Potential sources of equity for your business fall into two broad camps.

• Informal sources, by which I mean people or businesses who may be interested in investing in your business for a variety of reasons, but who are not set up to act as professional investors, or are actively looking for investment opportunities. These can include:
  • you;
  • the three Fs – family, friends and fools;
  • employees;
  • trade partners.
• Formal sources: people or institutions who are professional investors actively looking for opportunities to invest and for whom making such investments is one of their principal business activities, such as:
  • business angels;
  • venture capitalists;
  • the public through institutional investors such as pension schemes.

Since the characteristics of the informal sources differ significantly from those of each of the formal sources, these are looked at separately below.

INFORMAL SOURCES

You

The first informal source of finance for your business is of course you, yourself.

You can invest your own cash, or cash that you have raised by borrowing against your other assets (for example by raising a mortgage against your house) into the business.

The advantage of this approach is that if you are providing all of the equity funding, you will retain full control and ownership of your business.

The disadvantages, however, can be that you may find:

• you may not have sufficient resources to fund the business properly to the level required; and that
• your personal assets (and personal financial health) are now mortgaged to the success of the business.

Nevertheless, for many new businesses, raising your own money to go into the business may be the only approach available and this will either involve:

• using your savings;
• selling off assets to raise cash;
• raising personal loans or borrowing on credit cards; or
• if you’re a homeowner, borrowing against the equity in your property.

Personal loans

As many readers will be aware either from the frequent adverts in the press or indeed from the junk mail that pours through your letterbox, most people who own a home and who have a reasonable credit history will be able to obtain an unsecured loan of up to £25,000 (which is a limit imposed under consumer credit legislation) over say ten to 15 years. As unsecured loans these tend to be expensive when compared with loans secured against your property such as a mortgage or second charge. However, they do tend to be quick to organise and can provide a valuable resource for business start-ups.

Credit cards

Similarly, most people who have a reasonable credit rating will also receive a large number of offers of credit cards. As is well known, interest rates on credit cards are extremely high in comparison with most other forms of borrowing. However, some small businesses are taking advantage of the competition in this marketplace whereby many of the offers of new cards have an introductory period of up to six months at 0% interest, including on balance transfers.

For those who are sufficiently organised and brave, these can be used to provide a source of finance at 0% where a personal credit card is used to meet business expenditure. The minimum payments are then made on a regular basis and the balance is transferred to a new card with another 0% balance transfer rate at the end of each introductory period.

The risk is obviously that at some point you will need to either repay this borrowing to clear the card, or you may end up with funds borrowed at a very high rate, so it’s not a strategy that I would recommend.

Borrowing against personal property

Most individuals’ major store of personal capital is the equity in their house. Therefore when looking to raise business capital, borrowing against this is usually the only realistic option.

It is also true that cash raised against the security of residential property can be amongst the cheapest sources of financing available as it is raised at domestic mortgage rates. If you simply want to arrange a top-up loan by borrowing against your house without disturbing your existing mortgage using what is called a second charge (because the lender will take a second charge on the property behind your mortgage lender) there are a number of websites which will allow you to apply for such money direct (try www.creativehomeloan.co.uk).

If you need to seek a full remortgage, this is now an area that is highly regulated and you will need to take professional advice from an independent financial adviser. Contact Creative Business Finance (see Useful Contacts p 429) for referral to one of the appropriately qualified advisers with which they work.

In any event, you must always remember that, as it says in the small print, your home is at risk if you do not keep up the payments on a mortgage or other loan secured on it.

There are obviously an enormous number of mortgage products on the market which change all the time. It is worth noting, however, three types of product in particular which may be of assistance in buying a business.

Fleximortgage – flexibility

This is a residential mortgage that provides a revolving loan against your property that can be drawn down and repaid up to a specified number of times a year without penalty.

It can therefore provide a ready source of flexible funding at domestic mortgage rates, which gives you the ability to draw down your domestic equity over short periods at short notice without the high costs of bridging.

Loans of up to 85% of open market value (OMV) are generally available up to an upper capital limit of £250k (but higher loans may sometimes be available by discretion). A satisfactory prior lender reference is required, but a small amount of adverse credit history is generally acceptable. Loans are normally for up to a 25 year term and rates are similar to high street rates.

