UK: Private Venture Investing – An Overview

Investors thinking about investing in a private company or project need to ask a number of key questions and deal with certain issues before committing themselves to this type of investment. This article contains general information about private venture investing, and should not be construed as specific advice about a particular investment opportunity.

Why private venture investing is on the increase

A number of factors have contributed to an increased interest in private venture investing in recent years:

• Money market returns are at historical low levels and many investors are seeking out higher returns with private venture investments.
• A consolidation of equity is occurring as the parents of baby-boomers transfer accumulated wealth to their sons and daughters.
• Certain local and regional economies are vibrant and growing; apparent opportunities abound.
• Interest and enthusiasm among entrepreneurs is very high in some locales.
• Public equity markets have produced significant gains for investors, some of whom are looking to diversify by investing profits into private venture investments.
• Significant amounts of labour-sponsored venture capital funds (e.g. pension funds) have built up in recent years, encouraging entrepreneurs to pursue ideas in the hope of attracting this and other sources of venture capital.

Why are you considering venture investing?

Bear in mind the lament of the once burnt, twice shy investor: "Why did I ever get involved in this mess?"

The romance of venture investing fades rapidly against a backdrop of investor cash calls, poor results, overly optimistic projections and unmotivated management, to name but a few. In all cases, the full amount of a venture investment is susceptible to loss.

Security over assets (such as land, buildings and equipment) is often granted to a financial institution to cover loans. This means that those assets are not available to secure the venture investment. If a venture's assets are liquidated in the future, investors are in theory entitled to receive a return of their capital, but only after priority-ranking creditors are paid. In reality, there is seldom enough cash to go around and equity investors are often left on the short end of the stick.

Points to consider

• What are my objectives in making the investment? Are these objectives consistent with those of other shareholders?
• What do I expect to gain? What is the probable return on my investment?
• How much could I stand to lose? Is the risk of loss offset by the potential for return?
• Is there a balance between risk and return?

Tips

• Have a clear set of objectives in considering an investment.
• Write your objectives down, if only to force you to seriously address this aspect.
• Beware of "can't lose" deals that just happen to find you. Remember, an experienced venture capitalist will review ten deals before considering one, and is likely to pursue only one in ten of those. This works out to roughly one investment made from a hundred opportunities reviewed.

Who is making the sales pitch?

Often the founders of an opportunity will engage intermediaries to act as agents in raising project financing. In other cases the founders will attempt to raise funds themselves. Make sure you know whom you are talking to, and whether a commission is being paid to an intermediary. You should know the terms of engagement.

The party "pitching a deal" is often called the promoter. Securities law in most jurisdictions restricts the ability of intermediaries and promoters to charge commissions on certain types of private investment offerings.

The prospectus, if available, will disclose the method used to calculate any commissions. However, this document does not comment on whether the commission is fair or not.

Points to consider

• Are there any fees being paid to the people making the sales pitch?
• Are those fees contingent on success of the money-raising efforts?
• Why are they talking to you?
• How long has the opportunity been offered to others?
• Who else is contemplating an investment?
• Can you team up with other investors to review the opportunity together?

Tips

• Never respond quickly to an investment proposal. High-pressure tactics that suggest a tight time deadline should be avoided.
• Find out who else is considering an investment in the project and ask to talk to them. This may not always be possible, but if the promoters of an investment will let you talk to other potential investors, do so. If they won't let you do this, at least find out why they won't.

Is there a complete business plan?

The business plan is the blueprint for the business venture. Stay away from business plans that are "in my head". By the same token, don't be fooled by a glossy, polished presentation that lacks substance.

Points to consider

• What are the key aspects of the business plan?
• What are the competitive advantages of the business or project?
• What is the stage of the business or project: concept only, start-up, growth, turnaround, buyout?
• How much money is being raised?
• What will the money raised be used for? What amount of this money will be spent on tangible vs intangible assets (e.g. operating and start-up expenses)?
• How much income will the company make if the business plan is successfully implemented?

Key business plan contents

A detailed discussion on business plans is beyond the scope of this White Paper, but generally a business plan should contain:

• a one or two page executive summary of the entire business plan
• history of the business/project to date
• people profiles and an indication of their status (i.e. board members, management, full-time and part-time employees, etc.) and company culture
• a clear description of the product or service, how competitive advantage will be established in the marketplace, and an analysis of the competition
• details of the marketing plan, including:

• whether all regulatory requirements (environmental regulations, zoning requirements) have been met
• details of any independent study of the technology or product (SWOT analysis – strengths, weaknesses, opportunities and threats – may be appropriate)
• full details of legal structure and ownership
• full description of the ownership structure after the investment is completed
• details and sources of project financing requirements
• an analysis of risk
• full projected financial information for the venture, including balance sheets, income statements and cash flow statements for at least three years
• details of the assumptions utilised in the projections (particularly the basis for revenue projections); this could be compared to some industry standards.

Tips

• There are numerous books and other sources of information on business plans, including some excellent publications provided by financial institutions and professional firms. Learn what a good business plan should contain.
• Before being provided with a detailed business plan, you may be asked to sign a confidentiality and non-disclosure agreement. This is a standard practice, but, if you are not sure exactly what you are signing, ask your lawyer to review it with you and get a legal opinion.

