tools that follows applies to the legal stages of an investment completing funding for the first time.

MAJOR FEATURES AND DOCUMENTS The major documents that are used in completing an investment (in the UK) are: 1. 2. 3. 4.

the term sheet (previously known as the offer le�er); the subscription agreement; a shareholders’ rights agreement; and the articles of association of the company.

Sometimes the subscription agreement and the shareholders’ rights agreement are combined into one document; sometimes some of the provisions of the shareholders’ agreement may be repeated in the articles.

WHAT THE TERM SHEET CONTAINS The first thing that the term sheet contains will be a description of the deal structure. This is likely to centre on the types of shares that are the backbone of the investment. Because of their need to exercise additional rights over the direction of the investment, venture capital investors will normally invest in some 180

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form of preferred shares (which we have already seen are preferred because they have some form of preferential rights). These shares have rights that the ordinary shares owned by the founding management team of the business (called with startling imagination ‘founders’ shares’ or ‘management shares’) do not possess. The preferred shares will also include protections for consent for certain actions – these will probably include, at least, bars on:  capital spending above a certain limit;  a change of name;  a change of registered office;  a change of directors (hiring or firing);  the assumption of further borrowing;  the granting of any security;  any form of warranty being given without consultation with the investor;  anything that investors and their lawyers can’t think of at the time the documents are prepared but that investors might want to object to when it is presented for decision. These preference shares will have a value that is computed by reference to the ‘pre-money’ valuation of the company – ‘the money’ being the injection that the venture capital fund is about to make. They may have dividend rights a�ached (again, as we have already seen) and may be invested in tranches – or blocks – that enable the investor to withhold the entirety of the investment until certain ‘milestones’ are achieved along the business plan. As well as reducing the risk involved to the venture investor, this mechanism also is supposed to incentivize management. It should normally only be used where the business plan suggests that the money used by the company will diminish slowly – so that the initial injection can be topped up by a later tranche when the need arises. Anything else is really an abuse of the process and will probably have the effect of goading rather than incentivizing. Another red rag for most management shareholders is the liquidation preference that most venture capital investors will insist on. This says that in the event of the business going belly up during the time that the 181

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VC is invested then the venture money has the right to come out first if there is any surplus available for distribution to shareholders. This right is contentious enough to throw among ordinary shareholders in the form described, but it also applies to what are called deemed liquidations – mergers, acquisitions, changes of control of the company, consolidations or flotations (now more usually called IPOs, again following US practice). In short, what this means is that, whatever happens, the VCs get back their capital (plus any accrued but unpaid dividends, which will be protected under the preference clauses) before anyone else gets a sniff of the cash. Where the business is sold for a sum that only equates to the venture investment, this means that the VCs come out clean but no one else gets anything. Anything below the invested amount, where a liquidation preference is in place, means that the investors get all the pot – and, again, everybody else has to whistle. Even more tendentiously, this liquidation preference can be extended to include multiples in the event of an ‘event’ – so that VCs might stipulate a two- or three-times liquidation preference. This will ensure that the proceeds of any cash-generating event flow first to the VCs in the required multiple of their initial investment. The problem with this mechanism is that it potentially cuts across the rights that banks will seek to impose in determining security for themselves on the loans they might be willing to offer companies. That leaves the poor old management team caught between two sets of powerful financiers, without any powers of their own. The further undesirable effect of this is to make venture capital best suited to businesses that don’t need it (because they have no cash requirements other than those needed to change ownership) or where managers don’t really count as drivers of the investment and so can be disregarded as fellow shareholders; this is o�en the situation where the big independent funds now buy and sell (large) companies between themselves. The ratchet mechanisms that we have already looked at (Chapter 12) will be embodied in the conversion and redemption rights that are described in the term sheet. As we have seen, redemption rights can force companies to effectively buy out the shareholdings of VCs if the investment is not performing as expected or if the company takes an unexpected path instead of that outlined in the business plan. Conversion rights can be used as either positive or negative ratchets. They are fairly readily accepted by management. A variant of this procedure is to incorporate vesting terms into the term sheet. These control the amount of the company that the 182

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management own at any one time: the management only get their hands on a certain proportion of the management shares (sometimes called ‘founders’ shares’ in a start-up) over an extended period of time, growing cumulatively year by year. The vesting arrangement may be a straight line (say 25 per cent each year) or by determination and agreement. As is dealt with in Chapter 10, directors or founding employees who leave through some form of misbehaviour or of their own volition before a crucial commercial point may forgo their shares entirely or be forced to sell them back either at par or at some independently determined valuation. Perhaps less easy to swallow though are the anti-dilution provisions that are o�en incorporated in term sheets. These are designed to protect shareholders from the effect of the blow-out financings that were described in Chapter 8. These provisions will provide for methods to calculate additional shares that investors will be entitled to at the new price that is being struck in the so-called ‘down round’ to protect the capital that they invested. The effect of this provision is to grant investors additional shares at a lower price to make up for the fact that their higher-price shares have been undercut, so that the total monetary amount of the investment is not wri�en down: more shares at a lower price mean that the original monetary value of the investment is preserved. Again these conditions may well have the effect of so steadfastly protecting the original investment, through protecting share stakes, that they make subsequent (rescue) financing very difficult. Issuing more shares will normally be subject to pre-emption rights, which again will be covered in the term sheet. If the company sells more shares then the investor will have the initial right of first refusal of such equity before the shares are offered to outsiders. The Companies Act 1985 already includes such provisions (to protect shareholders from fraud), so quite why term sheets include this provision is open to question. Presumably there is no harm, as far as the VCs’ lawyers are concerned, in just making sure that everyone knows what the law of the land says. Disposal of existing shares is the mirror of selling new shares and will also be subject to a number of provisions. The most important of these are rights of first refusal – also embodied, of course, in the clauses governing the disposal of shares by founders and senior employees. The idea is to prevent hostile parties gaining a foothold in the company or the sale of shares at a price below the book value of the investors’ holding, which under UK accounting regulations would require the 183

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investors to write down the value of the investment – not an option that is liked, as we have already seen. Right of first refusal imposes no obligations on the VCs to buy the shares – merely that the seller must offer to them first. This can block sales completely unless balanced by a clause in the final agreement saying that once the offer has been refused by the investors, a�er a reasonable time for deliberation, the seller is free to sell the shares elsewhere. The addition of such a provision will probably be resisted. If one investor decides to sell his or her shares and can find a buyer, the term sheet will also usually provide what are called ‘tag-along rights’ for the VC. These may require that a similar proportion of the VC’s holding to that being sold by the other investor also has to be bought by the incomer – and not surprisingly it usually makes share stakes unsaleable because of the quantum of cash that has to be found by a buyer. The obverse of tag-along is drag-along. This provision is roughly equivalent to (but more robust than) that which exists in public companies where minorities who have not sold their shares to a predator at the conclusion of a bid can be forced to sell at the last prevailing price. It is, in fact, a sensible provision and makes companies more saleable rather than less. It is designed to prevent one shareholder holding out for a be�er price and obstructing everyone else who wants to sell – although it can also be used, of course, by an investor with cold feet to bale out of an investment that appears to be wobbling or to compel a management team to sell up against their be�er judgement. However, the twist that is usually incorporated by VCs is that the drag-along provisions will not apply to them if the sale is for anything except cash, other than at their discretion. The term sheet will almost certainly stipulate that in the event of the breach of any of its provisions then the investor is entitled to take certain remedies. These will probably centre on the right to pack the board with its nominees so that its normal rights, to have one or more directors, are suddenly tripled or quadrupled without any countervailing increase from management nominees. Some funds refuse to appoint directors because they are mindful of the requirement of the Companies Act that directors may not be partial in their behaviour at the board and have to act in the interest of the company as a whole. They will o�en appoint board observers who will a�end meetings – but not participate in discussions – and then report back to the fund. (The legal position of these individuals is ambiguous: shadow directors, according to the Companies Act, are those ‘in accordance with 184

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whose wishes other directors are accustomed to act’; such observers, when they have the power of the investment agreements at their elbows, are roses by another name.) These reports back up the frequent management information reports to which the term sheet will also entitle the investor, probably specifying frequency, form and content. The term sheet will also make reference to representations and warranties that the management team will be expected to make about the business. This clause provides endless problems, since it seeks to place a burden on the management that requires them to guarantee that everything that has been said about the company – everything, either wri�en or spoken – and passed on by them to the potential investor is accurate. Since every company is a moving target in terms of the way that it changes day to day, this can provoke considerable heartburn in the management. The warranties are actionable at law in the event that they are found to be flawed – and as VCs will not want to take the remedy by biting the company (that is by biting themselves) they will bite the managers instead. And needless to say the VCs’ lawyers will be dra�ing this clause as widely as possible. Management teams can console themselves with a number of thoughts:  There is usually a de minimis clause, below which claims cannot be made (although they can be aggregated and actioned once the total breaches the threshold).  Actions for breach of the warranties are comparatively rare in a going concern (it is only when things go wrong that the VCs start to search for scapegoats).  The disclosure le�er is there to protect them. The disclosure le�er comes a li�le later in the process, at the point where the deal is nearly complete. The reason for leaving things this late is to incorporate any last-minute changes into the information that needs to be laid on the table about the company. The term sheet will also contain details of the conditions precedent to the deal, which need to be completed before the deal can be signed off. These may include some or all of the following (and other terms too):  satisfactory completion of legal documentation;  satisfactory completion of due diligence; 185

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 approval by the investment commi�ee;  a full legal review of the company by the lawyers working for the venture fund;  tax clearances if required (usually by a venture capital trust);  satisfactory references for the senior managers – this may now include Criminal Records Bureau searches;  key person insurance being taken out on named executives;  satisfactory fidelity bonding.

THE DISCLOSURE LETTER Many management teams get the wrong end of the stick initially about the disclosure le�er. This is the device by which the management shield themselves from actions for breach of warranty – so the trick is to get everything you possibly can into the disclosure le�er, because once it is in there the other side is deemed to have been informed about it and cannot pursue it legally. This sometimes leads to ludicrous theological negotiations between lawyers about what is and what is not disclosable. These arguments may be riveting for the lawyers but cost a great deal of money. Shut them up by refusing to accept any changes to the disclosure le�er and stand on a point of principle; threaten that nonacceptance is a deal breaker. Non-acceptance should be exactly that – a deal breaker. But refusing to agree to non-acceptance does not mean that the consequence of the point of disclosure cannot be negotiated.

OTHER POINTS The term sheet is an effective halfway house in determining what the deal will be if the due diligence reveals no unexpected problems. It forms the briefing sheet for the lawyers who will be dra�ing the legal documents. It is not the end of the process of legal documentation but the first step. As such it can be negotiated and changed if there are sufficiently valid arguments from the management team for so doing. The term sheet will have a duplicate a�ached to it that should be countersigned by the management team, usually within a stipulated 186

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period of time, signifying that they have understood and agree to the terms. A�er legal advice has been taken – and not before – the sheet can be signed and returned if the terms are acceptable. If they are not, then the sheet should not be signed but an urgent meeting should be requested to discuss points at issue. There is no harm in doing this, and if the points are valid only good can come of it. No investor really wants to get into an investment where the terms of the deal are such that the investment will not work. If the management know of a good reason why the deal should be changed they have an obligation to the deal to try to get it changed. In truth, it is the process of completing the legal documents that is important. What results from the process – the shareholders’ agreement – is o�en largely redundant as a device for controlling the conduct of the investment. You end up with a big, thick, bound book of documents that is really only useful for hi�ing people over the head with if they don’t play the game. Those who have no intention of abiding by the rules really won’t care about a legal agreement and will normally put up only token resistance to points at issue during the negotiations. The process of discussing the legal documentation flushes out all the points that need to be understood by both parties and reveals the anomalies in the documentation that need to be ironed out to the satisfaction of both sides. It is this interplay that has real value, as each side gets to know the intentions of the other and the moods and characteristics of the other far be�er.