15 day mortgage- speed

Some lenders have stripped down the search and credit referencing procedure to provide a residential mortgage which can deliver a draw down of funds within ten to 15 days from application.

Again the advances available are normally up to 85% of the property’s value on a self-certified basis with no requirement for an accountant’s confirmation or lender reference in most cases. These loans are available to individuals with a significant adverse credit history and are for terms of up to 25 years. Rates tend to be slightly higher than normal high street levels and there will be redemption penalties.

Domestic bridging

If you only require the cash on a very short-term basis, as for example you believe that you will be able to take sufficient cash out of the business to repay this equity within three to six months, you might consider taking out a bridging loan rather than completely remortgaging the whole of your property.

Loans of up to £500k at up to 70% of OMV with rates from 1.1% per month are normally available from a range of lenders and can be swiftly put in place.

These are, however, very short-term funds and if you have any doubt about your ability to repay the bridging at the end of an arrangement you should not go into it.

Planning for personal investment

While you will obviously not need to prepare a pitch in order to sell yourself the idea of investing in the business in the way that you will have to if you’re seeking money from other people, it is still always a good idea to prepare a formal business plan to help you think through how much money the business is going to need and where you’re going to raise this from. The old insolvency saying about putting enough fuel in the plane to only fly halfway across the Atlantic has already been mentioned. If by preparing a business plan, including a cashflow, it becomes obvious that you cannot arrange sufficient funds from your own and the business’s resources to make it through to a sustainable trading position, you need to either find another investor at the outset or rethink or abandon your existing plans.

One tip, however, is that while lenders will always be looking for you to put in as much as possible both to demonstrate your commitment to the business and to reduce the amount of money you need to borrow from them (and therefore their risk) you should always try to keep something in reserve. This is because if your business ever gets into difficulty, in extremis you may decide to pay in funds to see you through, where a third party funder such as a bank, which doesn’t have such an emotional stake in the outcome or a financial incentive in terms of the value of the business, may not.

Of course, as covered in the section on turnarounds in Chapter 16, if your business ever does get into difficulty you need to think very carefully about pouring more money into it and the risk of simply sending good money after bad.

In practice, many small business owners start off by funding much of the business’s initial expenditure from their own resources, bearing expenses like rent or stationery or advertising from their own funds, because until the business has achieved a successful level of trading, it simply doesn’t have the funds to do so. Once the business is up and running the owner then has the choice as to whether these expenses should be repaid, or the cash left in the business by way of a director’s loan, or treated as an equity investment. This is something that you might want to talk to your accountant about as it may have an impact on your tax position.

Your family, friends or others known to you

The second group of people that you might turn to are people with whom you have a personal connection, sometimes dismissively referred to by finance professionals as the three Fs of family, friends and fools. However, it is wrong to be dismissive as this type of funding has been vital for the start-up of thousands of businesses over the years, right up to well-known examples such as the garage owner who invested a few thousand pounds in a small new venture called Body Shop being started by Anita Roddick and ended up with a multi-million pound investment.

Through your personal network you may have direct access to people who may be able to provide cash. What’s more you can do so without incurring the significant costs of trying to access this type of cash through more formal means. You will also have some idea as to whether they are actually likely to invest or not whereas, as discussed below, some formal sources may be much more uncertain.

However, you should think very carefully about the implications of using such money and how these relationships will be affected by the arrangement, because of the serious questions it raises such as the following.

• Do they understand the difference between a loan with a regular payment of interest, and a structured repayment back to them of their capital, and a shareholding with dividends only when the company both makes a profit and decides to distribute some to its shareholders?
• How long can they afford to wait to have their money back?
• Do they understand that they may have to wait and won’t simply be able to ask for it to be repaid if they need it for something else?
• What are they going to get out of it? A full commercial level of return or a more limited one as they are providing funds for other personal reasons?
• To what extent do they understand the risks? Are they providing the money on your say so? Are they taking professional advice and undertaking some due diligence or are they simply taking your word for it?
• What happens if there is a business problem? How much can they afford to lose? What will this do to your relationship?

