The first external fundraising that a company undertakes.
Friends, family, members of your professional network, business angels, possibly SEIS / EIS funds or seed funds, startup accelerators, crowdfunding platforms.
While most seed rounds are between £250k - £750k, it is possible to raise more depending on valuation, your willingness to dilute, the funding requirement of the company, industry in which the company operates and growth potential.
Ordinary equity, i.e. shares in your company.
Once you have prepared your investor materials, a significant portion of the raise is spent meeting with and pitching to potential investors to build up a pool of committed capital. During this process, investors will ask questions that form part of their due diligence. Once all of the funding is committed, the legal documentation is prepared and the round can be completed.
Depending on how long it takes to secure commitments, it can be very quick – as short as a month, but will usually take 3-4 months from start to finish, so it’s good to start the process comfortably in advance of when the cash is needed.
Venture capital investments may be defined in a number of ways, but when we use the term “venture” we are referring to what is usually a company’s first or subsequent institutional investment, i.e. funding sourced from a professional fund. A venture round may follow a seed round, undertaken with individuals or dedicated seed-stage funds.
Venture capital is usually associated with high growth, often technology oriented companies.
One or a group of venture capital funds, EIS funds, VCT funds or other early stage funds.
Typically between £1m and £10m but there are no hard rules and this will depend on the specifics and attractiveness of the investment opportunity.
Equity that may be ordinary equity or preferred equity, i.e. shares with preferential legal and commercial rights attached. Venture investors ordinarily hold minority stakes and rarely take controlling stakes in a business.
Initial preparation of investor materials is important to ensure the investment opportunity is adequately represented. Initial meetings will be held with institutional funds and investors where they will assess the opportunity. If these discussions progress, then you will normally be issued a term sheet setting out the terms on which the investor is willing to invest. If multiple investors are taking part in the round, then usually a lead investor is secured first who then leads the negotiation on behalf of the other investors.
Once a term sheet is agreed, due diligence will commence and the legal documentation will be negotiated and agreed.
Provided that due diligence is satisfactory, the transaction will then complete.
From preparation of investor materials to completion, the process can take as little as a few months but six months is more typical. The greatest variation occurs in the stages before a term sheet is issued and agreed, when initial conversations with potential investors are being held.
These terms primarily relate to the stage and profile of the business raising investment.
Venture capital is usually deployed into highly scalable, high growth and high risk companies. Many venture capital backed companies are technology oriented to enable this rapid growth to occur, but some occupy other sectors.
The traditional venture capital investment strategy involves making highly selective investments into a number of high growth companies. The associated higher risk entails a higher failure rate, and thus each portfolio company must be expected to contribute a sufficiently high return to compensate and enable the fund to generate a return.
Growth capital is usually deployed into growing companies that are not necessarily as high growth or high risk as venture capital backed companies. As a result, growth capital is often invested into non-tech sectors, such as professional services. The lower growth profile entails lower risk, and thus a higher number of portfolio companies are expected to deliver a return. Return expectations for growth capital investors tend to be lower than those of venture capital investors.
There are a number of grey areas too. Companies may be suitable for both venture and growth capital, and the route taken may depend on the risk appetite of the board – does the team want to pursue a higher risk, high growth strategy, or a lower risk, lower growth strategy?
Companies that initially raise venture capital, for example in a Series A, may go on to mature and become suitable for growth capital, as their growth curve flattens. Companies that initially raise growth capital may experience a significant uptick in growth and subsequently seek a subsequent investment with venture-oriented investors to their shareholder structure.
While the majority of funds typically describe themselves as “venture” or “growth”, there are also some that play in the space between. The VCTs (Venture Capital Trusts) are often seen as somewhere in between – some take a more venture-leaning approach while others are more growth oriented.
Growth capital is raised by established, growing companies that utilise it to accelerate their growth. These companies issue new equity to private investment funds, which may be alongside or instead of other forms of financing such as bank loans.
Unlike the traditional venture model, in which multiple rounds of financing are raised, growth capital may be the first external equity injection into a business, and may also be the last, depending on the cash needs of the business.
It is also common for existing shareholders to realise a return on their own investment to date and sell a portion of their shares to the new investor, depending on how established the business is. This is sometimes referred to as “cash out”.
It is usual, but not always the case, that the new investor holds a minority equity stake, in contrast to the more traditional private equity model in which the investor holds a majority stake and controls the business. As a result, the investment represents the formation of a partnership between the old and new shareholders, and the management team.
Institutional investment funds are the primary source of growth capital for businesses. These funds may be structured in a variety of ways, for example:
Co-investment is less common for growth-stage businesses, as the entire round can usually be sourced from a single fund; however, occasionally funds do invest alongside one another. It is relatively rare for more than two funds to participate.
Typically, between £1m and £20m depending on the specifics of the business and opportunity.