FORMAL LEGAL DOCUMENTATION If the due diligence and the accountants’ report reveal nothing that substantially alters the expectations of the investor, then the details that were contained in the term sheet will be retained into the discussion of formal legal documentation. The shareholders’ agreement will embody the majority of the terms that were first displayed in the term sheet, with necessary correction and adjustments being made to the company’s articles of association. As we have already noted, sometimes the articles will repeat terms that occur in the shareholders’ agreement – mostly unnecessarily but, as the lawyers say, for the avoidance of doubt. If the term sheet is properly wri�en, then there should be no surprises for management when they receive the dra� documents – in that all 187

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the points made in the term sheet should crop up again. But there are two things to watch out for when the dra� documents arrive: changes to the documents that reverse points that were agreed upon, either by accident or by design; and the detail of the points that were previously only set out in summary form. Legal stages can take a long time to hammer through.

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14

Post-investment considerations: culture shock

Enough, pron: All there is in the world if you like it. (Ambrose Bierce, The Devil’s Dictionary)

 The failure of mutual comprehension  Costs  Additional scrutiny – and the consequences  Requisite skills  Board atmosphere  Increased formality  The false hope of synergy  Outside involvement  Personnel change 189

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 Tactical actions of the investor  Further funding  The problems with angels  Non-problems It may have seemed a long, hard road to get to the point where the cheque is passed over, the lawyers cap their Mont Blanc Meisterstucks and gather their papers, the investors and the entrepreneurs lean back contentedly in their chairs and the post-investment party celebrations begin. In fact it is merely the start of the exercise. The true culmination of the investment is perhaps two or three years beyond the point when the financing is actually completed, sometimes more. Investors know this and now prepare to bend their efforts to making sure that the promise of the business plan is fulfilled. This will involve bending the management too – sometimes willingly, sometimes not – and sometimes leaving the business mostly as it came to the venture fund and sometimes changing it to something radically different. The completion of the (initial) financing process should mark the point where the interests of the financiers and the entrepreneurs begin to run along the same path. Until this point there has probably been something of an adversarial relationship at times – more or less apparent, according to the natures of the participants and the stage through which the deal was passing, as each party sought to ensure that the outcome of the legal negotiation favoured their position. In some deals, of course, for instance management buy-outs, the interests of the financier and the management are both almost the same from the outset – they both want to secure the lowest possible price for the business they are buying and are both anxious to reveal weaknesses (up to a point). It is only when the deal enters legal stages that the community of interests begins to separate. For companies seeking development capital (at any stage) a semi-adversarial relationship exists much earlier. But now that the deal is se�led there should be a combination of effort towards seeing the business plan brought to fruition. That’s what should happen and what both parties – management and investor – should expect to happen. Unfortunately it does not, in many cases. The paragraphs below detail some of the major reasons why.

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THE FAILURE OF MUTUAL COMPREHENSION The truth is that it is usual at this point for the two parties’ understanding of the practical mechanics of the achievement of the targets in the business plan to diverge. The management side o�en think that they will be allowed to go away and get on with running the business; the VCs believe that, because several times during the negotiations they alluded to the way they will want to get involved in the detail of running the business, the management side will have fully absorbed what was said and understood the implications. Many management teams seem to fail to understand when they complete an investment that they have taken on a nervous partner. Such anxious partners will want to know the progress of the business against the plan they have bought into, at least on a monthly basis and probably in real time; they will want to appoint their own director to the board of the company to represent their interests (even though this is strictly against company law); they might also want to appoint the chairman; and they will probably have all sorts of provisions in the legal agreements entitling them to control of (unusual) financial activity. Still less do most management teams comprehend at the outset of the relationship that investors – or their appointed directors – will probably want to get deeply involved in the development of the business’s future strategies. In short, the management team probably won’t have completely understood that they haven’t just taken on finance – they have married an investor. It wasn’t just a completion meeting they went to; it was a civil ceremony. It should be obvious from being set out like this, even though it may have escaped some management teams, that there will need to be changes made in the way that the business operates.

COSTS The first and most significant change is that running the company will cost a lot more than before the investment. One of the principal reasons for this is that the board of the company will swell in number – and cost. Most venture capital funds will be mindful of the current tenets of good corporate governance and will want there to be a majority 191

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of non-executive directors on the board of the company. (In small companies, where this may be impractical, they will still want at least one.) These people have to be paid for. There are no prizes for guessing who pays. Where the funds do not appoint directors of their own, they may also charge a monitoring fee that purports to defray the costs of the work they do in checking the business remotely. This will certainly be the case where they appoint an observer from among their own staff (and, it has to be said as an aside, it further complicates the shadow director conundrum).

ADDITIONAL SCRUTINY – AND THE CONSEQUENCES Outside directors, for those who have not been used to dealing with them before, can be a blessing or a curse – depending on the frame of mind in which the fund-raising has been approached and the temperament of both sides. Good ones are very, very useful; bad ones. . . Sensible companies will embrace them as both contributors (to the brainpower si�ing round the board table) and conduits (back to the investor). They have to be paid for, so they might as well be made use of. Several other developments will come very quickly. The management teams of all businesses will now find that they are under scrutiny in a way that they may be unaccustomed to. Subordinate staff are usually under continuous review in a commercial environment; most businesses recognize that the annual personnel review should merely be the device by which the summary of the continual assessment is communicated. At board level in a venture-backed business the annual review effectively happens every month when the board meets to discuss the company’s performance – and quite right that is, too. But this may be hard to accept for the managing director of a small to medium-sized independent business, who may have been top dog before taking on a large and powerful outside investor in the shape of the VC. One of the consequences of this change is that managing directors who operated quite comfortably in the sheltered environment of the private company, with only family and friends as shareholders and no real critics of their plans or opponents to their views, now find themselves exposed to the chill of external scrutiny on a regular basis. They may not immediately like it. The good ones rise to the challenge 192

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by making adjustments in both their own behaviour and the support that they can derive from the way the business is run. The bad ones – quite bluntly – get replaced (see below). The grounds for dismissing managing directors are not limited to a lack of professional capacity. It is surprising how many senior managers who have been used to running their own businesses cannot distinguish between the company’s money and their own. I can think of at least three cases, without much searching, where otherwise competent men who should have known be�er have been dismissed from very senior positions because they were unable to complete their expenses claims properly or because they anticipated, in their domestic spending habits, the proceeds of a flotation before it actually occurred and got used to using the company’s money to bridge the gap. Venture capital investors will not turn a blind eye to such misbehaviour. Nor will many tolerate extramarital affairs that occur between senior staff and jeopardize the future of the business in consequence. Most nonexecutives will be briefed by the VCs to deal with such ma�ers solely for the benefit of the company.

REQUISITE SKILLS Similarly, many early-stage investors find there is a need to change personnel as the business grows. The man or woman who started the business is not necessarily the person to run it as it expands. The skills required at start-up are different from those required to maintain and develop growth. A brilliant inventor or gi�ed technician who initiated the business’s product range may have started off as managing director – almost by default, since the managing director’s position is usually seen to be that of the pivot and leader. But it may make the company work be�er if that person is moved into a less managerially central position and one more suited to his or her skills and talents. Encouraging such changes is quite properly the responsibility of the outside investor (and the non-executive director), but not many companies – and even fewer major shareholders – will be prepared for this sort of advice being offered. Investee company managements may ask themselves when advice becomes interference. The answer for many is probably the moment you have a venture capital investor on board.

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The scrutiny of all the senior personnel of the business will now be much more plain than in the past, unless the business was used to operating to strict managerial reporting disciplines. Taking on venture capital is a bit like stepping on to a faster treadmill.

BOARD ATMOSPHERE The atmosphere at the monthly board meeting will almost certainly change, too – at least until the managerial directors get the measure of the new non-exec(s). And on the dark side, there may be management shareholders who feel for whatever reason that they did not come out of the negotiations and legal agreements with all that they wanted. Sometimes the deal may have been completed too swi�ly for them to put all the necessary arrangements in place to make it tax-efficient, or they may not have raised as much cash as they wanted to in the time they had. These individuals may well nurture resentments against their colleagues and the VC that can deepen into significant problems when the time comes for realization. Business angels are particular targets of such feelings – especially since they will almost always take an active part in the running of the business post-investment. They will be evaluating their new colleagues in a very practical fashion, from the moment they step across the threshold of their new investment. Their actions and involvement in the running of the business may put the noses of other team members out of joint. But with the background many of them have of senior managerial positions, they are probably be�er equipped to deal with these problems than the venture fund manager or non-exec who visits once a month. Non-executives may well want to spend some time ge�ing to know their new charges, and this will also involve some disruption to the business. Ideally non-execs should spend not less than three days a month looking a�er their responsibilities to each of the companies of which they are directors: one day for preparing for the board, one day for the meeting itself and one day a�erwards clearing up any consequential business and making a report to the investor if required.

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INCREASED FORMALITY Consequently, among young businesses, there is likely to be an increased level of formality in the way that they operate internally; in established businesses, procedures and systems are likely to need overhauling to ensure compliance with best practice; in expanding businesses, controls are likely to be reinforced to ensure that the money that has been raised is properly applied to the purpose for which it was raised. The ultimate purpose of the investor being on board should never be forgo�en: the money was invested to make the business more profitable so that it can be sold at a higher price. Everything that happens in the business from now on should be directed towards that goal. One of the ways that this can be done is to run the private business as closely as possible to public company disciplines. The VC and the fund’s appointed directors are unlikely to whip out the Combined Code to go through it line by line at every board meeting, but the major requirements of good governance in public companies will be at the core of the suggestions that are made for the be�er running of most venture-backed businesses.

THE FALSE HOPE OF SYNERGY At the period of the relationship when fund investors are courting good prospects and managers of likely investments are reviewing which fund to go with, there may be some loose talk on the part of the fund managers about the range of companies in their portfolio. The clear intention of such remarks is to suggest two things: that the fund will be well used to the particularities of the industry of which the proposing company is part, implying that due diligence will be less arduous and/or costly; and that there will be all sorts of synergistic opportunities for the company to exploit in making use of the huge range of contacts held within the portfolio. Management should beware of both these claims. As we have seen, due diligence is unlikely to be reduced for any purpose: the investor will want to know the nuts and bolts of the business intimately and, while familiarity with the industry or technology might make finding authorities to conduct appropriate market and technological reviews easier, it is unlikely to substantially alter the cost of doing the deal. 195

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As to the second point, while it may be possible for introductions to be arranged with senior industry figures by intermediation by the manager of a very large fund, that is about as far as it goes for most funds. Many funds are in fact quite leery about stimulating contacts between their investee companies, because of the commercial dangers that can arise when this happens. The prospect of conflicts of interest for the investor are not hard for anyone to foresee. Problems can arise when one company in a portfolio becomes a supplier to another. A venture manager who stimulated such an arrangement by positive introduction would stand in a very different position from one who happened to have two companies in his or her portfolio that happened to trade with each other. To give an example, consider this case – which is not too much of a straw man: what would happen when one portfolio company tried to buy another portfolio company to secure a market position? How would the VC approve a price that was acceptable to the fund as simultaneous purchaser of one company and vendor of another?

