Venture Capital

How do you pitch your idea to potential investors?

David Bennett of Powerflex Corporation co-presented at INNOVIC’S Grants and Finance seminar and outlined 10 Things Investors Care About.

Advantages of Venture Capital

Venture capital has a number of advantages over other forms of finance, such as:

  • Finance: The venture capitalist injects long-term equity finance, which provides a solid capital base for future growth. The venture capitalist may also be capable of providing additional rounds of funding should it be required to finance growth.
  • Business Partner: The venture capitalist is a business partner, sharing the risks and rewards. Venture capitalists are rewarded by business success and the capital gain.
  • Mentoring: The venture capitalist is able to provide strategic, operational and financial advice to the company based on past experience with other companies in similar situations.
  • Alliances: The venture capitalist also has a network of contacts in many areas that can add value to the company, such as in recruiting key personnel, providing contacts in international markets, introductions to strategic partners and, if needed, co-investments with other venture capital firms when additional rounds of financing are required.
  • Facilitation of Exit: The venture capitalist is experienced in the process of preparing a company for an initial public offering (IPO) and facilitating in trade sales.

How Does the Professional Venture Capital Industry Work?

AVCAL’s 47 Venture Capital Managers had funds under management or committed of approximately $A6 billion at June 2001. Some Mangers had multiple funds. Venture capital firms typically source most of their funding from large investment institutions such as superannuation funds and banks. These institutions invest in a venture capital fund for a period of up to ten years. To compensate for the long-term commitment and lack of security and liquidity, investment institutions expect to receive very high returns on their investment. Therefore, venture capitalists invest in companies with high growth potential or in companies which have the ability to quickly repay a high level of debt – as in the case of a leveraged management buyout. Venture capitalists typically exit the investment through the company listing on the stock exchange, selling to a trade buyer or through a management buyout. Although the venture capitalist may receive some return through dividends, their primary return on investment comes from capital gain when they eventually sell their shares in the company, typically three to seven years after the investment. Venture capitalists are therefore in the business of promoting growth in the companies they invest in and managing the associated risk to protect and enhance their investors’ capital.

Selecting the Venture Capitalist Investor

The Australian Venture Capital Association represents most venture capital organisations in Australia. The AVCAL Directory of Members provides basic information about each member’s investment preferences and is available from the association. Before selecting a venture capitalist, the entrepreneur should study the particular investment preferences set down by the venture capital firm. Often venture capitalists have preferences for particular stages of investment, amount of investment, industry sectors and geographical location. Once a short list of potential venture capitalists has been drawn up, it is often a good idea to contact the venture capital firm and request a copy of their publications, which will clarify the type of investments they favour. An investment in an unlisted company has a long-term horizon, typically four to six years. It is important to select venture capitalists with whom it is possible to have a good working relationship. Often businesses do not meet their cash flow forecasts and require additional funds, so an investor’s ability to invest further funds if required is also important. Finally, when choosing a venture capitalist, the entrepreneur should consider not just the amount and terms of investment, but also the additional value that the venture capitalist can bring to the company. These skills may include industry knowledge, fund raising, financial and strategic planning, recruitment of key personnel, mergers and acquisitions, and access to international markets and technology.

What does a Venture Capitalist look for?

Venture capitalists are higher risk investors and, in accepting these higher risks, they desire a higher return on their investment. The venture capitalist manages the risk/reward ratio by only investing in businesses that fit their investment criteria and after having completed extensive due diligence. Venture capitalists have differing operating approaches. These differences may relate to the location of the business, the size of the investment, the stage of the company, industry specialisation, and structure of the investment and involvement of the venture capitalists in the company’s activities. The entrepreneur should not be discouraged if one venture capitalist does not wish to proceed with an investment in the company. The rejection may not be a reflection of the quality of the business, but rather a matter of the business not fitting with the venture capitalist’s particular investment criteria. Venture capital is not suitable for all businesses, as a venture capitalist typically seeks:

