FAQs: venture capital explained

Last updated: 2 December 2020

Estimated reading time: 15 minutes

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We frequently advise and provide legal services for start-ups and high-growth companies who are seeking investment, but may not know where to start and so we’ve compiled some venture capital funding FAQs, as a quick tool for reference. Find out more with our handy introduction to the basics of venture capital that will help you gain a better understanding of fundraising for your business.

Jump to individual FAQs:

  1. What is venture capital?
  2. What’s the difference between venture capital and angel investment?
  3. What are the advantages of venture capital funding?
  4. When is the best time to seek venture capital funding?
  5. What are the disadvantages of venture capital?
  6. How do I find a venture capital firm?
  7. What do investors look for in a company?
  8. Who can get venture capital?
  9. How can venture capital schemes encourage investors?
  10. Who regulates venture capital firms?
  11. How does venture capital funding work?
  12. What is a venture capital trust?
  13. Are there different categories of Venture Capital Trusts?
  14. What information will you have to provide to a VC investor?
  15. What happens if you get venture capital funding, but you can’t comply with the terms on which the investment was made?

What is venture capital?

Venture capital (VC) is a form of equity funding in unquoted companies provided by institutional investors such as venture capital funds. Venture capital is invested in early-stage businesses that the investors believe will have long-term growth potential. The company receives the money needed to fund their early stage development and the investor receives a (usually minority) shareholding in the company, in exchange for the risk they are taking to invest their money at an early stage. Venture capital usually takes the form of equity rather than debt investment and this investment is usually provided at various stages of a company’s growth – typically at the beginning of a business’ life through seed and start-up capital and often again at a later stage through development capital to facilitate the growth and strengthening of the business.

What’s the difference between venture capital and angel investment?

Venture capital is different to angel investment. Angel investors are individuals who invest their own money, whereas venture capitalists typically invest money raised from third parties. Angel investors are also often willing to invest at an earlier stage in company’s life cycle than venture capital funds, perhaps even in the initial funding round of the start-up stage.

What are the advantages of venture capital funding?

Venture capital can provide a company with a cash injection at a key stage in its life-cycle: when it is looking to grow and expand. This is the point where businesses have the strongest potential for growth, but usually don’t have a proven record of profitability to attract other forms of funding, or they require more capital than that available from traditional avenues.

VC firms and individual investors don’t just bring money though – often their mentoring and contacts can be crucial to helping the business achieve its growth potential.

When is the best time to seek venture capital funding?

The short answer is at least three to six months before you think you’ll need it. It can take time to find the right VC partner for your company and, even when you have, the process of agreeing the terms of their investment will add further delay. Don’t wait until your business is stalling at a key growth stage – have your business roadmap ready, and identify the points where you will need extra capital to take it to the next level at the optimum time. You will need to show a VC firm exactly what its funding will do and how that will help the business to grow. Therefore, it’s important to prepare a solid and well thought out business plan demonstrating how the investment will be used.

What are the disadvantages of venture capital?

It can be difficult and time-consuming to find and attract the right VC partner for your company and there is a risk that too much management time is spent on this rather than running the company. The main disadvantage, however, to seeking venture capital funding is that you will be giving up some of the equity in your company in return for their investment. Obviously, this means that they will share in any profit when it comes to selling your company. However, if the injections of funds from the VC help to grow the value of the company then you might consider that the dilution of your shareholding will have been worthwhile.

The other disadvantage in having venture capital investment in your business is that they will want to (and indeed, may have a legal right to) be involved in the direction and decision-making of the company. A venture capital investor will usually require at least one seat on the board, as well as a right of veto over certain matters in its capacity as a shareholder of the company and usually in addition to its existing statutory rights pursuant to the Companies Act 2006. The extent of control required can vary between investors, so it is vitally important to choose a VC partner very carefully, and to make sure you fully understand the legal effect of the agreements you enter into with them. It is also important to put in place agreements that govern the working relationship between all parties (such as a shareholders’ agreement) so that all parties know the extent of their rights and obligations and have a clear process to follow in the event that there is a dispute over the direction of the business.

How do I find a venture capital firm?

There are a number of venture capital associations and online directories of venture capital firms, with details of the types of companies they invest in, along with the typical stages they invest at, and size of investment they may make. A reliable place to find a reputable venture capital partner is by purchasing access to the member directory of the British Private Equity & Venture Capital Association (BVCA).

However, if you’re not prepared to pay out for this, or are just in the stages of initial research, there are several useful lists of VC firms maintained by respected online publications, for example the Entrepreneur Handbook’s list of VC and early stage funds in the UK and Startups A-Z directory of VC funds.

It’s important to do your research on VCs however and there are a number of online databases and directories owned by specialist private companies that may suite your specific funding requirements better than the mainstream lists. It can otherwise be a waste of time to approach a VC that does not typically invest in your industry, type of business, or funding stage. Research in detail before you approach any VCs and try to get an introduction through a mutual contact or networking circle.

For further guidance on finding the right VC for your business, read our article on how to find venture capital investors.

What do investors look for in a company?