OUTSIDE INVOLVEMENT While things go well, most VCs will be prepared to let the business run on with only gentle tweaks of the rudder to encourage beneficial change. The first major involvement of substance is likely to come when the first post-investment budgeting round begins. Up until this time, of course, the fund’s non-executive director will have been participating in board meetings and making reports back on the progress of the investment. At the budget round, he or she will begin to engage fully in the process of making sure that the business sticks to the promise of its business plan, the premise on which the investor made the choice to invest. However, it is only when things start to go wrong that the real power of the investment agreement can be brought into operation. That is when the management of companies will begin to appreciate the size of the elephant that they have got into bed with. There are very many devices that VCs can employ to get their way in an investment that is not proceeding according to plan. They will use them all if necessary. Don’t forget – venture capital is all about understanding and reducing risk. In a situation that is going pear-shaped, reducing risk is accomplished by taking action. 196

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The first action that can be taken is to suggest that budgets be trimmed to preserve the profitability of the company. The legal agreement (following on from the term sheet) will have given the VC the power to approve or reject the company’s budgets. The quickest way of making a business profitable in the short term is to reduce overhead costs – that almost always means reducing staff numbers. These suggestions will usually be voiced through the directors appointed by the VC if they have not been made first by the incumbent management. One of the things that o�en comes hard to previously independent boards is the involvement that the VC will o�en want to have in se�ing pay levels for senior staff. The legal agreements will undoubtedly carry a provision that enables the venture investor to approve (that is, reject) pay increases for senior managers. If the increases are not commensurate with the performance of the company, they will not be approved: the budgets that the company presented in seeking to raise finance (perhaps as amended during the due diligence process) will be the guiding light for this.

PERSONNEL CHANGE Persistent weakness in the performance of individual directors will be spo�ed by the appointed directors, and if the VC believes that such weakness is potentially damaging then action can be expected to be taken. The term sheets and legal agreements of major funds will have provided that board changes are one of the areas where the VC has leverage. Angel investors may not be able to call on a legal armoury in the same way but will usually make their views known forcibly – not least because their likely greater involvement in the day-to-day operation of the business is likely to give them a faster perception of who is doing a good job. The legal agreements will have provided specifically for the situation where directors have to be sacked by incorporating vesting rights and forced sale provisions (sometimes called ‘deemed disposal’), with respect to management shareholdings, into the shareholders’ agreement and/or the articles of association. VCs are not known for their sentimentality where their investments are concerned and will not hesitate to have these provisions activated if they believe that they will preserve the value of the investment and protect its potential. And 197

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it’s no use the management thinking that if they all stand together then they can resist the investor’s wishes or play off multiple investors’ interests against each other. VCs have been there before, too, and know the way out of that one.

TACTICAL ACTIONS OF THE INVESTOR The shareholders’ agreement will provide that the VC has the right to approve or reject numerous actions that the board may wish to take. If that does not meet with compliance, then share class consents will have been built in for many actions involving variations from the business plan (increased borrowing, change of senior personnel, acquisitions and disposals, among others). And if all those still do not produce the desired effect, then board-packing provisions – the appointment of overwhelming majorities of non-executives to control board actions and the presentation of policies – can be employed. Such drastic actions are not o�en used but can be very effective in pushing policies through at board level. Their use would be an extreme measure, but o�en the threat of extreme measures can be just as effective as actual deployment. Despite these descriptions of the powers available to venture capital investors, punitive measures are not very o�en employed in running investments. Their adverse side effects in resolving the difficulty are usually disproportionate to the magnitude of the problem that is presented. The force of argument is usually much preferred by VCs but, inevitably, problems do arise that cannot be easily disposed of. The legal agreements are there to deal with such ma�ers, and the VCs will use them without compunction. There are more subtle methods of control, though, which have at least as great an effect and in combination with diligent communication between the investor and the company can be more powerful because they are less damaging. In Chapter 13, reference was made to the possibility of investments being staged: the total amount of money is injected in tranches according to the achievement of specified milestones. This method of dripfeeding investments is not suitable for every situation. It rarely works with management buy-outs, for instance. In the small proportion of proposals where it can be employed it is a very useful method by which the VC can exercise control over the 198

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progress of the investment. Using a series of agreed markers – pretax profit growth perhaps being the crudest, product development and margin change being more subtle – the investor makes sure that the investment performs as expected before cash is introduced to the business in the entirety suggested by the business plan. The advantages for the investor are very obvious – perhaps less so for the management unless the reduced use of cash can be rewarded by some form of ratchet mechanism.

FURTHER FUNDING The power of denial is also available to the investor. The glaring gap in the shareholders’ agreement, from most companies’ point of view, is the absence of any requirement on the part of the investor to supply further capital when needed by the company. Most funds will puff on about how they support their investments during the courting stage when tempting proposals are eyeing up the available sources of funds. The reality is that most funds will only want to follow through on an original investment if the combined rate of return from both the old and the new rounds is at least as good as the original projections. (Anything less, of course, and the return will be diluted.) And the failure of an existing investor to follow through may leave a new investor with serious doubts about the wisdom of making an investment, effectively denying management who have not performed to plan the ability of raising additional cash to get back on track. Of course there is less of a problem in finding funding for an existing investment that has fulfilled its initial promise and where the management team have acqui�ed themselves creditably. But even so, existing investors will regard the application for further funds as another discrete funding opportunity that has to be evaluated and negotiated as a separate deal. Some large funds may go so far as to appoint new managers to evaluate and pursue such proposals to ensure that there is no prospect of the original manager having ‘gone native’ and having his or her judgement clouded. The drag-along/tag-along rights that were contained in the term sheet and later embodied in the shareholders’ agreement will further constrain the ability of the management to do anything that affects the position of the venture shareholder. The bond between the company

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and the venture fund is soluble only at the instigation (or at least with the acquiescence) of the venture fund.

THE PROBLEMS WITH ANGELS Early-stage companies nearly always require more cash to fulfil their potential. Few can grow from nought to maturity on the basis of one injection. But there are major hurdles to be overcome in securing additional funding. These problems are caused by the different ethos of very early-stage funding and development funding (for details see Chapter 5). The difficulty, in the VCs’ eyes, o�en lies with the fact that these small companies were originally funded by angels on fairly straightforward terms, o�en using a fairly simplistic structure. The unique difficulties of arranging what used to be called blow-out financing (now o�en called ‘cram-down’ or ‘washout’ rounds) have already been dealt with (in Chapter 8). Incoming investors buying in at a value that may accurately reflect the busted record of a business may well encounter obstacles caused by anti-dilution clauses that protect the capital value of a previous investors’ position. These problems will eventually be overcome because it is not o�en in anyone’s interest to see a company that can be salvaged go bust. And of course not every refinancing problem is caused because the company is not performing. Young businesses that were able to raise finance in frothy market conditions, at advantageous prices, o�en find that they next go to investors for funds just as the stock market or the economy takes a tumble. Valuations of venture deals reflect the market moves, and everyone finds it difficult to justify P/Es that seemed eminently reasonable only a few months ago. The business’s prospects may not have changed but the surrounding landscape has. A similar sort of problem can afflict early-stage companies that have been funded by angel investors. Venture funds can o�en be unimpressed with the price that companies initially funded by angel investors’ funding think that they can command at second-round funding. In other words, the VCs don’t like the terms they are offered: they will o�en baulk at the price they are asked to pay for the equity that is on offer. The venture funds will complain that the funding structure that the angel used encouraged an inflated expectation of further value for the company and that the terms of the initial funding will have corrupted the company’s ability to secure subsequent money. 200

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You will gather from such exchanges that many VCs do not have much time for most business angels. The problems are usually resolved with a diminution of the ‘premoney’ valuation made in favour of the VCs: a deal that offers money is be�er than no deal and no money at all. Or alternatively, the company may decide to shop around until it finds a be�er deal from a more sympathetic backer. But simply securing the cash with which to expand is no more the end of the fund-raising for a second-round company than it is for a first-rounder. Problems can develop when the business angels and VCs are expected to exist side by side on the same board. The abilities, procedures, methods and objectives of the two types of funder are very different, and it is probably best not to mix them together. A business requiring second-round funding (series B funding as it is now known) should seriously consider whether that is a signal for a business angel to retire from the company and leave the way open for the venture investors to take up the funding burden – or, perhaps, for a syndicate of other angels to come on board and supply the necessary financial resources.

NON-PROBLEMS The picture is not uniformly bleak, though, and to give a one-sided view of how VCs act would be doing no justice to the many businesses that thrive a�er a venture capital injection. The newer venture funds are finding ways of ensuring that the problems that afflict many small businesses a�er they have taken on an outside investor are dealt with by the process of their investment. For instance, some smaller funds are now recruiting stables of industry experts whom the fund can call on to do the due diligence that would previously have been done by consultants. The twist is that the deal goes ahead only if the industry expert wants to put his or her own money in. Provided the expert is acceptable to the management on this basis, he or she also becomes the non-executive director appointed by the fund. The added advantage, especially for the company, is that the due diligence is also done very cheaply. Such schemes make clever use of combining the practical skills of the business angel and the greater funding muscle of the venture fund.

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Many of the issues that loomed so large during the investment process – especially the legal stages – also fade in significance once the deal is done. Warranties are mostly never called upon; sensible VCs know that the business plan is just a best guess of what might happen; the shareholders’ agreement is filed and never looked at again. Although VCs will want to see that the overall targets of the business plan are being achieved, they will probably be content with a business that is meeting broadly the objectives that it set itself in terms of the composition of the profit and loss account, provided that turnover and margins grow as predicted.

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Realization of the investment

Ambition, n: an overmastering desire to be vilified by enemies while living and be made ridiculous by friends when dead. (Ambrose Bierce, The Devil’s Dictionary)

 The realization event  Types of realization distinguished  Public flotation  Trade sale  Forced realization  The dark side The realization of the investment – when the business turns into money in people’s bank accounts – is the purpose of the whole investment exercise. This modern-day piece of alchemy, transforming the base metal of underfunded businesses into gold, is only achieved – like the 203

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experiments of the medieval alchemists – with much effort, hard work, usually long apprenticeships and not a li�le failure. At the very beginning of the investment one of the key factors in helping an investor decide whether to proceed with a proposal will have been the a�itude demonstrated by the management team to the concept of realization of the investment. Only if the management team understood that the VC has to sell at some point in order to make the investment – and could demonstrate that appreciation – will the investment have gone ahead in the first place. But at the same time there will have been other, conflicting signals given during the discussions. These o�en create false impressions among less-experienced management teams, for the discussions held during the investment process will usually have contained numerous statements about what VCs claim to do that a brief review of their actions demonstrates they o�en do not. They will have talked about the need for the management team to demonstrate ‘commitment’ to the business by investing as much as they can afford in the deal. Yet they are unemotional about their own investments. They will have offered reassurance about the fund’s willingness to support its investments with refinancing if required. Yet this happens only under very strictly limited circumstances and only when the auguries are right for the VC. They will talk about being long-term investors. Yet they are ready to sell at the first whiff of a good price to a third party. What management teams forget is that venture capital is the business of the VCs. The investment fund is their company – not the investment – and commands their first loyalty. Their own skins come first. VCs and bankers both provide money to businesses. But no one thinks that a banker’s business is anything other than banking: bankers are usually rather remote, see the business only once or twice during the year maybe (if things are going well), and have a rather formal relationship with the company. Because the VC o�en gets deeply involved in the management of a business, the expenditure of time in touring round subsidiaries and talking to staff at all levels, and a presence at occasions other than board meetings are o�en taken as evidence of something more than a simple financial relationship. Shared experiences round a board table tend to encourage the management to believe that the investor is one of them. Consequently, this willingness to sell out is something that upsets some management teams. They o�en consider it a sort of abandonment. They were exhorted to demonstrate commitment to the business (as if 204

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hitching your career, your standard of living and your family’s future to a risky commercial venture was not commitment enough), and they may well have sweated many nights over it. Yet it appears that investors will demonstrate a complete lack of loyalty to their interests in the business if a suitable offer is waved under their nose. Management feel that investors are always ready to sell out when they get a good price, regardless of their position. They are quite right. The management may have loyalty, enthusiasm, deep affection and in some cases even passion (a much overused word) for their business. VCs will regard it as a commodity. The business is something they buy into and, most importantly, sell out of. In the slang of the trading floor, VCs are price tarts. They are opportunists. So the first thing to grasp is that realizations may occur at any time in the life of an investment, when the opportunity presents itself, no ma�er what the original plan said. But only certain types of realization. Trade sales can occur when there is a willing buyer and willing seller and may be opportunistic events that can be completed in the space of a few weeks, perhaps even a few days in some cases. Flotations of the company on a stock market – IPOs – are a very different ma�er and can hardly be described as opportunistic since they take a great deal of time and a great deal of planning to bring about. There is a further consideration that has to be brought into the open and should be made plain by the VC who negotiated the deal. Chapter 6 made mention of the ‘carried interest’ that funds award to managers. Carried interest provisions trigger for the executives of the fund when the businesses that they have invested in achieve a successful realization. So it will be in the interests of the fund manager to achieve a successful realization. Quite a lot of money will depend on it for the manager as an individual. We have already seen that there are four basic ways out of an investment for VCs (and management too):  flotation (IPO);  trade sale;  buy-out by the company;  commercial collapse. Although corporate collapse is not contagious, many investors have superstitions about considering the event in the same breath as 205

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beneficial realizations. The spectre of collapse always hangs over any commercial enterprise, a continual reminder of the potential mortality of the corporate entity. So collapse is not talked about much in polite company – but most VCs have experience of collapse of some sort, especially a�er the dotcom debacle of a few years ago. Respecting tender sensibilities, we shall also put it in an isolation ward and consider it in a separate section. The main features of the other three routes are considered below.