Who will manage the venture?

Although the profiles of the management and employees are a part of the business plan, this aspect is so important that it warrants separate attention.

Points to consider

• Who are the key implementers of the business plan?
• Do they have significant accomplishments in their past?
• What are the terms of employment for these people? Who makes up the management team, i.e. who is actually going to be running the business and how much experience and background do they have? What is their level of management ability?
• Are they full time or part time?
• Are there, or will there be, employment contracts in place with key people? What will be their remuneration? Is any of their pay made up of contingent remuneration?
• Who are the current shareholders, officers and directors of the company?
• Who are the key professional advisors to the project? Consultants? Lawyers? Financial? These are people who are important to a venture.

Tip

• The best idea in the world is likely to fail if it is poorly managed, while excellent management can make the best of even an ill-conceived plan. Don't underestimate the importance of the people involved in the project. Check them out. Ask your lawyer, accountant and financial advisor: they can probably find someone who knows something about the people behind a project.

What is the legal structure of the investment?

Generally, securities law requires that a prospectus or some other form of offering document be prepared by those promoting an investment, unless certain exemptions from those requirements are applicable. The prospectus does not comment on how good the investment is; rather, it ensures that securities law has been met. If you are subscribing to an investment under such an exemption, make sure you understand what you are doing.

The ownership of a venture could be structured in a number of different ways, including:

• limited company
• partnership
• limited partnership
• joint venture.

Each of these possible structures has significant implications for the investor. You should obtain qualified professional advice in order to understand what these implications are for your particular circumstances.

Points to consider

• How is the investment legally structured?
• Is there a formal offering document?
• Are there upper and lower limits for the offering?
• What happens if not all the required investment capital is raised?
• Are you investing in debt or equity?
• If equity, is it subordinated debt? Convertible debt?
• Is some or all of your investment going to be secured by assets?
• Could you be legally required to put up more money in the future?
• Do you know all classes of ownership and how shares are paid?

Tips

• At a minimum there should always be a subscription form for an investment.
• Never simply hand over a cheque to someone promoting an investment.
• Have the subscription form reviewed by your legal and financial advisors before you sign.
  
  In addition, you can obtain some protection by paying your investment into a lawyer's trust account, pending the closing of an investment and possible other conditions.
  
  This practice is often followed, but make sure you understand the conditions of trust placed on the lawyer who receives the funds. The lawyer is often working for the company raising the money and, once the trust conditions are met, the funds can be released from trust.
  
  An investor may want clarification when they deposit the money in trust and have their own conditions placed on the funds, or they may want to involve their own independent legal advisor.
• Make sure that you understand what will happen if all of the funds are not raised. Will you get your money back, or will you become an investor in an underfunded project? In addition, make sure you understand whether you will have a legal obligation to put more money into the project in the future.

Who will own and control the venture?

Ability to control the direction of the project is an important issue. In many cases, the founders remain in control of project direction as long as the business plan is being followed to the satisfaction of the investors. However, if the business plan is derailed or serious problems are encountered, often the investment structure provides for the investors to have a bigger say and, in some cases, even to take control of the business.

For investments in companies (i.e. as opposed to partnerships or other forms of investment structure), this matter is often dealt with through the makeup of the board of directors. Corporate law provides for rights of minority shareholders, and these shareholders should be aware of these rights.

Founders' carried interest

In most cases, the founders of a project are entitled to a carried interest in the equity of the business or project, as compensation for getting a project to where it is warranted to seek out investment capital. There is no standard approach in dealing with this aspect of a venture investment structure. Each situation invariably has its own unique circumstances that impact the extent of the carried interest for the founders.

Founders of early stage projects are usually entitled to a lesser carried interest than founders of more mature projects. The greater the potential for return from a project, generally the greater the entitlement of the founders to a carried interest.

Points to consider

• How much cash have the founders invested in the project?
• Are the founders getting ownership in the business to compensate them for their non-cash investment of time and effort?
• How much will your investment be diluted as a result of the founders getting an interest for their sweat equity?
• Who will control the venture after the money has been invested?
• Is there room for negotiation in the project structure, or is it fixed?
• Will you be entitled to representation on the board of directors?
• Do you want to be on the board of directors?
• Are you expected – and do you want – to make a contribution beyond money (e.g. professional advice, time, etc.)?
• Do you have valuable contacts or knowledge that could improve chances of the project's success?
• Do the founders have warrants and/or provisions on the investment, and how do these affect control of the investment?

Tips

• Many of the above and other related issues are dealt with in a unanimous shareholders' agreement in a private venture investment. This is a critically important document that details the agreement (in advance) by the shareholders as to how certain important issues will be dealt with.
• Seek out competent professional advice if you do not understand the exact workings of the provisions of the unanimous shareholders' agreement.
• Being a director can be a great way to know everything that is going on and possibly influence direction. But directorship also has a significant potential downside. Make sure you understand this downside before accepting an appointment as a director.
• Often it is a good idea to structure the investment so that founders start out with a lower relative equity position but can earn a higher proportion of ownership, usually via a share option arrangement, if and when the business produces profits. A founder may want full value for their investment and anything beyond this through a "bonus".