Venture capital investors will be looking for:

  • One-of-a-kind business models or products that can disrupt industries
  • Businesses with a potentially very large market
  • Businesses with high growth potential
  • Business plans that are thorough and ready to go
  • Evidence of potential, or early performance
  • Businesses that might be perceived to be a higher risk investment but that present the opportunity for a high return.

Who can get venture capital?

A VC fund will look for young companies that have little trading history or that are unknown in the market. These companies often have few resources behind them to support their business idea. This lack of capital enables VC funds to exert influence more easily over such companies through investment and (often minority) share ownership than they would otherwise be able to with more established companies. VC investment are likely to make an assessment when deciding to invest in companies based on financials and the bottom line is often the rate of investment return. The investee company needs to be able to show how the investor will get its money back and at what speed. This often leads to VC funds investing in more technology-based sectors where, due to the rapidly expanding technology market, there is a likelihood of profit at a quicker rate than in more traditional industries, such as:

  • Software, particularly enterprise, telecommunications, cloud, and big data
  • Digital media ecosystems
  • Life sciences, including biotechnology, health, and medical technology
  • Financial technology
  • Information security
  • Educational technology
  • Energy

How can venture capital schemes encourage investors?

In the UK, there are venture capital schemes that are designed to offer certain tax relief incentives to investors that are willing to make investments in companies that have growth potential but that also have a higher level of perceived risk. The table below sets out different types of venture capital schemes:

Type of schemeOverview of scheme
Enterprise Investment Scheme (EIS)Used by individuals to make investments directly in small to medium businesses.
Seed Enterprise Investment Scheme (SEIS)Used to make investments directly in early stage start-up businesses.
Venture Capital Trusts (VCT) schemeUsed as a vehicle for individuals to make indirect investment in small, medium or start-up businesses.
Social Investment Tax Relief (SITR)Used by individuals to make investments directly in certain social enterprises (a social enterprise is an enterprise applying commercial strategies to maximise social impact, typically improvements in financial, social and environmental wellbeing).

Who regulates venture capital firms?

VC fund managers in the UK are regulated and authorised by the Financial Conduct Authority (FCA). The VC fund itself isn’t usually regulated because they are usually non-retail funds and therefore do not fall within the scope of regulation (unless it is a Venture Capital Trust, and structured as UK listed company) – but the fund manager must be authorised. There are restrictions on venture capital fund managers working across the European Economic Area (EEA), imposed by the Alternative Investment Fund Managers Directive 2011/61/EU (known as the AIFMD). It will be important for VC funds to closely track the changes to the regulatory landscape as a result of the implementation of Brexit in the coming months.

VC firms and fund managers will also need to comply with the relevant provisions of the Financial Services and Markets Act 2000 (FSMA) the financial promotion restrictions and prospectus requirements as well as the applicable marketing regime under AIFMD. Many VC firms also choose voluntary self-regulation by adhering to the industry guidelines and standards, for example, the European Venture Capital Association Reporting Guidelines and the International Private Equity and Venture Capital Valuation Guidelines.

How does venture capital funding work?

The first step is to attract a venture capital investor or fund to your business. You need to have a captivating pitch, a great presentation, and then a thorough and realistic business plan if and when the investor asks to see more. Ensure you fully research each VC firm or investor, and only approach those that are known – and thus likely – to invest in your industry and type of business. It’s advisable to approach only one VC firm at a time.

Once your business has found the right VC partner and developed a relationship, the next step is to agree the terms of the investment transaction, and document them into an investment agreement, and any other agreements that may apply. The investor will also usually carry out due diligence on the company and its founders to better assess the assets, risks and liabilities of the company and the business.

The UK venture capital industry has developed a set of standard investment terms that will be familiar to venture capital investors active in the market and the BVCA has published “Model documents for early stage investments” for use in transactions such as a Series A funding round. This means that often venture capital transaction documentation will look familiar to the negotiating parties and contain widely recognised terms. This can help deals to move faster and cost less as there will be areas of the transaction that can be covered by these industry standard terms, resulting in less negotiation between the parties.

The key documents involved in the investment will be:

  • A letter of intent may be put in place at the beginning of the process to document the commercial agreement and to set out the key terms agreed between the investee company and the investor.
  • An investment agreement or a subscription and shareholders’ agreement: this sets out the terms of the investment between the company’s existing shareholders, the investors and the company, and documents the share subscription by the investors and how the investment made (for example, some investments are made in two or more tranches). Depending on the level of risk that the investor is assuming with its investment, the agreement will usually include protections such as warranties given by the founders to the investor regarding the company and the business plan. There are also likely to be rights given to the investor in respect of access to information and the ability to appoint director(s) to the company’s board. The investment agreement will usually cover the commercial terms (profit sharing, recovery of capital, investment policies, fees) as well as setting out any regulatory compliance requirements, for example relating to the type of investment activities that can be offered or the maximum size of the investment. Founders will usually be expected to enter into restrictive covenants preventing them from competing with the company if they leave. This agreement will also include any rights the investor may have to veto strategic or operational decisions of the company. These agreements may also look at cross-border issues as recently there has been an increase in venture capital investment coming from foreign investors (such as any relevant regulatory or anti-bribery and anti-corruption legislation).
  • Articles of association: your company will already have articles of association, but an investor may require you to adopt new, more detailed, articles or amend your current ones. These will set out the rights attaching to the shares in the company, particularly if there is more than one class of share. The articles will also deal with share transfers, which are usually restricted, and may require founders or employee shareholders to offer their shares for sale if they leave. A lot will depend on the number of funding rounds that have gone before the proposed investment as you will need to balance the rights of existing shareholders (who may also be investors) with those of the new investor.
  • Limited Partnership Agreement: If the VC fund is a limited partnership, a limited partnership agreement can be drafted or amended between the investors and the fund.
  • Service agreements for directors and key employees: if they don’t already exist.
  • Company’s business plan: this can be included as an agreed form document to the investment agreement