FLOTATION – IPOS Selling shares in a company on a regulated public market was once seen as the most obvious route for investors to release the value of their holdings in venture-backed companies. But flotation is an expensive and very detailed business. It takes much time to plan for, much time to execute and a great deal of money to bring into effect. Not the least of the reasons for this is the amount and quality of information the company is required to put into the public domain. The standard of reliability for the information that is required for a prospect to enable shares to be listed is one of ‘utmost faith’. What this means in layperson’s terms is that all the pieces of information that go to make up a prospectus are issued, checked and then checked again to ensure accuracy. The people who do the checking are teams of lawyers and accountants from the big metropolitan partnerships – such resources do not come cheap. The precise details of the process are long, tedious and complicated and beyond the real scope of this book. A number of things need to be emphasized about IPOs:  The business needs to identify the date when it wishes to float and then work back several months to identify the time when the whole process should start; this means that a great deal of planning is required. Sensibly, a period of a year should be set aside, as a minimum, for the preparations for a full flotation. During this time, much management effort will be required to control the process. Only so much of this can be delegated, since directors of companies intending to float are personally responsible for the content of prospectuses and must therefore be active contributors to the process. While flotations on the subordinate markets are less 206

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onerous than full flotations in terms of the regulatory requirements, the burden is still heavy.  The business that chooses to float must be capable of running without the detailed daily intervention of senior managers. The effort that is required for preparation will take much of the a�ention of directors in the months prior to the event. This means that the business’s internal systems must be sufficiently robust to cope. While the actual period of preparation will be measured in months, the true run-up will be much greater. Only businesses with a full complement of support functions, including a properly staffed company secretary’s department, should contemplate any form of listing. Furthermore these support departments should be used to working with each other and not be brought together immediately before the flotation process begins.  Flotation will not suit everyone. Pu�ing a company’s shares on a public market now involves continuing regulatory burdens that are costly and heavy. Some companies that floated with high expectations of the benefits of public markets – Richard Branson’s Virgin Group and Andrew Lloyd Webber’s Really Useful Group, to name but two – have now been bought back into private ownership. The intense scrutiny to which they became subject – and the need to propel earnings forward all the time without any form of respite – hobbled their development.  The sanctions that the market regulators may impose on the management and venture shareholders of a business that is considering listing may involve shares being ‘locked up’ to prevent the market being swamped. When these provisions have been dealt with, management shareholders are still subject to (increasingly) detailed regulation concerning the closed periods when they may not sell shares.  Venture investors may be reluctant to give some of the warranties that are required to enable the listing to proceed smoothly. While these things can usually be worked through, the progress to market will not be smooth. (And see below for similar problems in trade sales.)  Not everyone can get out at the same time: the market makers will require lock-up periods, as we have already mentioned, but in addition, on the smaller markets particularly, buyers and sellers may 207

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not always be in the market at the same time. One of the persistent complaints of companies on AIM is the lack of liquidity of the market.  Being listed puts a company ‘in play’ as far as predators are concerned, once the lock-up period for founders’ shares is over. That may not suit some companies. Because of the trading record requirements that are imposed by the UK stock market (and most other senior bourses), few start-ups are likely to make the long run from inception to listing with venture backing. With the increasing sophistication of regulation undertaken by market authorities (with consequent cost and size implications for regulated businesses) it is likely to be businesses sponsored by private equity players that are entrants to listing. It is very difficult for a company to move to a flotation unless there is unanimity on the part of the shareholders and directors. Because of this, the desire to undertake a flotation is probably driven as much by the management team as by the investors. The same unanimity is not required for other types of realization.

TRADE SALES Once seen as a second best way out (less kudos, less fanfare), trade sales may well be a far superior exit route for all concerned (less hassle, fewer restrictions, possibly more cash). There are no regulatory requirements for a trade sale, of course. There are no obligatory long run-ups – although selling a business privately may also take a very long time. There are no requirements to have a fully staffed ba�leship of a business; trade buyers are looking for synergy, not heavy cost superstructures that have to be dismantled. But that does not mean that trade sales are the universal panacea, nor that they do not demand a good deal of effort to achieve a satisfactory conclusion, nor that they are accomplished without much stress. Trade sales fall into three different categories: 1. those initiated by the investor; 2. those initiated by the management; and 3. those where both parties agree that a trade sale would be beneficial. 208

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Investor-initiated sales o�en occur where investors have some form of pressure being placed on them to liquidate investments: perhaps the running down of a closed fund or a desire to liquidate to produce a good rate of return, or even an insight into market conditions that is not generally shared. Unfortunately, not every story has a happy ending. Despite the best efforts of the management, some businesses never make the breakthrough and languish in a steady state of marginal profitability. The point at issue for venture-backed businesses is that this state of affairs cannot be allowed to persist. Privately owned businesses can trundle along forever just making enough profit to satisfy the owners’ income needs and servicing their market niches. Venture-backed businesses cannot be allowed to do that. If they are not swimming, they are sinking. Sometimes investors just lose patience with management teams and decide that the investment would be be�er off under someone else’s wing. Management can resist such pressures if they are very strongwilled or can marshal very good arguments against a sale – but, as we have seen in reviewing the potency of shareholder agreements, the trumps are mostly held by the investors. Both negative and positive powers of compulsion are available to investors. If they hold anywhere near a majority of the company it will be difficult to resist their pressure, and in the absence of such large holdings they can still make life difficult for management by refusing to approve salary increases, saying no to acquisitions that would require more cash, refusing to allow changes to management structures, and so on. This may all seem rather pe�y but it o�en works. The management is on something of a sticky wicket if it tries to initiate a sale without the approval of the investor. Few investors take kindly to being driven into a sale and will probably scurry off to consult the shareholders’ agreement to see what sanctions can be applied. Of course, if the deal is a good one, then the salve of a high price will soothe any bruised feelings. But most investors will immediately assume that they are being outfoxed if the approach is made to the management directly without the courtesy of an approach to them in the first place. They will have expected the management to discuss the business’s prospects with them beforehand to enable a strategy to be developed for a sale. Joint decisions about the strategy of a sale are likely to work best – and, of these, the ones that work best of all are those where management have a good idea of who the potential buyers might be. If 209

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consultants have to be brought in to arrange a sale, then fees have to be paid and the result is rarely as slick as when inside industry knowledge is applied. Too o�en, if a potential sale falls over, the business begins to look sickly as a purchase and word rapidly gets around – no ma�er how good the confidentiality agreements – that the company is up for sale. Then the rumour mill starts going into overdrive. Essentially the process of selling a business to a trade buyer is the mirror image of selling to a venture investor. The legal documents will be similar; the requirements for information and warranties will also be closely related. But some twists will give rise to a variety of problems that have to be dealt with when businesses reach the point where the shareholders want to commit to a sale:  In contrast to the situation with a flotation, there is a danger that impetus can be lost. A sort of weariness can overtake businesses that are up for sale – especially if trading conditions have been difficult recently.  In a flotation, there is a definite target to aim for and, while flotations do get pulled when market conditions change or if something evil is discovered lurking in the corporate broom cupboard, the process is probably more under the control of the company than a sale to a third party. Corporate sales that collapse can have a serious impact on collective morale that can severely affect a business’s performance – especially if a�ention has been diverted from trading performance in order to get the deal done.  Individual directors in a business that is to be bought by a competitor or new parent o�en begin to wonder about their positions in the new regime. This can sometimes lead to fissures opening up between individuals si�ing around the boardroom table as they begin to manoeuvre for positions in the new organization structure. Individual ambitions rather than the collective ambition begin to dominate events. There is less of this in a flotation, where there is a unity of purpose.  There may be problems created between the investor – who will usually be bought out of the new arrangement by the incoming buyer – and the management shareholders. The employees may well find that they are required to exchange their holdings in their own business into holdings in the new one through a share-forshare exchange. This is done both to reduce the cost of the deal 210

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for the purchaser and to encourage retention of good employees. Businesses are o�en taken over for the quality of the management team, and the last thing that new owners want is to see their new employees with their pockets stuffed full of drop-dead money (newly rich employees can tell their employer to ‘drop dead’ if they don’t like what is being suggested). Very few investors, of course, will ever accept a share swap – as we have seen in looking at the legal documents.  Resentments that have remained hidden during the course of trading o�en resurface when money is being released. Management shareholders o�en harbour grudges if the progress of an initial investment did not run smoothly and they were disadvantaged in some way in consequence. Revisiting legal agreements during the course of the new sale revives these grudges, and the course of the deal then becomes difficult, especially if the other pressures that have been noted above are also in play.  Venture capital investors will not give warranties to incoming buyers, as a ma�er of course. Even though they may have held directorial positions they will refuse to accede to demands for warranties and will throw the burden entirely on the shoulders of the management shareholders. Most purchasers and all other VC investors understand this a�itude (possibly even sympathize with the logic of it), but the game of demand, refusal, counterdemand and offer has to be played out nonetheless. Management shareholders may not understand the game though and, although the practical effect of the investors’ refusal to conform is limited, this misunderstanding can again lead to difficulties between management and investors. The management shareholders will perceive this as a further example of the existence of two sets of rules – one for the venture investors and one for them. The effect will be particularly problematic if the sale falls through – regardless of whether the reason was for problems with warranties or not. Needless to say, given what has been outlined above, no sale is ever finalized until the ink is dry on the paper and the cash is in the bank account. The one principle that management should try to adhere to during any negotiations for a sale – either to a trade buyer or to the public through some sort of flotation – is to run the business as if nothing out of the ordinary was going to happen. This is easy advice to give but very difficult to implement. 211

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BUY-OUTS It is an unusual route for the management of a company once bought by an institutional investor to be able to raise sufficient capital to buy it out once more from the same investor. Usually the incumbent investor will be all too aware of the potential of the business and will want a price that is probably going to make the deal una�ractive. There are also usually – unless the fund is in some sort of distress itself – none of the strategic reasons for wanting to dispose of a business that might propel a commercial business to divest itself of a subsidiary. So buy-outs are an unusual realization route – not unknown, but rare. What does sometimes happen is that individual investors in a consortium get bought out over a period of time so that there is a gradual slimming of the numbers of professional investors involved backing the company – but this is not usually a management buyout in the accepted sense. And of course investors sometimes trade companies between themselves – a trend that has increased as the big private equity companies have taken on more and more of the characteristics of industrial holding companies.