What is your liquidity/exit strategy?

An often forgotten aspect of a venture investment is the investor liquidity strategy. Having the business or project succeed is one thing. Getting your money and gains back out is a separate issue.

Often the interests of the founders can be at odds with the interests of other investors. Founders, who depend on the business for their livelihood, may be motivated to reinvest profits in growth. Investors, on the other hand, typically want some or all of their investment returned at a point in time.

The liquidity strategy should also deal with two other issues:

• a disaster in an investor's family (i.e. death of the investor or a real need for the investment to be returned)
• the ease of sale of the investment down the road if an investor wants to realise on the investment.

Points to consider

• How and when will you get your money back out of the investment? Is this disclosed in the shareholders' agreement?
• Have you analysed the investment from the viewpoint of investors exiting and newcomers entering?

Tip

• While it is often difficult to establish an exact liquidity strategy at the time of investment, there are certain measures that can be put in place as part of the structure to ensure that investor interests are protected in this regard.
  
  Structuring an investment as preferred shares, with a requirement that the shares be redeemed by the company after a specified level of net earnings has been reached, is just one example of how this matter can be dealt with.

What is the financial position?

Financial information dealing with the past is generally referred to as historical financial information. Information dealing with the future is typically called projected financial information. Both are extremely critical in assessing the opportunity.

Historical vs projected financial information

Historical information will portray the financial path taken to date and results realised. It can give you a good sense of current financial stability or lack thereof. If an individual is investing a significant amount of money, he/she may wish to delve a little deeper into the company's historical financial information to look at the past financial stability as an indicator of management.

Projected financial information needs to be very cautiously reviewed and analysed. With the advent of computer modelling, extensive financial projections can be readily developed and presented very professionally. But beware, the accuracy of computer financial models can easily be distorted by even the smallest flaws in the logic of the assumptions that go into the model or in the calculation methods used.

It is also perhaps too easy to build a model on assumptions that go something like this: "If I could only get 1% of the market for this product, look what I can do!" Too much effort goes into the maths and not enough attention is devoted to developing the plan to capture the market share. This reinforces the fact that investors need to understand the assumptions for projections made in the business plan.

Value analysis techniques

The projected financial information is also the cornerstone of a detailed value analysis that the investor should perform to establish the upside potential from the investment. Quite simply, the value analysis extrapolates a future value for the business, assuming it is able to achieve the expected results, and calculates the individual investor's share of that value based on what percentage the investor owns.

One method of calculating this is to take the investor's share of value and divide it by the amount originally invested to get a rate of return on the investment. Divide that rate by the number of years from date of investment to the effective date of the value analysis, and you have an annualised return on investment (ROI), expressed as a percentage. The anticipated ROI must be high enough to justify the investor assuming the risk of loss.

Internal rate of return (IRR) is another value analysis technique. It is slightly more complex than ROI, but it reflects the time value of money. Projected and historical (past five years) earnings per share and price-earnings ratios (plus other indicators) will also assist in the analysis of the investment.

Points to consider

• Are audited historical financial statements available?
• What is the current financial position of the business?
• Is it operating now?
• Is it making money?
• If it is losing money, how much money is being lost each month? What is the burn rate? What is the turnaround strategy and who controls it?
• Has a reputable firm of accountants issued an accountant's report on the financial statements?
• Is the venture up to date on tax and other required filings?
• When is the business expected to become profitable?
• What is the expected ROI?
• What is the payback period for the investment?
• If the business plan is successful, how much will my investment be worth?
• How will profits be paid out (e.g. retained earnings, etc.)?
• How does the business compare with industry standards for (1) returns, (2) leverage and (3) payables and receivables?

Tips

• Look for a report appended to historical financial statements by independent accountants, recognising that the credibility added by independent accountants varies based on the nature of their report on the statements, as well as from firm to firm.
• The above points have been simplified for purposes of illustration. There are many additional factors that can impact the completion of a value analysis on an investment. You should seek out qualified assistance in analysing and interpreting all financial information pertaining to a prospective investment.

Have you completed a formal review of the details of the opportunity?

Before making the final commitment to an investment, you should complete a formal due diligence review. Have a lawyer conduct corporate and personal searches on those involved in the opportunity. Have a financial expert check out historical financial information, projections and the like.

This final, formal review can uncover deal-breaking information that you should not ignore. Above all else, it will help substantiate the character and trustworthiness of the people in whom you are investing.

Points to consider

• Have you formally confirmed representations made during the sales pitch and investigation phases?
• Have you been lied to, or have claims been exaggerated by the promoters?
• Have all legal documents (contracts, agreements, leases, etc.) been reviewed?
• Are all tax filings (income tax, payroll, etc.) up to date, and have these filings and related assessments been reviewed?

Tip

• Seek independent verification, from reliable sources, of representations made to you during your assessment of the opportunity.

Evaluation checklist

Below is a checklist you can use to evaluate a private venture investment opportunity.

Checklist for investment evaluation

The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.

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