To get over these sorts of issues, in the same way as you should draw up a loan agreement if you are borrowing money from relatives or friends, you should draw up a clear shareholder agreement if they are investing in your business. This should spell out their interest in the business and the overall arrangement to avoid as far as possible any later disputes.

Employees

As people intimately connected with the business, your employees can be a source of funds, but more often employees’ share schemes are set up as a way of incentivising and retaining key staff.

If you are considering approaching employees about investing in the business you should take tax advice. There are significant tax breaks for employee share schemes, including arrangements that allow employees to reinvest dividends received into shares which are held for three years attracting no income tax.

Trade partners

You should also think about whether there are any potential trade partners who might be interested in a stake in your business or in helping to fund a project in some kind of joint venture (JV).

The advantage here is that you’ll be dealing with somebody who already knows your business and, to a degree, your market. They should therefore be in a good position to make a judgement about the attractiveness of investing.

You need to be careful about how such an arrangement may affect your business, however. If you have a joint venture with a supplier, are you then tied to them for supplies or are you free to shop around? If you have a joint venture with a customer, does this give you problems with other customers who might be their competitors?

BUSINESS ANGELS

Business angels are usually successful business people who have:

• made sufficient money to have retired or sold their own business;
• are now interested in investing in small businesses both as a way of:
  • making money; and
  • continuing to be involved in business.

They are therefore usually interested in investing in small businesses with potential for high growth, where by taking equity they can look to become involved, while potentially obtaining a high return on their investment.

Business angels therefore bring not only cash but usually significant business experience and often a good network of business contacts. The downside for the entrepreneur can be that they will often seek to be actively involved in the direction of the business which can lead to conflict, so it is important to see how hands-on they want to be and how you feel about this.

For most businesses looking to raise less than say £250,000 (such as for a start-up or seed development money), business angels usually offer the only realistic option (other than some smaller specialist regional venture capitalists). Some business angels are prepared to invest quite small amounts, say from £10,000 upwards, whilst at the top end of business angel investment, over £500,000 may be possible although this would usually be through a syndicate of such investors rather than a single individual. The typical business angel investment is generally reckoned to be somewhere between £75,000 and £100,000.

One advantage of dealing with a business angel is that since it is their money it is also their choice. There is therefore no anonymous credit committee involved; when you speak to the business angel you are speaking to the decision maker, so if you can convince them you can get the money.

Obviously as individuals business angels will each have their own criteria and approach to assessing any proposal, so for example the degree to which they will rely on professional due diligence will vary significantly. Nevertheless this will be a serious decision and therefore you need to prepare a professional business plan as discussed below to give yourself the best chance of success.

The things that a business angel will be looking for will be the same as for all professional investors and include the:

• quality of the people involved in the business and their commitment to it;
• strength of the business’s competitive advantage or unique selling point;
• potential for growth in the market;
• realism and strength of the plan to take the business forwards;
• realism about the current value of the business and the stake in it that the proposed investment will require;
• preparedness to actually go through with selling some of the company shares (so that they are not wasting their time);
• degree to which the business’s and investor’s interest in the opportunity and view of the way forward are compatible such that they will be able to work together.

As most are interested in proactively helping the companies they invest in by using their own skills, experience and contacts, this means that they tend to invest:

• locally, so as to be able to be in regular contact with the business; and
• in businesses in sectors where they have some existing experience and contacts.

Some business angels invest on their own, while some work as part of clubs. There are a number of networks around the country which have been set up to enable prospective businesses to be put in touch with such investors, for example by circulating a regular digest of opportunities to a database of investors, or by running investment fairs where candidate companies seeking funding can take stalls and offer presentations on their proposals (see the British Business Angels Association as a starting point, www.bbaa.org). But since you are most likely to find an investor locally, you will also find that a good local business adviser such as an accountant specialising in corporate finance will have working relationships with local active business angels.

Whilst in some ways making the process of attracting business angel investment more difficult by way of the regulations discussed above, the government has also taken steps to try the following.

