The Tech Entrepreneur’s Journey – Venture Capital

Following on from the first article of the series, The Tech Entrepreneur’s Journey – The Capital Requirements, this article will consider key aspects that a tech entrepreneur should be conscious of prior to taking on Venture Capital.

What is Venture Capital?

Venture capital (VC) is a form of investment for early-stage, innovative businesses with strong growth potential. Whilst not always the case, VC houses typically invest in technology companies with an exciting concept or piece of technology. The optimum investment outcome being that the investment company is revolutionary or becomes what is known as a “disruptor” leading to a greater return on the house’s investment.

To be a “disruptor” is to create a product, service, or way of doing things that initially displaces and then eventually replaces the existing market leaders. Disruptors are generally entrepreneurs rather than industry insiders or market specialists.

Investment Structure

VC investments are traditionally made in return for a minority shareholding in a company, due to the perceived higher risk associated with investing into early-stage businesses. Unlike a private equity investment, VC houses are willing to invest in businesses not yet making a profit and typically hold their investments for a period of between five and seven years before seeking an exit.

Subject to the risk profile of the (investee) company that is seeking VC and its target investment amount, it is not uncommon for multiple VC houses to invest alongside each other with each VC house taking its own minority stake.

As we noted in our first article in this series, although the Founder(s) should expect to provide VC houses with a number of investment protections they should still expect to retain ultimate control of the company (including the board) and, subject to investor veto rights, the day to day operations of the business. However, ‘Series A Investment’ documents (those being used for the first VC investment made into a company) will normally impose more stringent restrictions on the management of the company and the business when compared to previous capital raises from family and friends and seed investment.

Any VC investment will be structured in a manner that is as tax efficient as possible for the VC house. As the tech entrepreneur/Founder you should obtain your own tax advice to make sure that taking on the VC investment in the proposed structure is in the best interests of both the company and you as a principal shareholder of the company.

Management Team

Prior to taking on VC, the Founder(s) will need to have a well thought out, realistic and achievable business plan which the management team will aim to deliver. A key element underpinning the business plan will be the financial modelling, which the Founder(s) will need to be able to justify and stand behind. An astute investor tends to make its investment based in no small part on its assessment of the management team and their ability to execute the business plan.

Conclusion

The VC house’s reward for investing in a ‘disruptor’ business can easily be lost by one or a number of poor investments so, before investing, VC houses will heavily scrutinise the potential risks of the proposed investment and assessing what the key ingredients to success are for the company, including the management team. VC houses want to know whether management is up to the task, the size of the market opportunity and whether the concept or piece of technology which is the focus of the investment has what it takes to guarantee a return on its investment. Ultimately, due to the early-stage nature of the business a VC house will seek to reduce the risks associated with its investment in as many was as possible.

Finally, we again set out below an overview of a typical business corporate life cycle. Having now addressed the first four stages (being (1) Incorporation, (2) Founder(s) friends and family funding, (3) Seed Investment and (4) Venture Capital) the next article in this series will address Private Equity Funding with the final article of the series addressing the various options open to shareholders to realise value for their business upon an Exit.