THE DARK SIDE: CORPORATE COLLAPSE No one likes to think about it, but most people in senior positions in business will have contemplated corporate collapse at some time. The inevitable periods of cash-flow stickiness, the crucial contracts that seem to take ages coming through, the nosedive of a competitor – all prompt the shudder of realization that things are usually balanced on a knife edge in the commercial world. The brutal language of the legal agreements also casts a shadow over the fund-raising process. The lawyers are paid to think about what will happen in the worst of situations and prepare documentation to cope with it. Despite the unemotional a�itude that they adopt to investments, most venture capital funds will do what they can to prevent businesses going under. This will probably involve practical help in the form of introductions to consultants or company doctors, perhaps more time discussing strategies to dig the business out of a hole, or using their contacts to find companies that might take on some bits of the business 212

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to relieve cash-flow problems. However, ‘what they can’ usually falls very far short of pumping more money into a dying business. VCs are very strong on not throwing good money a�er bad. Unfortunately, as in all venture investing, there are pressures that impinge on individual investments differently at different times. Market falls will alter the prevailing P/E rate that contributes to calculating rates of return and so make recovery financing more difficult; even mild economic recessions affect investor confidence; investment commi�ee willingness to contemplate rescue packages may decline; portfolio considerations may inhibit individual managers’ ability to arrange rescues – particularly if there has been a spate of problems in the portfolio. Investors with board positions in a number of companies are also very mindful that they have legal obligations that must be observed. As directors of businesses that fail they will be subject to the potential scrutiny of the BERR inspectors if they are involved in cases where there has been financial misbehaviour. Even so, investors are usually anxious to avoid failures in their portfolios for a number of reasons:  It obviously damages the portfolio rate of return.  It does their reputations no good to have failures – although everyone encounters them at some time.  No one likes having to deal with such problems.  It takes time away from doing profitable deals.  It costs them money individually through the carried interest provisions of the fund.  It makes future fund-raising very difficult if they gather reputations for making more poor investments than normal, even if the overall rate of return is still good.  Turning businesses round from the brink brings its own form of kudos – both within venture capital circles and among investors. Recent revisions in the law of insolvency have made company voluntary arrangements more a�ractive and practical. This may well bring fewer liquidations of venture-backed businesses, since it is usually in the interests of very few creditors to see companies go under. With the removal of Crown preference for debts in the Enterprise Act 2003,

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the pressures on businesses to fold are now much less likely to be prompted by the tax inspector. VCs probably consider it is be�er to cut their losses early and put a business into an orderly shutdown rather than go through the messy and traumatic process of forced receivership. This may run counter to the wishes of the working directors, of course, who usually stand to lose far more financially than the VC. They are more likely to try to run businesses out of trouble, since they have fewer options. They cannot walk out of their offices and into another boardroom and another deal as the VCs can. Consequently, they are more likely to skirmish with the problems of insolvent trading than the VC is willing to do. Working directors lose their investment and their livelihood; VCs (angels excepted) just lose someone else’s money.

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Summary: do you still want venture capital?

Faith, n: Belief without evidence in what is told by one who speaks without knowledge, of things without parallel. (Ambrose Bierce, The Devil’s Dictionary)

 Are you sure you still want venture capital?  In defence of other funding  In defence of VCs  Overall verdict  The point of departure In Chapter 5 the question was raised as to whether inviting VCs into your business is like doing a deal with the devil. A�er reading an introduction and 15 chapters you may be closer to being able to make a judgement on that. Or maybe not: maybe this book has dealt more 215

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with the mechanics of raising venture capital than with the reasons for doing so. Maybe we should put the case more formally and consider the two options, and work out an argument in defence of doing without venture capital funding and one in defence of working with VCs.

IN DEFENCE OF OTHER FUNDING There are potential problems with venture capital funding at every stage of the process – which is what makes the alternatives to venture capital a�ractive to some businesses. The problems can be dealt with by looking at the investment opportunity in a number of ways and contrasting the different approaches.

Size of investment The funding gap may or may not exist; the statistics can be used to ‘prove’ the case either way. But what is certainly true is that if you are seeking only a modest amount of funding – say, much below £250,000 – you are going to find it difficult to a�ract venture capital funding: that is, of course, unless it is very obvious that the total amount that you require over a fairly brief period is quite considerably larger in the longer run – the sort of situation where the initial modest amount will get you through the first six months but then you will need a further tranche of at least as much again to start the business moving on. The upshot of this is that you are be�er off finding a business angel, using the good will of your family or friends (if they have cash) or remortgaging your house if you need much less than a couple of hundred thousand. One of the other routes for funding that is o�en neglected – despite the amount of effort that goes into publicizing it – is the rich seam of grants and matching funds from public money that can be used for defraying the cost of starting up a business, ge�ing training, taking on staff, and designing and building prototypes. VCs will think more highly of a funding proposal where any or all of the above routes have been tapped first when it comes to securing additional funding – even, despite what has been said in earlier chapters about the slightly fraught relationship that o�en exists between the two, the angel route – which

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indicates that basic market research has been done and that someone has been willing to back a deal with cash. Science-based opportunities may well be able to raise small amounts of funding from university seed funds (either captive or associated ones) or some of the semi-philanthropic bodies that exist to provide early-stage development money. Public funding is also a suitable source for proof of concept money for proposals coming from this sector. Angels are the obvious source of funds where a commercial business needs between £25,000 and £200,000. The smaller sum is usually within the compass of one investor, and the larger amount can be raised by a�racting a syndicate of angels. (If you need less than £25,000 then you really should be thinking about raising it from your own resources.) They will apply common sense to assessing the opportunity and management skills in helping to develop the business. Verdict – find your funding from other than a VC if you don’t need much money. Score – others: 1, VCs: nil.

Type of funding The basic rule in funding any cash gap is to match the life of the debt with the life of the activity being funded. Approaching VCs to fund an imbalance between seasonal trading levels and available cash is a sure-fire route to becoming one of the proposals on the reject pile. The same will be true of talking to business angels. If you need to plug a temporary cash hole then go and talk to your bank about an overdra�. Venture capital – provided either by a fund or by an angel – is for a fundamental change in the business, not a temporary cash embarrassment. But angels are likely to be more flexible in injecting the money, since they will want to be involved in spending it too, through their usual requirement that they get involved in some sort of managerial capacity. Verdict – match the cash source against the life of the project. Score – draw. Cumulative score – others: 2, VCs: 1.

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Type of opportunity Chapter 2 dealt with some of the opportunities that cannot be followed up by VCs: sole traders, businesses run by those with criminal records, and illegal or embarrassing businesses (the crack house, the porno cinema chain) are unlikely to get much of a hearing. The same will be true for reputable angel investors. Geography and sector play their part in what makes a proposal fundable too. If you are in a high-tech business you are probably a be�er bet for a VC than if you want to build a nationwide chain of Be�er Blacksmiths Ltd. (Don’t laugh – that was an opportunity offered to the Coal Board Pension Fund in the early 1980s.) If you live in the South-East of England, the East or West Midlands or the (near) SouthWest then you are probably in a be�er position than if you live in Hawick or Stornoway. But the truth has to be faced that some businesses, even though they apparently have the right structure (incorporated), are seeking the right amount of money, are located in the right place and seem to address the right marketplace, are just uninvestable. And the reason is that the people behind the investment opportunity cannot command the confidence of potential investors. A popular myth seems to have built up, over perhaps the past decade, that everyone who wants to start a business ought to be given the chance to do so. This stems from a corruption of the entirely appropriate and reasonable idea that there ought to be a more level access to the funding process that doesn’t distinguish between people on the basis of gender or race or eliminate you at the outset if you didn’t go to the right university (or even no university). But making sure the door is wide enough and making sure that everyone passes through are two very different things. And so they should be. It used to be that everyone thought that they had a book inside them – everyone thought that they could have wri�en Harry Po�er if only they had had the idea first, had the time, had the application, possessed the sheer doggedness or had the grit to pick themselves up from each defeat and kept on going. But they didn’t – so they didn’t deserve to have the best-seller either. The same goes for business. Unfortunately, government policy, popular culture, the press and television all conspire to make the lazy, the gullible or the chronic daydreamer think differently. Encouraged by the Pop Idol mentality, starting business is now a sort of televisual event. The whole conceit of the popular series Dragons’ Den, with a panel of judges who si�ed good 218

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business ideas (few) from the rubbish (many, vast, overwhelming) that people dream up every day, and lampooning the unfortunate rejects in the process, is to make good television for the sofa-bound masses. The unpalatable fact for many would-be entrepreneurs is that building a business is a very hard slog for which only a few have the appetite or the aptitude. It does not ma�er whether you approach a VC or an angel; if there is no basic a�raction to the business in terms of the personnel or if the idea is bankrupt from the start, you will get turned down – by both. Verdict – not every opportunity deserves to be funded (or re-funded, see below). Score – goalless draw. Cumulative – others: 2, VCs: 1.

Re-funding For many businesses that struggle to achieve the promise of their original business plans, the existence of a venture capital investor among their shareholders can become a financial straitjacket. They can wriggle a bit but they can’t get free. Not doing well enough to a�ract further funding from the original venture funder, they will be stuck in financial no-man’s-land, where the prospects of them achieving funding from anyone else are also very limited. The powers of the shareholders’ agreement that protect the position of the original VC may make bringing additional capital on board in a timely way very difficult. To be fair, VCs are no happier with this sort of situation than the management of the company. The usual way out in such circumstances, if no compromises can be made over pricing and/or shareholding, is a distress sale to a business that might have a strategic fit or a change of senior personnel to try to revitalize the business (a process that was discussed in Chapter 14). A secondary trade in large investments is now developing among very large venture capital funds (which are now so large in some cases that they have become industrial holding companies rather than venture funds), and this also provides some possibilities of shi�ing companies to different owners, who can try different tactics with different senior personnel. A venture-backed business that has performed badly is extremely circumscribed in its ability to raise additional funding because of the 219

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anti-dilution clauses that protect the venture investor’s shareholding. When you consider that perhaps three out of every 10 early-stage investments go badly wrong (see the BVCA statistics in Chapter 1) then this sort of restriction may be contributory in killing off a large number of businesses. So not doing well with venture capital on board is a highly risky situation for the individual entrepreneur or management team. In mitigation of the VCs’ a�itude over this, many businesses that go badly wrong do not deserve another chance; failure is not always simply ‘a bit of bad luck’. Recognizing this, VCs are not very tolerant of failure in management teams and are unlikely to be able to inject further funds in an ailing business without substantial managerial changes. Angels will probably be no more tolerant of failure but may have the time, ability and hands-on approach that will contribute to catching such problems before they occur. In addition, since they are less reliant on detailed and complex investment agreements they can be more nimble in sorting out problems a�er the event. Very early-stage investments o�en lack managerial capacity, as well as being vulnerable to market movements, and are probably be�er le� to the a�entions of skilled business angels whose time and application can, again, be brought to bear in sorting out soluble problems in a way that fund mangers cannot afford to do. Verdict – higher-risk and small opportunities probably do be�er out of the detailed a�ention that can be given by business angels. Score – others: 1, VCs: nil. Cumulative score – others: 3, VCs: 1.