• Encourage business angels to invest under the Enterprise Investment Scheme, which provides tax incentives for business angels investing in companies that meet the criteria.
• Attempt to make more funds available by schemes such as:
  • the Early Growth Funding scheme which can invest up to £100,000 in small businesses to match commercial funding and which can usually be accessed via the DTI’s Small Business Service or some business angel networks; and
  • a proposed scheme to be known as Enterprise Capital Funds, which is intended to provide extra cash for SMEs of potentially up to £2m by following or matching business angel investment, although at the time of writing it is not yet clear how these will actually work. In addition, there are suggestions that the government will require to have first claim on cash coming back out of the business which may make this unattractive for some investors.

The disadvantages of business angel funding include the following.

• It’s true to say that most business angels will only make a limited number of investments and for much of the time may not be actively looking for opportunities. It can therefore be extremely difficult to find the right investor and the process is often very time consuming.
• It can also be expensive, as some of the networks are privately owned and charge high levels of fees to companies seeking to access their network of investors, which will be in addition to the cost of your own professional advisers.
• As they are investing their own hard earned money, however, business angels tend to be very choosy about which businesses they invest in and potential business angel investments have a reputation amongst some business advisers of falling away at the last moment.
• Finally, as people who have already made their money, some can be seen to be quite arrogant and overbearing by the owners of the businesses that are still on their way up, so it is absolutely vital to ensure that any such investor is someone that you will be happy to work with over the lifetime of their investment in your business.

VENTURE CAPITALISTS

For sums larger than are available through business angel finance you will need to turn to one of the over 150 venture capital firms operating in the UK today.

Venture capitalists (VCs) are businesses that exist to raise funds from institutional investors such as pension funds (or for bank related VCs, their parent bank) which they are then looking to invest to provide them a higher return than they can achieve from other sources.

A venture capital firm (VC house) therefore regularly goes through a cycle of:

• raising a fund and investing the cash raised;
• managing a portfolio of investments for the life of the fund which might typically be seven to ten years;
• before then selling off its investments in order to realise a capital gain, and pay back their investors’ capital together with a sufficient return to attract investors for their next round of fundraising.

This structure obviously puts pressure on the VC house to get a good return so as to make its next round of fund raising easier, which will be passed on to you. But it also puts pressure on the VC house to exit from its investments by the target date and investments that are still held by a closed fund can find themselves under pressure to achieve a sale.

A Venture Capital Trust (VCT) raises funds slightly differently in that it is a publicly quoted company that raises funds from private investors who get a tax incentive for putting money in for three years. The operation and investment of a VCT is usually managed by a VC house on a contract basis so VCs of all types will therefore be looking to:

• invest in unquoted companies with high growth potential and ambitious, experienced management;
• be more willing to commit a material amount of their own money into the venture;
• be prepared to sell a realistic stake in the business for the funding required and the risk the VC is taking;
• expect to be able to sell their investment on within say three to seven years which will mean the:
  • sale of the shares back to the company;
  • sale of the company; or
  • a flotation; and
  • return on their investment by way of a capital gain on their exit of say over 20% to 30% a year.

This means that before considering venture capital (or business angel) investment your business needs to be an entrepreneurial one that is looking for a high rate of growth, rather than a lifestyle business which gives you a decent standard of living, but which is unlikely to provide the financial returns to make it worth an outside investor risking their money in the business.

Dealing with a VC as a potential investor, however, has some advantages over dealing with a business angel, in that a VC house will have a process of investment appraisal which is likely to be extremely tough, but you can at least assume that if you clear the high hurdles set, they are likely to invest and will not suddenly get cold feet and put their cheque book away as business angels can do.

Another advantage for many business owners of VCs over business angels is that a VC will not generally become involved in the day-to-day operations of your business as the management of the business will remain your responsibility, whereas business angels will often actively seek a role. The VC firms’ approaches differ, but they will normally want a seat on the board and may also wish to appoint a chairman of the board to both provide guidance to the business and act as the VC’s eyes and ears. There are some exceptions to this general rule, most notably a VC house specialising in turnaround such as Alchemy Partners, which because of the nature of the situations they are investing in become very actively involved in the hands-on management of the business.