  • Superior Businesses: Venture capitalists look for companies with superior products or services targeted at fast-growing or untapped markets with a defensible strategic position. Alternatively, for leveraged management buyouts, they are seeking companies with high borrowing capacity, stability of earnings and an ability to generate surplus cash to quickly repay debt.
  • Quality and Depth of Management: Venture capitalists must be confident that the firm has the quality and depth in the management team to achieve its aspirations. Venture capitalists seldom seek managerial control; rather, they want to add value to the investment where they have particular skills including fundraising, mergers and acquisitions, international marketing and networks.
  • Corporate Governance and Structure: In many ways the introduction of a venture capitalist is preparatory to a public listing. The venture capitalist will want to ensure that the investee company has the willingness to adopt modern corporate governance standards, such as non-executive directors, including a representative of the venture capitalist. Venture capitalists are put off by complex corporate structures without a clear ownership and where personal and business assets are merged.
  • Appropriate Investment Structure: As well as the requirement of being an attractive business opportunity, the venture capitalist will also be seeking to structure a satisfactory deal to produce the anticipated financial returns to investors.
  • An Exit Plan: Lastly, venture capitalists look for clear exit routes for their investment such as public listing or a third-party acquisition of the investee company.
  • Approaching the Venture Capitalist: Once a short list of appropriate venture capitalists has been selected, an approach can be made. The venture capital firm will ask prospective investee companies for information concerning the product or service, the market analysis, how the company operates, the investment required and how it is to be used, financial projections and, importantly questions about the management team. In reality, all of the above questions should be answered in the business plan. Assuming the venture capitalist expresses interest in the investment opportunity, a good business plan is a prerequisite.
  • Investment Process: The investment process begins with the venture capitalist conducting an initial review of the proposal to determine if it fits with the firm’s investment criteria. If so, a meeting will be arranged with the entrepreneur / management team to discuss the business plan.
  • Preliminary Screening: The initial meeting provides an opportunity for the venture capitalist to meet the entrepreneur and key members of the management team to review the business plan and conduct initial due diligence on the project. It is an important time for the management team to demonstrate their understanding of their business and ability to achieve the strategies outlined in the plan. The venture capitalist will look carefully at the team’s skills and backgrounds.
  • Negotiating Investment: This involves an agreement between the venture capitalist and management of the terms of the memorandum of understanding. The venture capitalist will then study the viability of the market to estimate its potential. Often they use market forecasts that have been independently prepared by industry experts who specialise in estimating the size and growth rates of markets and market segments.The venture capitalist also studies the industry carefully to obtain information about competitors, entry barriers, and the potential to exploit substantial niches, product life cycles, distribution channels and possible export potential. The due diligence continues with reports from accountants and other consultants.
  • Approvals and Investment Completed: The process involves exhaustive due diligence and disclosure of all relevant business information. Final terms can then be negotiated and an investment proposal submitted to the board of directors. If approved, legal documents are prepared. A shareholders’ agreement is prepared containing the rights and obligations of each party. This could include, for example, veto rights by the investor on remuneration and loans to executives, acquisition or sale of assets, audit, listing of the company, rights of co-sale and warranties relating to the accuracy of information enclosed. The investment process can take up to three months, and sometimes longer. It is important, therefore, not to expect a speedy response. It is advisable to plan the business financial needs early on to allow appropriate time to secure the required funding.
  • AVCAL – Mission: The Australian Venture Capital Association Limited (AVCAL) was established in 1992 as a forum for the industry participants to meet, to pursue topics of common interest, to promote the local venture capital industry and to encourage investment in growing business enterprises. AVCAL’s mission is to create a world-best environment in Australia for venture capital and entrepreneurship.

Objectives

Public Policy

To create an environment in which venture capital can flourish.

VC as an Asset Class

To create an awareness of the returns institutions can receive by investment in venture capital funds, and encourage them to allocate 10% of their portfolio to venture capital.

Statistics

To collect, analyse and publish performance information. This involves an annual survey of venture capital firms and their investees. The survey is conducted for AVCAL by Venture Economics, part of Thomson Financial Services. Results are published in the AVCAL Yearbook.  The metrics are derived by taking cash flows from investees and generating IRR’s using the same computation formula used by Venture Economics across the world. Hence it is possible to compare Australian performance figures with other markets.

Education

To encourage the provision of courses aimed at:

  • Increasing the supply of skilled venture capitalists
  • Increasing the skills of Australia’s entrepreneurs
Member Services

To provide the following services:

  • Website – a virtual hub of venture capitalists and service
  • Networking events across Australia
  • Annual Australian venture capital conference
  • Industry tools: Non-disclosure agreement, Valuation guidelines, Standard Industry Trust Deed, Standard VCLP
  • Information for entrepreneurs seeking capital
  • Employment database
  • Research information
  • Register of non-executive directors

For more information on Venture Capital please contact AVCAL at their website DISCLAIMER: The information in this document was provided by AVCAL. Neither AVCAL nor INNOVIC shall be responsible or liable for any loss or damage whatsoever which may result from the use of this information or from any associated activities.