Complexity of the deal Well over two-thirds of the amount of money raised in 2003 by UK venture capital funds for investment in the UK came from US sources. If we take into account the local subsidiaries of US banks and venture funds that are operating in the UK, that means that somewhere around three-quarters of the money that goes into UK businesses, as part of venture capital funding in rounds soon to come, will be of US parentage. All money comes with strings and, in the case of the UK venture funds raising money in the United States, this means there will have 220

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to be a regime of regular and detailed scrutiny of investment returns. Venture fund managers in the United States are accustomed to much more regular scrutiny than their UK counterparts and have a need to justify their investment records on a more frequent basis. UK fund managers will have to do the same, and may have to increase the frequency of their formal reports to their investors. Unfortunately, small and young businesses o�en take more time to develop than the period between the reviews conducted for investors in the funds. Although returns in good small businesses can be explosive, they o�en come with a bang at the end of a long, hard slog rather than in a steadily increasing accumulation. This does not suit VCs – unless they can arrange it that their portfolios of small companies all fire in sequence rather than in a lumpy pa�ern. Consistency and risk reduction go hand in hand down the investment path. In the United States, the wealthy lawyers, dentists and doctors (and pension funds) who fund the US venture managers’ bets prefer solid and consistent returns. Consequently, the fund managers cater for their preferences in order to raise more funds next time round (to preserve their own jobs). A similar process began some time ago in the UK – mixed with the desire of managers to mobilize their funds quickly. So there have been four pressures on funds in recent years:  the need to prove solid returns;  the need to provide good returns (from controllable situations);  the shortening time span for generating positive returns;  the need to mobilize large amounts of cash. Not surprisingly, the market for funds has moved to bigger, safer deals – as we have seen, over 90 per cent of the private equity pot now goes into MBOs and MBIs. The transatlantic influx of cash has been accompanied by an influx of transatlantic-style legal agreements. When the UK market for venture funding developed strongly in the late 1980s and early 1990s, US venture funds entered the UK market in strength and they brought their style of legal agreements with them. Although it o�en sits oddly with English company law (with its bias towards favouring the rights of the creditor above those of the shareholder), the style of US agreements (which is founded in a body of law that adopts the diametrically opposite tack) has been adopted by most venture managers. (For some time it looked 221

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as though 3i might hold out against the trend and develop a uniquely British way of doing deals, but with the market flotation of that company it has succumbed to the general flow.) The adoption of US practice has tended to give rights and powers to venture funds, as shareholders, that are considerably out of kilter with the responsibilities that they have towards management and other shareholders. This means long and detailed investment agreements – the appropriate parts of term sheets, shareholders’ agreements, due diligence reviews, accountants’ reports, completion audits and so on. All this documentation – all of which is completely understandable, and necessary in many respects – has led to a ponderousness in the behaviour of many funds that the managers of companies seeking finance can find very frustrating. Many entrepreneurs seeking to raise cash find the approach taken by VCs painfully bureaucratic, legalistic, costly and – dare it be said – risk averse. Angels, by contrast, o�en seem to be extraordinarily nimble in the way that they can review, evaluate and complete deals. They will o�en evaluate the deal by ‘feel’ and using their own industry knowledge; they will complete on fairly simple legal agreements involving, perhaps, only modest modifications to the articles of association: warranties tend to be limited in nature. Unfortunately, when the big funds try to compete in the nimbleness races they o�en come severely unstuck. Too o�en, in order to get nimble, the funds have to bend rules. So when feeding frenzies like the dotcom mess arise, they bring out the worst in VCs as they bend their own rules to accommodate their greed. The Clickmango debacle, which was briefly detailed in Chapter 13, is a prime illustration of this. The legal documentation was point-perfect but the basic work on the prospects for the deal had not been done. Although Clickmango collapsed honourably, in an orderly shutdown, collapse it did. It is, perhaps, unfair to concentrate on Clickmango again when there are numerous other examples that could be used. But the point is that the funds – with their formalized paraphernalia of methods, their house styles and so on – are like elephants in the slow, focused and stately way that they advance through their procedures. It’s when they try to tango that they start to trip over their feet – and elephants dancing mostly make themselves look ridiculous. Complex legal agreements and long and detailed due diligence may not be suitable for every deal. We have already seen that some smaller funds are experimenting with doing deals differently – combining elements of the approach adopted by business angels with the best of 222

Summary

their own practices. By making the process of investment less costly, this development may well be the way forward for the smaller funds and will be welcomed (if it succeeds) by companies seeking smaller amounts of capital. Verdict – VCs like complexity; it makes them think that what they are doing is more respectable than riverboat gambling (but with the added frisson that they are using other people’s money). Score – (assuming you don’t like complexity) others: 1, VCs: nil. Cumulative score – others: 4, VCs: 1.

Overall verdict With a cumulative score of 4 to 1 it looks like, on most counts, other sources of funding – retained income, mortgage funds, the three Fs (friends, fools, family), so� loans, grants and so on – are a be�er bet than VCs. But hold on. We haven’t made the case for VCs yet. And the raw scoring conceals some fairly close similarities on some aspects. How does venture capital score when we look again at some of the aspects of funding and include some different ones?

IN DEFENCE OF VCS We shall review the case for the same points as we have discussed above. At the moment, the VCs appear to have lost fairly conclusively on: 1) small-size deals, 2) deal complexity and 3) (some) elements of re-funding, and have come out neutral on: 4) type of funding and 5) type of opportunity. We shall have to look again at these and perhaps other factors to see if the VCs can come out with a be�er score on other aspects. Let’s concede small-size deals. Most VCs are not equipped to deal with them since the cost of doing the deal, in the complexity that their procedures require, makes them uneconomic. Most VC funds, mobilizing large(ish) amounts of money simply can’t get the return they need in the volumes that they require to make these deals worthwhile. Let’s also recognize, though, that there are honourable exceptions to this among the smaller funds – so it’s not a total whitewash.

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And let’s concede complexity, too. The reason that the VCs’ deals are complicated is because they are dealing with large amounts of other people’s money that have to be properly stewarded. Business angels are looking a�er their own money and can do what they like with legal agreements and due diligence. When syndicates of angels get together the complexity of the legal agreements also usually increases (although perhaps not to the level of a typical VC term sheet). Again, not a total whitewash – a bit less than an honourable draw though, because the VCs are being driven by the people pulling their strings rather than opting for complexity for complexity’s sake. Where VCs score is on the following.

Follow-on funding With a total of nearly £10 billion being invested every year, venture capital funds are not short of a bob or two. Their capacity for follow-on funding is virtually unlimited – at least collectively. With this amount of money available to them they are always looking for sensible ways to spend it – indeed the BVCA’s standard line is that good proposals will never go short of an offer (although that offer may not be acceptable of course) because of the sheer weight of funds that have to be invested. The investors in the funds do not expect to see their money si�ing idle while the managers draw management fees; they want their money invested. Business angels only have pockets of limited depth and, while more angels can be brought in to provide more cash, eventually the number of participants can become unwieldy. Above a certain size, unless the angels act like one venture capital investor, it will be be�er, easier and simpler to deal with only one investor. For sums above a million, then it may be difficult to find sufficient angels to contribute the amount required while still retaining the flexibility that is the hallmark of their contribution. It is rare for an investment that has achieved its targets not to be supported by a first-round (or series A) funder. However, some small funds may find themselves unable to follow on simply because of portfolio constraints. The regional venture capital funds, for instance, were limited in the amount that they can put into any one investment by their charters. The idea of this was to prevent them moving upstream into progressively bigger deals, but many of the regional managers chafed at this restriction. So it is conceivable that 224

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some investee companies that have done very well will find that their original investors cannot give them the extra push that they want. This will be a problem for the RVCFs rather than for their companies to work through, but it may well involve some hard negotiation on the part of all concerned – companies, RVCFs and new investors. The major constraint on follow-on funding is that the rate of return for the period of growth for which the funding is being sought has to be at least as good as that which has been already achieved or the overall rate of return will be diluted. Verdict – VCs have deep pockets. Score – other sources: nil, VCs: 1.

Large and complicated deals The converse of the fact that business angels are probably the best sources of funds for small deals is that venture capital funds are probably the best for large ones. Business angels are simply unable to operate collectively in sufficient numbers to generate the funds that large deals require. Few angels will be willing to place sums of more than £200,000 in any one investment (there simply aren’t the number of people with that level of funds to invest coupled with the desire to invest directly). So raising funding for a business turning over £40 million (the average venture-backed business turns over that amount at investment) would involve more angel investors than I have fingers and toes to count on – I know it’s not worth taking my shoes and socks off to try. Angels also make a virtue of their simple approach to investment – a feature that many small firms greatly appreciate. The other side of this is that complicated deals involving many subsidiaries, complicated inter-trading or long supply chains are not suitable fodder for business angels. Verdict – if you like or need complexity then VCs are the right source of funding. Score – other sources: nil, VCs: 1. Cumulative score – others: nil, VCs: 2.

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Cross-border transactions With Europe increasingly becoming a single market for many types of consumer good, as economic reality takes over from the political rhetoric, many large businesses are now in play for venture capital. Consequently there is an increasing tendency for British venture capital firms to test the waters outside the UK. In 2003 nearly 200 such deals were done. Not surprisingly, many of these deals involve vast amounts of money as pan-European conglomerates are broken up. The Parmalat affair in 2004 provided many operational managers with a chance to test the appetite of European venture capital firms to invest in Europe-wide food businesses, for instance. Many of these very large deals are now arranged across European borders rather than within one legal jurisdiction. This involves complicated legal arrangements that have to respect the very different legal background of the European states. There are comparatively few people in professional practices of lawyers and accountants who can undertake the work required to arrange such deals, and only a few of the very large venture firms consider themselves equipped to operate across borders. Business angels are not able to work in this environment. They do not have the legal or accounting resources to execute such deals. The development of the Societas Europaea – the European limited company, which will be subject to the embryonic body of European company law – will stimulate such developments and add a further stratum to the market. Verdict – very big deals that cross borders are the preserve of only a very few venture firms as yet. Score – other sources: nil, VCs: 1. Cumulative score – others: nil, VCs: 3.

Nurturing investments through to stock market flotations Fully one-third of the flotations that took place under the Official List requirements of the London Stock Market between June 1992 and December 2003 were of businesses funded by venture capital. Since the inception of the Alternative Investment Market in 1995, venturebacked businesses have accounted for 10 per cent of all its flotations. 226

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The large venture capital companies have a good record in grooming their businesses for flotation. The resources of the large funds, in terms of the web of contacts that they have and the skills of the individual investment managers, are of a sufficient level of sophistication to support businesses aiming for a flotation – an ‘initial public offering’ of shares. While some business angels will be able to do this it will be beyond the ability of the majority. Some angels, of course, will have superlative networks of professional contacts and a thorough understanding of the complexities of the listing requirements – or more importantly the work that needs to be done to prepare for listing over a long run-up to the event. But these people will be very few in number. Angels specialize in applying their practical managerial skills to the development of the businesses they have invested in. While they may have experience of working in big listed companies, they do not usually have big company listing experience. Verdict – if you are aiming for a float within a few years of the investment being made, the support available from a large fund will be invaluable. Score – others: nil, VCs: 1. Cumulative score – others: nil, VCs: 4. Overall score – others: 4, VCs: 5.

Overall verdict Using an additional set of measures it is not quite so clear cut that VCs are less desirable choices. In fact, taken overall, they have definite advantages over other sources of funding, in terms of bringing large amounts of money to bear and following through with that funding. The score when taken on all counts confirms what common sense will already have suggested – that companies wanting modest amounts of funds should try informal routes first and then business angels. Companies wanting to raise larger amounts of money should go straight for venture capital funding but grit their teeth and think of England when confronted with some of the less user-friendly aspects of the terms they will be offered. For particular opportunities, VCs also have distinct advantages over other sources of funding. Venture capital funding from larger formalized funds is most suitable for deals where follow-on funding 227

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is almost certainly required, probably in the same sort of magnitude as the original injection; for large and complicated deals; for those involving cross-border ownership of subsidiaries; or for businesses that know that they want to aim for a flotation within a short(ish) period of the investment being completed. Angels in particular find it difficult to match the funding capacity of the venture funds in these situations, and other sources will have run out long beforehand. There is one further point that needs to be discussed before any conclusive stances are adopted. It applies to all situations where there is an investor and an investee but is probably most relevant to those situations involving a venture capital fund rather than a business angel. It concerns the point of departure between the interests of the two.