Of course, not all investments will work out as planned and so VCs will generally work on a portfolio basis. That is to say that out of any ten investments they might expect say two to fail, seven to survive and succeed at a moderate to good level but not deliver the super returns of a star, and one to really shine and deliver a phenomenal return.

The equity gap

Other than some smaller regional funds that specialise in smaller amounts (as discussed below), most venture capitalists are also looking for large investments to justify their time and costs in undertaking a transaction. The minimum level of deal that a VC will be interested in will obviously differ from house to house, but for most mainstream VCs this is likely to be in excess of say £2m. Since business angel finance can generally only deliver funds of a few hundreds of thousands of pounds, this presents a difficulty for businesses seeking from say £500,000 to £2m in investment, known as the equity gap.

In order to try to bridge this equity gap the government with European support has introduced the Regional Venture Capital Funds (RVCs) listed below, which are managed by professional fund managers, can advance up to £250,000 and will often work in concert with business angels.

There is some justified criticism that given the level of funding available from the RVCs they are not actually addressing the real equity gap which lies in the region of £500,000 to £2m. From this point of view the introduction of the Enterprise Capital Funds discussed above, which are expected to be able to invest up to £2m, may present more of a solution to this problem if they can be made to work in practice.

There are also a number of other schemes which include the following.

• Regional funds managed by local development agencies such as invest in Northern Ireland, Scottish Enterprise and Welsh Finance which can offer ranges of funding up to £1.5m.
• Bridges Community Ventures, which is a government scheme designed to regenerate deprived areas of England that can invest up to £2m.

In addition, listing your shares on Ofex or AIM, the junior UK stock markets discussed below, may also provide a solution for some companies.

Types of investments

Venture capital firms distinguish between a number of different types of investment based on the use the money is going to be put to and the stage of the company’s life cycle. These can be summarised as below.

Seed capital

Seed is the first stage of developing a business idea and perhaps manufacturing a prototype to demonstrate its potential, through sometimes to small scale manufacturing or piloting. Given the small scale of seed capital requirements, and the huge risks involved in an untried business and relatively small management team which can then require a lot of handholding and support, few venture capital firms are interested in this type of funding which traditionally relies more on business angel finance.

Start-up and early stage funding

These are normally designed to support the development of existing products, and the launch and commercialisation (or taking to market) of a product at commercial levels of operation.

As a small business grows and demonstrates its potential it may require further rounds of funding in order to exploit the opportunities that it is creating and continue its expansion, as it requires investment in machinery to increase production levels or additional working capital to deal with the level of trade being generated. These types of development or growth capital investments are one of the main uses of venture capital in the UK. Where there is an existing business angel or venture capital investor in the business, this process is sometimes referred to as second round funding.

Buy outs

Here venture capital funding is used to buy an existing established business from the owners. Buy outs can take a number of forms including:

• Management buy out (MBO) where the existing managers in a business seek to buy it from the shareholders.
• Management buy in (MBI) where a manager or managers from outside the business seek to buy it.
• Buy in, management buy out (BIMBO) where existing managers team up with some external managers to acquire the business.
• Institutional buy out, where a venture capital firm buys a business directly and may then sell on a stake in it to existing or new managers.
• Public private, where funds are used to buy control of a listed company in order to take it off the stock market and back into private ownership.
• Secondary buy out, where a VC house purchases another VC’s stake in a business.
• Rescues and turnarounds, where a business in difficulty is bought, normally at a very low value to reflect its circumstances, with a view to turning it around and resale at a profit.

Refinancing

Refinancing can involve the following.

• Replacement equity, where a VC house is brought in to replace an exiting investor or to provide the funding to redeem an investor shareholding.
• Replacement of debt, where a company may need to restructure its balance sheet and replace some level of debt with equity in order to reduce its gearing.
• Bridging finance, where a company requires a very short-term level of funding. For example, a highly seasonal VC funded business with a turnover of £90m had a short-term requirement for a six-week overdraft facility of £1.5m, without which it would undoubtedly have failed, but for which it could offer no security without the VC house providing a guarantee to the bank.

Different firms have different levels of appetite for each of the above types of investment, with some specialising in seed and early stage investments whilst others are only interested in buy outs or even rescue and turnaround situations.