Find out more about our venture capital legal services, including how we can help you with the documents and advice you’ll need during the venture capital process.

What is a venture capital trust?

A venture capital trust (VCT) is an investment company which is quoted or listed – which means that its shares are traded on the London Stock Exchange. They are part of a government-backed scheme approved by HMRC and set up in 1995. VCTs are set up to invest in small unquoted UK businesses with strict qualifying criteria, to carry tax reliefs to encourage investors to invest their money into the trust.

Under a Venture Capital Trust, individual investors buy shares in a quoted company (the VCT), who uses those funds to buy the shares of (or lend money to) unquoted companies. The VCT passes the tax relief available onto the investor, who also benefits from capital gains tax relief on any gains, as well as tax-free dividends.

The VCT must be approved by HMRC and must meet a variety of conditions during the relevant accounting period in which the application for approval is made.

Conditions include:

  • Having ordinary shares listed in the Official List of the London Stock Exchange or admitted to trading on an EU Regulated Market (not AIM).
  • The VCT cannot be a close company (the definition of close company is complex but it is essentially a UK resident company with five or fewer participators, or any number of participators who are directors and either have control of the company or have rights to receive the greater part of the assets of the company available for distribution on a notional winding up).
  • The VCT must get most or all of its income from shares or securities and must distribute at least 85% of its income from shares or securities.
  • The VCT must not have more than 15% of the value of the VCT’s total investments in any one company.
  • At least 80% of the investments made by the VCT must be in eligible companies carrying on a qualified trade.

Are there different categories of Venture Capital Trusts?

Yes, there’s different types of VCTs. Types of Venture Capital Trusts include:

  • Seed money VCTs provide low level financing for developing and proving a new idea.
  • Start-up VCTs provide funds for new businesses that need finance for expenses, marketing, and product development.
  • First-round VCTs provide financing for manufacturing and early sales.
  • Second-round VCTs provide operational capital given to early stage companies which are selling products but not obtaining a profit.
  • Third-round VCTs (mezzanine financing) provide financing for expanding a newly beneficial company.
  • Fourth-round VCTs (called bridged financing) provide financing for a business to go public.

What information will you have to provide to a VC investor?

The first thing you’ll need to provide to the investors is your business plan. This should include:

  • A summary of your business proposal.
  • A description of the opportunity, market potential, and size of the potential market.
  • A review of the existing and expected competitive scenarios.
  • Detailed financial projections.
  • Details of the management of the company.

Interested investors will then proceed to enter the due diligence process. This will require your company to provide extensive information about its constitution, operations, and affairs. For example, the investors may want to review your management team, market potential, product/service, and business model as well as details of all of your assets and liabilities and any risk areas that could cost a lot in the future.

You may also be asked to provide information about the structure of your company, your contracts with customers, suppliers, and other third parties, any loans, and other arrangements made between the company and shareholders/directors (both past and present).

The company accounts will also need to be provided, along with details of the company’s latest budget, forecast and business plan. An overview of the company’s assets must also be provided by detailing what fees are being paid, existing credit arrangements, any contracts/deals/projects in the pipeline, as well as the assets owned by the company.

The investors may also want information about employees, the terms of their employment and pensions. Further information may consist of any litigation in which the company is engaged in, data protection policies, insurance and tax.

What happens if you get venture capital funding, but you can’t comply with the terms on which the investment was made?

If you can’t comply with the terms originally agreed with the investor, it’s important you inform the investor as soon as practicable. A failure to comply could mean that you’re in breach of the terms of the transaction documentation, such as the investment or subscription agreement, the shareholders’ agreement, or the articles of association.

By informing the investor, you may be able to negotiate a variation in the relevant agreement. For example, if your inability to comply is due to litigation against the company (meaning you cannot repeat your warranty that there’s no pending litigation), then the investor may waive this non-compliance under certain conditions. The transaction documents may set out a timetable that you have to follow to notify the investor of any potential or actual breach of the agreed terms and so it is important to make sure that the documents have been read carefully and any important deadlines or timescales noted.

If the investor doesn’t waive the breach, the investor may be able to terminate the arrangement, withdraw funding and recover any losses that result from your non-compliance (breach of contract).

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