THE POINT OF DEPARTURE The basic purpose of any commercial proposition that might a�ract venture capital has to be the creation of wealth. This is simply because there is no other way that the effects of the injection (and hence the suitability of the opportunity for the investor) can be measured. So it is a given that the objective of the VC and the entrepreneur must be the same initially (at least). That is, both parties want to see their wealth increase as a consequence of making the investment. Or, using a notion that is important to VCs, investors want to achieve a rate of return on individual investments that is sufficiently high to make them commit time and resources to a�empting to achieve it. It has to have a value that is higher than the opportunity cost of pu�ing the money elsewhere, given the risks involved. However, while the objective (in its rawest, least precisely defined form) may be common between entrepreneurs and VCs as potential partners, not all routes to achieving it will be equally a�ractive to both parties. So the point of departure from the existing position – just before cash is injected into a business – also becomes potentially the point of departure between the aims and intentions of the VC and the entrepreneur(s). Consequently, it is vitally important for the health of the investment to recognize from the outset that the interests of the entrepreneurs and the VCs will not be congruent; they will be overlapping.

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The area of overlap between the intentions of the parties will be one of the major determining factors in the eventual success of the investment. The longer the overlap can be sustained and the greater the degree of overlap the more successful the investment is likely to be. Unfortunately there are at least two groups of factors that contribute to confound the maintenance of this overlap. First, both the VCs and the entrepreneur will be carrying a whole bagful of objectives – some of which may be similar in terms of the way that they are achieved, others of which might even serve to work against each other over time. For instance, the entrepreneur might want the VC’s money but not the necessity of appointing him or her to the company’s board (a common requirement for many investments); or the entrepreneur may be happy to see the business develop in such a way that it provides employment for the family in the longer term, while the investor wants an investment with a fast realization and a quick profit. What is even more complicated is that these bags of objectives that each of the parties to the deal will carry to the negotiating table may be explicit or implicit, recognized or not, known or concealed. Second, investors rarely make their investments in isolation: portfolio pressures may compel the fund’s initial realization policies to change over time (sometimes quite quickly) and fashions in investment can also radically affect an investor’s perception of the current value of an individual opportunity – for be�er or for worse. As an example, suppose a venture capital fund has suffered a series of reverses in the investments that it has made and is approaching a new round of fund-raising to replenish the funds it manages. The success of just one investment being realized through a trade sale or flotation can then be crucial to the success of the fund managers in demonstrating that they can pick winners, in order to secure the contribution of future participants to their funds. This may mean that they might place pressure on a business to accept an offer from a commercial suitor even though the duration of the investment has not been as long as was foreseen at the time that the investment was originally made, in order to achieve that valuable ‘signal’ realization. But while a realization might suit the fund, the entrepreneur in charge of this venture might feel that the profit opportunity is being foreshortened and that the realization is too early – waiting another year or two until that recently introduced new product line has fully developed its market potential might be the be�er outcome for the entrepreneur. 229

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Or suppose an investor has a portfolio largely composed of investments in technology-based businesses. An irrational swing in investing fashion – like the dotcom boom – might prompt a change in investment or realization policy so that the investor feels he or she has to unload holdings as soon as possible in order to take advantage of market buoyancy. When changes are irrational – as fashion changes in investment o�en are – then good performance from an individual investment is no guarantee of immunity from policy changes founded on that irrationality. Third, the relationship is one-sided in its preponderance of power. If you are thinking that it looks like most of the problems outlined above emanate from one side of the investment fence, you are right – the entrepreneurs’ intentions will have been pre�y thoroughly flushed out prior to the investment having been made. The investment agreement will have been dra�ed to favour the outside investor in terms of the timing of a realization. What also has to be appreciated is that when entrepreneurs do have a change of heart in some way they can o�en be replaced with someone else by the VC – in fact, it happens all the time. It will be less easy and comfortable for an entrepreneur to sit with an impatient shareholder than the other way round – since venture capital shareholders will have the backing of an investment agreement that will probably give them the power to compel the realization of the investment if they feel it is in their interest. Both parties might have entered the investment with the expressed intention that it would last a certain amount of time, but outside pressures that cannot be predicted at the outset will affect the actual life of the investment. In particular, although they might have truthfully voiced their intentions when the investment was made, no VCs will ever commit irrevocably to a specific time horizon for the life of an investment. Above all else, VCs are opportunists. So you can appreciate that factors that are unknown at the time of an investment being completed can very o�en overthrow the original intentions of the parties towards the timing of the realization of the investment.

GENERAL CONCLUSION What has been said numerous times throughout this book can still be repeated with profit: venture capital investing is not about taking 230

Summary

risks; it is about reducing risks. Everything that VCs do is focused on this. It has been pointed out before in this book that it may be that the pendulum has swung too far: the desire to reduce risk has strayed into a desire to eliminate risk for many venture capital funds. Certainly, four factors have contributed to this:  Much of the legal armour that now coats venture capital deals. A neutral reading of many investment agreements would suggest that there is li�le being ventured. The extreme reaction of the lawyers to protecting their moneyed clients’ interests actually inhibits deals being done expeditiously and at reasonable cost; it also makes the development of the business more difficult, except for proposals that are racing certainties; it probably stultifies the development of many companies by denying all but the surest of investments the oxygen of capital.  The move upstream to larger and larger deals. This has become a game of pass the asset parcel, which means that many VCs are now concerned with asset manipulation rather than developing new businesses.  The triumph of the US way of venture investing. This has transformed the style of doing deals, the pace of deal and portfolio review and even the terms that used to be used, just as surely as the aggressive US grey squirrel has ousted the native red.  The general confusion between private equity investment and venture capital. This book has not sought to unravel that confusion, because the twin terms ‘private equity’ and ‘venture capital’ lead to such clumsy usage when talking about direct investing generally. But the distinction that is increasingly made within the business itself is a valid one: venture capital really only applies to earlystage investments; everything else is private equity. Large deals involving changes of ownership of existing businesses are really not venture capital at all. They are private equity deals with active investors having what investors in quoted businesses have been forced to cede to management and pension fund investors – control of the overall direction of the business. But there are signs that things may be moving the other way. Two or three times, mention has been made of the newer, younger venture 231

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funds – some of which are utilizing different techniques of stimulating enquiries and evaluating proposals. These funds are utilizing the best techniques of the angel investors allied with the more rigorous investigative style of the formalized funds to produce dynamic and effective investment processes. It is as yet too early to tell whether these will result in good returns for both investors in the funds and the investee companies, as the funds have not yet been in existence for long enough to begin realizing investments. Other actions need to follow from those funds that are still active in the venture capital field to complement these changes. Primarily what is needed is a less legalistic way of behaving in completing deals. The legal baggage of doing deals that restricts and inhibits and makes raising funding more costly than it need be should be reduced. Overly restrictive term sheets, anti-dilution provisions, drag-along and tag-along, liquidation preference – all should be gradually dispensed with so that the venture funds get back to being more like the angels that they once were, willing to take the knocks and bumps of the commercial world. Markets where no one fails and no one loses are ossified mechanisms that only provide for passing the parcel and the manipulation of financial assets. They do not stimulate real investment, real technological progress or the development of wealth.

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Appendix 1

Glossary of terms

Dictionary, n: a malevolent literary device for cramping the growth of a language and making it hard and inelastic. This dictionary is however a most useful work. (Ambrose Bierce, The Devil’s Dictionary)

This is a brief listing of some terms that may be unfamiliar and will be encountered throughout the text. Chapter 13 gives further specific definitions of legal clauses that may be encountered in negotiating a deal. Alternative Investment Market (AIM) The junior market of the London Stock Exchange; companies floating on AIM are not required to comply with the Listing Rules but are subject to lesser regulation. AQAP Allied Quality Assurance Programme. Articles of association Legal documents required for every company, describing how the business works internally, by detailing the rights and obligations both of the members of the company to each other and also of the company to the members. 233

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BBAA British Business Angels Association. Blow-out financing Refinancing that eliminates the value of previous rounds of financing. Also – perhaps more usually – called ‘washout’ or ‘cram-down’ rounds, a�er US usage. Business angel A private investor willing to provide cash to a business in return for a slice of equity. Such individuals are assumed to be ‘sophisticated’ investors and of high net worth (HNW). BVCA British Venture Capital Association. Closing The completion of a deal. Completion meeting The meeting of lawyers, investors and management at which legal documents are signed and the investment completed. Control premium The additional amount of money, usually beyond the strict asset valuation, that has to be paid to gain complete control of a business. Development capital Funding to enable the organic expansion of a business; sometimes called expansion capital when it includes acquisition. Dilution The reduction in a shareholding consequent upon a further round of financing. Due diligence The process of investigation of an investment proposal. Elevator pitch Originally a presentation given in the space of time that a li� takes to go up (or down) a skyscraper; now any brief initial presentation to investors. Equity Ordinary shares conveying ownership rights. Equity dri� The difference between the amount of equity possessed at the start of an investment and the final holding. Equity gap The purported failure of the market to provide funds for small companies or for companies requiring small amounts of capital. Exit A sale or other event prompting the departure of the investor. Flotation The listing of a company’s shares on a public stock exchange; now largely superseded by the US term IPO (initial public offering). Follow-on funding (Usually) additional financing provided to a company by the first round (or ‘series A’) investors recognized as being necessary at the outset of an investment.

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Hurdle rate The rate of return that an investment has to achieve before it can be considered further. Intermediaries Professional financial advisers of one sort or another. Investee Someone who receives investment. Investment commi�ee The internal body of an investment fund that has the final say as to whether an investment goes ahead. Usually composed of senior executives of the fund and outsiders, and perhaps even representatives of the investors in the fund. IPO Initial public offering, a flotation. IRR See ‘Rate of return’ below. Legals Abbreviation for legal documents or legal stages. LSE London Stock Exchange. Main market The senior market of the London Stock Exchange, subject to detailed regulation and control by the regulating authority. The Listing Rules, which govern the market, do not have the force of law, but failure to comply with them would result in a listing being suspended. MBO Management buy-out; divestment of one company by another by direct sale to the incumbent management; a variant is the management buy-in, or MBI, where outsiders take over a company from a parent, sometimes retaining members of the old management. Despite excited press reports to the contrary there is no such thing as a BIMBO – supposedly ‘buy-in management buy-out’ – at least not in finance. Memorandum of association A counterpart document to the articles of association. The memorandum explains what the company has been set up to do. Mezzanine finance Intermediate funding with some of the characteristics of debt and some of the characteristics of equity. Minority rights Certain legally protected rights of small shareholdings, enshrined in Table A of the Companies Act 1986 and by default in all articles of association. Non-executive director A legal officer of the company; a director without line or staff functions, but still owing a fiduciary duty to the company, whose appointment is registered at Companies House. Offer le�er Now usually called ‘term sheet’ – the document se�ing out the terms on which the investor proposes to make his or her 235

Appendix 1

investment. It is non-contractual and may be negotiable as to specific terms. P/E The price–earnings ratio – a measure of the comparative value of a share. Pre-emption rights The right of first refusal to buy (or sell) shares. Ratchet A device for transferring shares between investors and management shareholders. It operates (usually) through convertible shares, is dependent upon certain targets being achieved and can be either positive (gives a proportion of the company back to managers) or negative (retains shares in investors’ hands). Rate of return (RoR) Specifically the internal rate of return. The compound annual interest rate that will reduce the returns from an investment to zero over a given period of time. Realization A sale or some other event at which shareholdings become both crystallized and liquid – sequentially, of course. Rescue capital Funding provided to salvage a business – o�en provided on penal terms. Risk–reward ratio The investor’s perceived balance between the a�ractiveness and disadvantages of an investment proposal. RVCF Regional venture capital funds – established in every English planning region, professionally run by private sector managers with a mixture of public money and privately raised capital. Sweat equity The immeasurable component of an investor’s direct contribution. SWOT A SWOT analysis investigates a business in terms of strengths, weaknesses, opportunities and threats. Term sheet See ‘Offer le�er’. Trade sale A sale of one company directly to another business. TUPE Regulations Transfer of Undertakings (Protection of Employment) Regulations. Working capital The amount of money tied up in debtors, creditors (including future taxation) and stock.