These differing types of investment can also lead to a degree of confusion concerning the terms venture capital and private equity, as they have slightly different meanings in the UK (where the terms are essentially interchangeable) and in the US (where they are used to refer to the two different ends of the scale).

For the purposes of this book I am using the UK convention.

Finding a VC

Obtaining VC investment is undoubtedly difficult, with some sources quoting a rate of 1 % of business plans submitted to VCs actually attracting investment.

So what can you do to stand the best chance of being in the 1 % that attract funding?

As different VCs will have different appetites, the first step in obtaining VC investments is to find the right one to put your proposal to. The key criteria for finding the right VC are outlined below.

• The stage or type of investment, as discussed above.
• The value of investment sought, where for reasons of scale and the relative costs of undertaking transaction, for thousands or millions of pounds, the bulk of VCs are seeking larger levels of investment, but where there are some specialists who will look at smaller transactions.
• Your industry or sector as some VCs may have:
  • particular sector skills;
  • raised a fund designed to be specifically invested into a particular sector (such as a biotechnology fund that will be targeted on investments in that sector); or
  • particular sectors that they either do not wish to invest in or may be barred from investing in (for example funds raised from some ethical investment sources are unlikely to be available to invest into say a defence or tobacco related business).
• Your location, as some VCs will have specific geographical preferences, which in one case, for example, meant that a London based VC declined to receive a business plan from a company based in Hull as ‘we would never travel that far north’. VCs vary in that:
  • some VCs are regionally based and are looking to invest in their local region;
  • some only have an office in London but will operate UK wide;
  • some only have an office in London and don’t deal elsewhere (as illustrated by the example above); while
  • the best known of the VCs, 3i plc, has a network of offices nationwide.

The British Venture Capital Association (BVCA) has a directory of members available at www.bvca.co.uk that you can search online using all the above criteria.

Corporate venturers and incubators

Depending on which industry you are in, you can also find that larger companies on the lookout for emerging products and talent have set up internal funds to act as a quasi VC in order to invest into smaller innovative businesses. Since these activities are always industry related, they are generally reasonably well known and a study of your trade press may be sufficient to identify companies operating in this way.

Some of the leading universities have recognised the potential of businesses being spun out from the research work they do and are therefore seeking to provide support to the businesses to get off the ground. During the dot com boom this approach was taken one step further when a number of private businesses were set up described as incubators, where potential entrepreneurs with a viable idea could be provided with funding to help set up in business together with other managerial and facilities support as appropriate. Since the demise of the dot com boom much less is heard about this type of approach.

Achieving investment

If you are looking to raise venture capital you will undoubtedly need a business adviser both to sell the proposal to the venture capitalist and to help you in structuring the deal. This leads to the second major step you can take, which is to appoint good professional advisers who will give you credibility with the VC houses that you approach.

With a 1 % investment rate, VCs look to advisers to screen deals before presenting them to the VC. They will build relationships with advisers who build a reputation for only bringing the VC sensible, doable deals that have been well thought out and tested before presentation. As a result, any deal introduced to a VC by such an adviser is likely to attract more attention and to be taken more seriously than a business plan received directly.

Which brings us onto the next key point which is to have a good business plan.

There are entire books available on how to write a good business plan which I do not intend to try to reproduce here. The key points that I would make in respect of any business plan used to raise finance are the following.

• It has to be your business plan. Professional advisers can be vital in helping you to shape it and test it so it stands up when subjected to critical examination by an investor, but fundamentally it has to be your creation which you can convince the VC that you live and breathe.
• The numbers are important in terms of robust financial projections, but they are not the be all and end all. As important are the reasons that the numbers will happen, which are:
  • the details of the market;
  • the opportunities for major growth;
  • the reasons why your product or service is going to fly; and critically
  • the strength of your management team. VCs will often say they don’t back businesses, they back people, so they need to be convinced about the skills, experience and commitment of you and your team to making the business funded with their money a success.
• It has to consider what the investor will be looking for in terms of an understanding of the purpose to which their cash is to be put, the likely risks and the expected return, which in the case of a VC will need to include a discussion of the likely exit routes and timetable.
• It has to be readable, short enough to be easily digestible and to interest an investor; but long enough to cover the subject in sufficient depth to show that you have considered all the key issues. If you need to include detail, put this in as appendices.
• It has to be professionally (but not ostentatiously) produced, with the contents clearly structured to show a logical progression of thoughts, data clearly presented using tables and graphs so as to assist the reader in understanding the proposal, and carefully spelt and grammar checked, as failure to do so can give an impression of lack of attention to detail. Given the sums involved, using a professional copy editor and proof reader to check the final product before it goes to press can be a worthwhile investment (try pabulum@hotmail.co.uk).
• It needs to be carefully drafted to ensure it doesn’t trip up on any of the regulatory issues discussed above.

