1. What is venture capital?(1)

Venture capital involves funding high growth private start-up companies, particularly in the information technology and e-business industries. Venture capital offers medium term equity finance and does not require regular interest payments. Venture capital can provide a number of value added services include mentoring and the introduction of strategic alliances.

Venture capitalists (high net worth individuals or companies who provide the capital) generally take a minority share in the company and usually do not seek day to day control of a business. They generally appoint a representative to the board of directors and require input and in many cases retain veto rights over key strategic decisions.

2. Stages Of Growth

Venture capitalists categorise companies into four stages of growth:

(a) Stage one—Seed: the business is little more than a concept, the product is in development and the company is concentrating on research and producing a working model or prototype. The founders will fund the business from personal funds, typically requiring between $50,000 to $500,000.

(b) Stage two—Start-up: known as the "Angel round", the concept or products have been developed but the company has no track record and often has not made a profit, thereby making more traditional funding difficult to obtain. This is the riskiest stage for investors. The company needs a large amount of capital (typically between $500,000 to $2 million) but has no reliable indicators of its future success. Many businesses fail during this phase.

(c) Stage three—Expansion: known as the "second round" and may comprise multiple rounds before stage four. The company is fully set up, has usually received some funding and is building a financial track record. The company however, needs further funding (typically between $2 million to $10 million plus) to expand existing operational and marketing capacity. Some companies choose to meet financing needs with traditional bank finance (note that a bank will usually require personal guarantees from directors together with collateral).

(d) Stage four—Mezzanine: known as pre-Initial Public Offering (IPO) funding (typically between $10 million and $50 million and up). Funds are used to prepare for IPO including strategic acquisitions. Mezzanine investors may provide experience in the IPO process; for example, the company is "dressed up" for listing by introducing recognised business people to the board.

3. Steps typically involved in a venture capital investment

(a) Prepare a business plan

Business plan should include:

* a company background and looking forward statement;

* a product or service description, a market analysis (industry size, competitors, market share, customers, barriers to entry and growth, distribution channels);

* a marketing plan;

* a description of the manufacturing process and participants;

* the status of research and development;
* a management profile;

* a risk analysis;

* a summary of past and projected financial performance;

* a statement of funds required;

* capital and corporate group structure before and after financing; and

* company details (directors, shareholders, lawyers etc).

(b) Select suitable venture capital funds

A company seeking funds should consider the investment preferences of the various venture capital funds, the quality of the relationship between the management team and the investor, the ability of the fund to provide future funding, the investment exit horizon and the value the investor can add through industry experience, contact networks and expertise in start-up financing.

The fund should be a member of the Australian Venture Capital Association Limited (AVCAL), which has adopted an industry Code of Conduct.

(c) Submitting a business plan for evaluation

Submitting unsolicited business plans is unlikely to secure funding. Attract the attention of an investor through introduction by a third party who has a relationship with the fund.

(d) Negotiating valuation

Valuation is generally based on management projections and deals negotiated in the industry by other companies, supported by the financial and legal due diligence and based on reasonable assumptions.

Other issues include: restrictions on the shares of the founder, the ability of the investor to introduce strategic partners and the preferential rights attaching to his or her shares.

(e) Negotiate a Terms Sheet

A terms sheet sets out the terms of the deal until parties negotiate detailed legal agreements. Term sheets can be legally binding and care must be taken to be certain of the legal status of the term sheet. A term sheet typically includes provisions on:

* Form and size of the investment: the number and amount of ordinary shares, preference shares or convertible notes;

* Investor Protections: any preferential right to dividends, preferential right on a liquidation or winding up of the company, right to convert preference shares into ordinary shares, anti-dilution measures to prevent diminution in price or underlying value of shares resulting from any future share dividends, share issues at a discount, share splits, reverse splits or similar recapitalisation;

* Investor board representative - the investor typically wants a board representative and may recruit additional management executives. It may specify that certain decisions have to be made by a special majority of directors (ie a majority including its board appointees);

* Information rights: the rights of the investor to financial statements, budgets, business plans;

* Pre-emptive rights: the rights of the investor to invest in future issues of shares or debt raisings in preference to a third party;

* Exit strategies - the rights of the investor to force a trade sale or IPO on a public stock exchange if such an event has not occurred within 3 or 4 years of the investment; and

* Exclusivity period - in which the venture capitalist may conduct due diligence inquiries and negotiate the investment and management agreements.

Venture capitalist may require the following:

* investment made in stages (tranches), each stage conditional upon the company achieving certain milestones;

* the company must buy back or redeem the venture capitalist shares if an IPO or trade sale has not occurred by a certain date;

* a "drag along" clause compelling all shareholders to sell their shares if more than a specified percentage of shareholders (usually a majority) accept a third party offer;

* founding shareholders agree to a standstill provision which prevent them from selling their shares in the company for a period of time;

* key executives sign appropriate executive service agreements;

* assurance that the company has sole legal and beneficial ownership of the intellectual property rights.

When negotiating terms for early round funding, note that future investors may want the same or similar rights as those granted to early-round investors.

(f) Due diligence investigations will then be undertaken by the fund

Upon signing a terms sheet, the investor (or its agent) examines the corporate structure, assets, intellectual property, financial statements, material contracts, employment agreements and any actual or threatened litigation (due diligence).

(g) Negotiate and execute formal investment documentation

Upon completion of due diligence, parties typically prepare and sign the following formal legal documentation:

* Subscription Agreement: sets out number and price of shares, funding tranches and dates of subscriptions, detailed warranties concerning the company, rights attaching to shares, and conditions precedent to funding;

* Shareholders Agreement: sets out ongoing relationship between the Shareholders and the company as agreed in the Terms Sheet;

* Intellectual Property Acknowledgment Deeds: acknowledgment by other parties they have no rights in any intellectual property which they developed and assign all such creations to the company; and

* Executive Service Agreements: will bind "key" employees to the company for a period (usually two or three years), and will set out the employee terms of service, remuneration, and bonus entitlements.


Other relevant Articles on this site:

Other relevant Fact Sheets:
Corporations and Securities Law
Funding Business Start-ups

End Notes
(1) Based on N Humphrey Venture Capital Guide (2000), Gilbert and Tobin