236

Appendix 2

Useful addresses Many useful documents are published electronically and free of charge by the BVCA and the BBAA. Consult their websites for more information. Beer and Partners Painters Hall Li�le Trinity Lane London EC4V 2AD Tel: 0870 163 3033 www.beerandpartners.com British Business Angels Association (BBAA) 52–54 Southwark Street London SE1 1UN Tel: (020) 7809 2305 www.bbaa.org.uk British Venture Capital Association (BVCA) 3 Clements Inn London WC2A 2AZ Tel: (020) 7025 2950 www.bvca.co.uk 237

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Great Eastern Investment Forum Richmond House 16–20 Regent Street Cambridge CB1 1DB Tel: (01223) 720316 www.geif.co.uk IQ Capital Richmond House 16–20 Regent Street Cambridge CB2 1DB Tel: (01223) 357131 www.iqcapitalfund.co.uk Matrix Private Equity One Jermyn Street London SW1Y 4UH Tel: (0207) 925 3300 www.matrixgroup.co.uk Taylor Vinters Solicitors Merlin Place Milton Road Cambridge CB4 0DP Tel: (01223) 423444 www.taylorvinters.co.uk Turnaround Management Association (UK) 81–82 Gracechurch Street London EC3V 0AU Tel: 0870 760 7116 www.tma-uk.org

238

Index 3 Fs 49 3i 72–73, 79, 82, 158, 222 see also Industrial and Commercial Finance Corporation (ICFC), Investors in Industry 3Ms: mathematics, market, management 14–16, 91 accountants accountants’ investigation 70, 98–99, 152–54 due diligence process, role in 138 employed as professional advisers 92–93 flotation, role in 206 as venture capital fund managers 82 Alternative Investment Market 226 annual compound growth 141 anti-dilution provisions 183 Apax Partners 81 Apple Computers 3

assets significance of in due diligence process 101 balance sheet 14, 74, 89–90, 141, 167 balloon loan 166 see also loans banks 68, 120, 204 account history 150 captive funds 72 covenants 41 loans 166 mezzanine capital 4, 173 overdra� 217 sources of finance 34, 46 Beer and Partners 68 Beermat Entrepreneur, The 17, 46 BERR (Dept for Business Enterprise and Regulatory Reform, previously DTI) 68 BERR inspectors 213 Bevin, Lord 12 biotech 9, 141 Bloomfield’s Laws 239

Index First 123 Second 126 blow-out financing 110, 161, 169, 172 see also refinancing board packing rights 168 Boo.com 17 Boots 39 Branson, Richard 207 British Business Angels Association (BBAA) 66, 68 British Venture Capital Association (BVCA) 8, 49, 62, 95, 99–100, 224 business angels on boards 194 changes in investment pa�erns 24–27 desk review by 141 further reviews 153 individual investors 3, 17, 46, 66–68, 172 investment structuring 172 problems with angels 200–01 selecting as investor 95, 216–20 as sources of finance 46, 85, 216–20 syndicates of 76 and VCs 33 business life cycle 49 et seq of funds 79 et seq Business Links 95 business plan 14, 76, 89–91, 150–51 desk review 140–41 due diligence process 138 routes out 105 Cambridge 30 Cambridge Phenomenon 73 Candover 73 captive funds 72 see also semi-captive funds carbon-reducing technologies 31 carried interest 84–85, 205 240

cash flow 90, 137 corporate collapse 212 routes out 57, 105–06 CinVen 72, 73, 81, 137–38 see also Coal Industry Nominees’ Industrial Investments Cisco Systems 3 clandestine arrangements 56 ClickMango 178, 222 Coal Board Pension Fund 137 Coal Industry Nominees’ Industrial Investments (CINII) 73 see also CinVen Cohen, Sir Ron 17 Combined Code (London Stock Exchange) 195 Companies Act 2006 183 completion audit 152–53 completion meeting 89 conditions precedent 98 consortia 76 consultants 66 control premium 54 convertibility rights 168, 182 corporate collapse 212 County Court Judgements (CCJs) 149 Covenant-lite 41 cram-down rounds see blow-out financing creditors 118–19, 161 cumulative rights 167 CVs 122, 137, 141, 155 deal brokers 66 deal structuring 158 et seq debt, as source of funding 40, 46, 48 ‘cheap’ debt 41 deemed disposal see forced sale provisions deemed liquidations 182 Department of Trade and Industry see BERR

Index desk review 140–42 development capital 52–55 development funds 135 directors 128–29, 168, 191, 192 et seq chief executive 100, 103 dismissal/release of 130–31, 193, 197 executive 83 finance director, importance of 93 non-executive 83, 129, 155, 192, 196–97, 201 succession 131 disclosure le�er 185–86 discretionary trusts 57 dividends 168, 171 rights to see preference shares dot.com boom 3, 5, 13, 80–81, 222 bust 29, 39 drag-along rights 184 see also tag-along rights due diligence 5, 88–89, 98, 100–02, 109, 118, 133–56 adverse reports 154 remit given 138 Dyson, James 15 early-stage specialists 135 East Anglia 30, 31 e-commerce 10 effective access 8 Electra 73 electronic filing 89 ‘elevator-pitches’ 51 EMI 39 Enterprise Act 2003 213 Enterprise Investment Scheme equity 4, 166–70 Equity Capital for Industry (ECI) 73 ECI Partners 73 ECI Ventures 73

68

equity gap 9–11, 48 Europe 8, 12, 19, 226 European Union 74 exit route 49–59, 89, 94, 103–10, 203–14 factoring business 48 fees in deals 83, 99 professional 22, 27–28 financial engineering 4, 40–42 flotation see exit routes follow-on funding 94, 199–200, 224–25 forced sale provisions (‘deemed disposal’) 197 founders shares 182–83 see also vesting terms functional coverage, management 124 functional specialists 71 funding gap 216 funds fund life cycle 79–81 fund of funds 74 fund size 32, 39, 78 London-based 38–39 gearing, 41 Great Crash, the 12 Great Eastern Investment Forum 68 Hermes 72 high net worth individuals 67 high-tech funds 39 high-tech problems 80 house investment style 135–37 impatient money 64 incorporated businesses 17 Industrial and Commercial Finance Corporation (ICFC) 73 see also 3i, Investors in Industry 241

Index Information and Consultation of Employees Regulations (2004) 162 initial public offerings (IPOs) 177, 206–08 see also flotation intellectual property 3, 16, 51, 101 internal rate of return (IRR) 40, 91, 100, 133 see also rates of return (RORs) inventors, serial 18 investment commi�ee 70, 132 fees 139, 143 fora 50 funds, sources of 8, 65 managers 60–63 process 88–89, 96–97 ratchet 136, 168 statistics 9–10, 13 investor-initiated sales 208–09 Investors in Industry 73 invoice discounter 48 judgement, ma�ers of in due diligence 153 ‘going native‘ 199 and management 128, 134 key man insurance as requirement 186 Keynes, John Maynard 12 Land Rover buy-out 56 leadership 143 legal documentation, changes in 22–25 legal stages 6, 88–89, 127, 175–88, 211 complexity 223–25 and shareholders 116 standardization 22 legal title 101 242

limited companies 16–17 limited liability partnerships (LLPs) 16, 69 limited life deal 18 liquidation 110 liquidation preference 182 liquidity 44 Lloyd Webber, Andrew 207 see also Really Useful Group loans 62, 166 see also balloon loan Macmillan Commi�ee on Finance and Industry report 12 Macmillan, Harold 12 Malmsten, Ernst 17 management details in business plan 90 functional coverage 124 as key determinant 91 key elements 123 management buy-ins (MBIs) 9–11 management buy-outs (MBOs) 9–11, 55–57, 112 management information reports 185 mezzanine capital 4, 173 Moulton, Jon 18 Netscape 3 newco 117, 158–60 Nobbs, David 71 offer le�er 179 see also term sheet off-shore trusts 57 opportunism 63 ordinary share 166 see also shares Parmalat 226 participating preferred ordinary (PPOs) 167 see also shares

Index patent protection 51 patient money, myth of see impatient money philanthropic trusts 3 portfolio investment approach, 67, 92, 104, 196 constraints 224, 230 life-cycle 66 problems 213 pre-emption rights 183 preference shares 22, 166–67, 181 preferred ordinary 166–67 see also preference shares pre-tax profit growth 199 price/earnings ratio (P/E) 40, 106, 138 prediction of 106–07 private equity 3–4, 8 profit and loss account, in business plan 14 public limited company (PLCs) 55 BVCA Performance Measurement Survey 9 Qinetiq 39 qualified by experience (QBE) quasi-equity 173 see also equity

82

ratchets 53, 136, 169 convertibility 168 final offer le�er 99 positive and negative 168, 182 reverse ratchet 136 rates of return (RoRs) 49, 141, 228 significance of 14 see also internal rate of return realization 203–14 Really Useful Group 207 see also Lloyd Webber, Andrew redemption rights 167, 182 refinancing 110 see also blow-out financing

regional venture funds (RVCFs) details of 74–76 residual shareholders 115 rights of first refusal 183 risk 14, 136–37, 165 avoidance 137 categories of venture capital 3 individual 66–67 investigation 101 managers as factors in assessment 128 market risk 164 minimization 63, 104–05, 136, 139, 177, 231 risk analysis 155 risk and reward 5, 136, 165 risk profile, perception of 97, 169 and size of funds 78 start-up 49 syndicates 76 running yield 167 Saga plc 107 Sainsbury’s 39 seasonality 146 seed capital 3 semi-captive funds 72 see also captive funds sensitivity scenarios 90 serial entrepreneurs 16 serial investors 16 shareholders change of 47, 55–57 relationships 111–17 shares see ordinary shares, preference shares Sinclair, Sir Clive 16 size of fund as determinant of investment policy 66 and fund structure 66–74 small- and medium-sized enterprises (SMEs) 74 243

Index Societas Europaea 19, 226 sole traders 16 Southon, Mike 45–46 stakeholders 117–19 star performers, in portfolio 104 step-change 48, 128, 150 stock market 65 succession plan, managerial 131 suppliers 118 sweat-equity 52, 68 Sweden 16 SWOT analysis 147 syndicates 76, 172 see also consortia tag-along rights 184, 199 see also drag-along rights taxation 159 as an issue in structuring 40–42, 162–63 term loan 48 term sheet 98–99, 140, 179, 186–88 timing, of approach 53 topco 18–19 trade buyer 160, 210 trade sales 208–12 trading record 159 tranches 181 Transfer of Undertakings, Protection of Employment regulations (TUPE) 117, 162 Turnround Management Association 58

244

UK as domicile for companies 19 unique selling proposition (USP) 15 United States as source of investing style 8, 222, 231 as source of funds 220 university environment 50 venture capitalists background and experience 82 investment by, as principals 84 pressures on 64–65 remuneration 83–84 see also carried interest ‘Venture Capital Lite’ 76 venture capital trusts (VCTs) 40, 41, 73 vesting terms 182, 197 see also founders’ shares Virgin Group 207 warranties 181, 185 countered by disclosure 185–86 reluctance of VCs to give 211 sequence in legal stages 185 washout rounds see blow-out financing workforce 117