Investment structure

Where a venture capital firm invests in a business it can structure its holding in a number of ways. This can be a complex area and is one where you are likely to require guidance from your professional advisers, particularly where this involves issuing shares.

As equity investors the VC will obviously require a shareholding in return for their investment. In order to match the required return to the business’s circumstances this may well mean the creation of special classes of shares in addition to the normal ordinary shares that will already be authorised. The VC will typically want to structure part or all of their holding in some form of preferred ordinary shares which will carry voting rights, but also rank ahead of the ordinary share capital for both dividends and payments out of capital; as well as holding preference shares designed to give a specific rate of return on the investment which, as discussed above can be cumulative, convertible and/or redeemable.

In addition, the structure of the investment and the specific levels of shareholding may actually be determined by the business’s performance as the transaction could include the following:

• An ‘earn out’, where the total value of the payments and therefore the funding required from the VC house is in part determined by the business’s performance after the buy out.
• Or a ‘ratchet’ (also known as an ‘escalator’), whereby the shares allocated to the management team can be increased if the business achieves specified targets.

In order to maintain control of the business’s structure the transaction will usually also specify pre-emption rights. These are essentially an agreement between the shareholders that in the event that a shareholder wishes to sell their shares, they are normally required to give first refusal to the other shareholders.

In addition to equity, a VC may put in part of the funds required by way of a loan which can be unsecured, although where there is security available, including PGs from the directors, the VC will usually take it. These loan elements tend to be expensive, particularly if they are unsecured, and they tend to be required to be paid down relatively quickly. This then often puts significant cash pressure on the business in the early years and is a factor that probably contributes to the failure of a number of buy outs.

As has already been discussed, there is usually a tax advantage in having debt finance rather than equity, as the interest charge is deductible from profits before calculating any corporation tax due. As a result, many VC investments have traditionally included a significant amount of debt in their structure. However, HM Revenue & Customs appears to be taking the view that this is an abuse of the process in that it is simply structuring what would otherwise be an equity investment in order to gain tax advantages.

At the time of writing there is therefore a change in the rules being proposed under which interest on loans that are provided by the major source of finance of a company may not be treated as an expense for tax purposes. You will therefore need to take professional tax advice about the current state of legislation in this respect if debt of this kind forms any part of a VC investment in your business.

Process

You should remember that raising money by way of finding equity essentially involves selling part of your business. The process therefore follows that of a business sale very closely, in that once the marketing of your business plan to potential investors has led to a VC firm being interested in buying a stake, the process then involves the following.

• An offer letter, which although not legally binding sets out the terms of the VC’s offer of finance which will always be subject to both due diligence and final contract negotiations.
• Due diligence, which is essentially a form of legal, financial and commercial audit of the business, its plan and the proposed investment in order to give comfort to the VC firm about investing.
• Completion of a contract, which will involve you providing warranties to the investor about the state of the company and the information provided to them on which they have based their investment decisions.

More detail on how to manage each of these stages can be found in Selling Your Business for All It’s Worth, also published by How To Books.

One difference from a normal sale of a business, but one that is only of relevance if the investment is very large, as in for example a major buy out or taking a listed company private, is that a VC investment may require syndication if it is too large or too risky for a single VC firm to do alone. Syndication involves a number of VC firms coming together to participate in the deal, each providing part of the funding package and holding a stake in proportion to their contribution, the syndicate being put together by a lead investor.