In its simplest form, growth capital is structured as equity, i.e. new shares, in the company. The equity will ordinarily be structured as a new class of share to allow for the fact that investors often require certain “special” rights that other shareholders do not.
In practise, growth capital investments can be structured across a spectrum of instruments that vary in their level of commercial risk and return:
Each investment can be structured as one or a combination of the above, to provide the right balance of risk and return to the new shareholders and existing shareholders.
Initial preparation of investor materials is important to ensure the investment opportunity is adequately represented. Initial meetings will be held with institutional funds and investors where they will assess the opportunity. If these discussions progress, then you will normally be issued a term sheet setting out the terms on which the investor is willing to invest.
Around this time, the investor will prepare and present a paper to their internal investment committee. There may be one or multiple sittings of investment committee throughout the transaction.
Once a term sheet is agreed, due diligence will commence and the legal documentation will be negotiated and agreed. Provided that due diligence is satisfactory and agreement has been reached on the legal documentation, the transaction will then complete.
This can vary considerably based on how long it takes for the business to prepare investor materials, how initial discussions with investors go and whether any issues arise during due diligence. Assuming no significant roadblocks in the above, a process typically takes 6 months from start to finish.
Raising from individuals means attempting to please potentially highly variable investment preferences. The most important thing is that you present your business and the investment opportunity fairly and openly so that each investor can reach the right conclusion for their own investment objectives and risk appetite.
There are a number of core principles that drive attractive investment returns and investors will look out for these in making their investment judgement.
An experienced team is more likely to have the skills required to deliver the business plan, respond to external shocks and work collaboratively with their investors. Investors at this early stage will place greater importance on the quality of the people and team that they are investing in than almost any other metric.
How this can be demonstrated:
Barriers to entry make it difficult for others to enter the market and compete with you. This makes the business less to susceptible to commoditisation and price erosion, and more likely to achieve or retain its status as a market leader.
How this can be demonstrated:
A sufficiently sizeable market ensures that the concept is not too niche. Growth in the market is arguably more important – even a new market is investible provided there is a sensible rationale for demand to grow.
How this can be demonstrated:
Proof of concept means that it has been demonstrated that the core business model works, specifically, that you have an attractive customer proposition that can also generate a profit. It can be difficult to show profitability and long-term customer relationships in the early days, but it is possible to show progress and potential.
How this can be demonstrated:
This is not as important for seed rounds as it is for later-stage rounds that involve institutional investors; however, seed investors will also want some reassurance that there is both the possibility and intention to realise a return on their investment in the years ahead.
How this can be demonstrated:
Many early stage investors expect to invest through one of these tax schemes. These schemes provide favourable tax treatment to encourage investment in small businesses.
Each venture fund or organisation is set up with a number of broad principles that govern the types of investments the fund will do, for example, to invest in a certain sector. Regardless of these principles, there are a number of core themes that almost all venture investors seek to fulfil when selecting their investee companies. It is not necessary to meet every single one, and not all will be applicable to every business, but if your business can achieve and communicate the items detailed below, then it will be more likely to succeed in raising from venture investors.
A team that has deep experience in their respective business and sector
An experienced and motivated team is more likely to have the skills required to deliver the business plan, respond to external shocks and work collaboratively with their investors. Venture investors place greater importance on the quality of the people and team that they are investing in than almost any other metric.
How this can be demonstrated:
Relevant, industry advisors can also add credibility and endorsement to your investment thesis, provided they are genuinely involved and available to lend their experience as the business grows.
High barriers to entry
Barriers to entry make it difficult for others to enter the market and compete with you. This makes the business less to susceptible to commoditisation and price erosion, and more likely to achieve or retain its status as a market leader.
How this can be demonstrated:
Operating within an attractive, growing market
A sufficiently sizeable market ensures that the concept is not too niche. Growth in the market is arguably more important – even a new market is investible provided there is a sensible rationale for demand to grow.
How this can be demonstrated:
Beyond proof of concept and an attractive customer proposition
Proof of concept means that it has been demonstrated that the core business model works, specifically, that you have an attractive customer proposition that can also generate a profit, in time. It can be difficult to show profitability and long-term customer relationships in the early days, but it is possible to show progress and potential.
How this can be demonstrated:
Differentiation from the competition
A typical venture capital firm will be presented with hundreds of investment opportunities every year – it is therefore safe to assume that they will have come across similar businesses to yours. Demonstrating differentiation is therefore very important. Investors are looking for companies that can generate above average returns and thus must be differentiated in order to do so. A long list of points of differentiation can dilute the features that are particularly important. Remember that you are highlighting how the investment opportunity is differentiated, which is often linked, but not necessarily the same as, the product or service - those points of differentiation matter more to customers than investors.
How this can be demonstrated:
Recurring or predictable income
This depends to some extent on the industry in which you operate; however, recurring, predictable income is considered attractive as it brings greater certainty of trading and often represents an attractive return on capital invested.
How this can be demonstrated:
Short customer payback period and high lifetime value
This is the average time it takes for the cost of customer acquisition to be repaid through income from the customer. For example, if it costs £50 in marketing spend to acquire a customer, who then pays £10 a month for a subscription, then the payback period is 5 months. Business models with a short payback period (some are instantaneous), are particularly attractive.
Lifetime value is also important – if the same customer only requires the product for 5 months, then although the cost to acquire has been repaid, there is no further value generation. If the customer uses the product for 2 years, then the lifetime value of the customer is higher.
How this can be demonstrated:
A clear use of funds
New funding into a business must be deployed effectively to generate a return on investment. Venture investors look for businesses with a clear use of funds and demonstrable return on capital from those uses.
How this can be demonstrated:
The potential for value growth at subsequent fundraisings and ultimately, an attractive exit
Venture capital funds will seek to demonstrate value growth to their limited partners (their own investors) through price growth at subsequent fundraisings and ultimately realising a return through an exit event, for example, a public market listing, sale to a strategic acquirer or sale to private equity.
How this can be demonstrated:
EIS or VCT eligibility
If you are raising from an EIS or VCT fund, then your business will need to meet the criteria for these schemes.
Each investment fund is set up with a set of broad principles that govern the types of investments it will do, for example, to invest in a certain sector or a certain size of business. Working within these specific principles, there are a number of core themes that almost all investors seek to fulfil when selecting their investee companies. It is not necessary to meet every single one, and not all will be applicable to every business, but if your business can achieve and communicate the items detailed below, then it will be more likely to succeed in raising capital.
An experienced and motivated team is more likely to have the skills required to deliver the business plan, respond to external shocks and work collaboratively with their investors. Minority equity investors place a lot of importance on the quality of the people and team that they are investing in relative to other metrics.
How this can be demonstrated:
Relevant, industry advisors can also add to the credibility of the company, provided they are genuinely involved and available to lend their experience as the business grows.
Barriers to entry make it difficult for others to enter the market and compete with you. This makes the business less to susceptible to commoditisation and price erosion, and more likely to achieve or retain its status as a market leader.
How this can be demonstrated:
A sufficiently sizeable market ensures that there is capacity for further growth, and one that is growing demonstrates rising demand. A new market may also be addressed provided there is a clear rationale for demand to emerge and develop.
How this can be demonstrated:
A product or service that has demonstrated success with customers, while also being commercially viable with an attractive margin.
How this can be demonstrated:
Investors are looking for companies that can generate above average returns and thus must be differentiated in order to do so. Remember that you are highlighting how the investment opportunity, i.e. the company, is differentiated, which is often linked, but not necessarily the same as, the product or service - those points of differentiation matter more to customer than investors. A typical investment fund sees hundreds of investment opportunities each year, and therefore it is important to communicate this clearly – it may be best to focus on the one or two most salient points of differentiation in place of an extensive list.
How this can be demonstrated:
This depends to some extent on the industry in which you operate; however, recurring, contracted and predictable income is considered attractive as it brings greater certainty of trading and often represents an attractive return on capital invested.
How this can be demonstrated:
This is the average time it takes for the cost of customer acquisition to be repaid through income from the customer. For example, if it costs £50 in marketing spend to acquire a customer, who then pays £10 a month for a subscription, then the payback period is 5 months. Business models with a short payback period (some are instantaneous), are particularly attractive.
Lifetime value is also important – if the same customer only requires the product for 5 months, then although the cost to acquire has been repaid, there is no further value generation. If the customer uses the product for 2 years, then the lifetime value of the customer is higher.
How this can be demonstrated:
Dependency on one or a small number of customers can be a concern to investors, who look for companies that have a long term, diversified customer base. This also applies to the supplier base – how dependent is the business on a single supplier or a small group of suppliers and how easily could they be replaced.
How this can be demonstrated:
New funding into a business must be deployed effectively to generate a return on investment. Investors look for businesses with a clear use of funds and demonstrable return on capital from those uses.
How this can be demonstrated:
The company’s business plan (financial forecasts) should demonstrate growth in turnover and profitability that is sufficiently strong to deliver an attractive return to investors, while also being deliverable and credible.
Exceptionally over-optimistic business plans are sometimes to blame for an investor declining the opportunity.
How this can be demonstrated:
Equity investors require a form of exit or liquidity event in order to deliver a return to the investors in their fund. They will be looking for companies that have the potential to deliver a successful exit for their investment, such as through the sale of the company to a strategic acquirer, the sale to a private equity firm or a listing on the public markets.
How this can be demonstrated:
If you are raising from a VCT fund, then your business will need to meet the criteria for this scheme.
