Venture Capital

Definitions on Venture Capital-Private Equity

Private equity is medium to long-term finance provided in return for an equity stake in potentially high growth unquoted companies. Some commentators use the term “private equity” to refer only to the buy-out and buy-in investment sector. Others, in Europe but not the USA, use the term “venture capital” to cover all stages, i.e. synonymous with “private equity”. In the USA “venture capital” refers only to investments in early stage and expanding companies.

Stages of investment

To allow a business concept to be developed, perhaps involving the production of a business plan, prototypes and additional research, prior to bringing a product to market and commencing large-scale manufacturing.
Only a few seed financings are undertaken each year by private equity firms. Many seed financings are too small and require too much hands-on support from the private equity firm to make them economically viable as investments. There are, however, some specialist private equity firms which are worth approaching, subject to the company meeting their other investment preferences. Business angel capital should also be considered, as with a business angel on a company’s board, it may be more attractive to private equity firms when later stage funds are required.
To develop the company’s products and fund their initial marketing. Companies may be in the process of being set up or may have been trading for a short time, but not have sold their product commercially.
Although many start-ups are typically smaller companies, there is an increasing number of multi-million pound start-ups. Around half of BVCA members will consider high quality and generally larger start-up propositions. However, there are those who specialise in this stage, subject to the company seeking investment meeting the firm’s other investment preferences. Around 15% of companies receiving private equity each year are start-ups.
Other early stage
To initiate commercial manufacturing and sales in companies that have completed the product development stage, but may not yet be generating profits.
This is a stage that has been attracting an increasing amount of private equity over the past few years, accounting for around 20% of the number of financings each year by BVCA members.
To grow and expand an established company. For example, to finance increased production capacity, product development, marketing and to provide additional working capital. Also known as “development” or “growth” capital.
More UK companies at this stage of development receive private equity than any other, generally accounting for around 50% of financings each year by BVCA members.
Management buy-out (MBO)
To enable the current operating management and investors to acquire or to purchase a significant shareholding in the product line or business they manage. MBOs range from the acquisition of relatively small formerly family owned businesses to £100 million plus buy-outs. The amounts concerned tend to be larger than other types of financing, as they involve the acquisition of an entire business. They tend to account for around 15% of financings undertaken each year by BVCA member companies.
Management buy-in (MBI)
To enable a manager or group of managers from outside a company to buy into it.
Buy-in management buy-out (BIMBO)
To enable a company’s management to acquire the business they manage with the assistance of some incoming management.
Institutional buy-out (IBO)
To enable a private equity firm to acquire a company, following which the incumbent and/or incoming management will be given or acquire a stake in the business.
This is a relatively new term and is an increasingly used method of buy-out. It is a method often preferred by vendors, as it reduces the number of parties with whom they have to negotiate.
Secondary purchase
When a private equity firm acquires existing shares in a company from another private equity firm or from another shareholder or shareholders.
Replacement equity
To allow existing non-private equity investors to buy back or redeem part, or all, of another investor’s shareholding.
To finance a company in difficulties or to rescue it from receivership.
Refinancing bank debt
To reduce a company’s level of gearing.
Bridge financing
Short-term private equity funding provided to a company generally planning to float within a year.

Types of private equity companies

Private equity firms that raise their funds for investment from external sources, mainly institutional investors, such as pension funds and insurance companies.
Private equity firms that obtain their funds mainly from their parent organisation.
Captives that raise funds from external sources as well as obtaining funds from their parent organisation.

Classes of capital used by private equity firms
The main classes of share and loan capital used to finance UK limited liability companies are shown below.

Share capital
The structure of share capital that will be developed involves the establishment of certain rights. The private equity firm through these rights will try to balance the risks they are taking with the rewards they are seeking. They will also be aiming to put together a package that best suits your company for future growth. These structures require the assistance of an experienced qualified legal adviser.
Ordinary shares
These are equity shares that are entitled to all income and capital after the rights of all other classes of capital and creditors have been satisfied. Ordinary shares have votes. In a private equity deal these are the shares typically held by the management and family shareholders rather than the private equity firm.
Preferred ordinary shares
These may also be known as “A” ordinary shares, cumulative convertible participating preferred ordinary shares or cumulative preferred ordinary shares. These are equity shares with preferred rights. Typically they will rank ahead of the ordinary shares for both income and capital. Once the preferred ordinary share capital has been repaid and then the ordinary share capital has been repaid, the two classes would then rank pari passu in sharing any surplus capital. Their income rights may be defined; they may be entitled to a fixed dividend (a percentage linked to the subscription price, e.g. 8% fixed) and/or they may have a right to a defined share of the company’s profits – known as a participating dividend (e.g. 5% of profits before tax). Preferred ordinary shares have votes.
Preference shares
These are non-equity shares. They rank ahead of all classes of ordinary shares for both income and capital. Their income rights are defined and they are usually entitled to a fixed dividend (e.g. 10% fixed). The shares may be redeemable on fixed dates or they may be irredeemable. Sometimes they may be redeemable at a fixed premium (e.g. at 120% of cost). They may be convertible into a class of ordinary shares.
Loan capital
Loan capital ranks ahead of share capital for both income and capital. Loans typically are entitled to interest and are usually, though not necessarily, repayable. Loans may be secured on the company’s assets or may be unsecured. A secured loan will rank ahead of unsecured loans and certain other creditors of the company. A loan may be convertible into equity shares. Alternatively, it may have a warrant attached that gives the loan holder the option to subscribe for new equity shares on terms fixed in the warrant. They typically carry a higher rate of interest than bank term loans and rank behind the bank for payment of interest and repayment of capital.

Other forms of finance provided in addition to equity

Clearing banks – principally provide overdrafts and short to medium-term loans at fixed or, more usually, variable rates of interest.
Investment banks – organise the provision of medium to longer-term loans, usually for larger amounts than clearing banks. Later they can play an important role in the process of “going public” by advising on the terms and price of public issues and by arranging underwriting when necessary.
Finance houses – provide various forms of instalment credit, ranging from hire purchase to leasing, often asset based and usually for a fixed term and at fixed interest rates.
Factoring companies – provide finance by buying trade debts at a discount, either on a recourse basis (you retain the credit risk on the debts) or on a non-recourse basis (the factoring company takes over the credit risk).
Government and European Commission sources – provide financial aid to UK companies, ranging from project grants (related to jobs created and safeguarded) to enterprise loans in selective areas.
Mezzanine firms – provide loan finance that is halfway between equity and secured debt. These facilities require either a second charge on the company’s assets or are unsecured. Because the risk is consequently higher than senior debt, the interest charged by the mezzanine debt provider will be higher than that from the principal lenders and sometimes a modest equity “up-side” will be required through options or warrants. It is generally most appropriate for larger transactions.

Additional private equity definitions

Burn rate
The rate at which a company requires additional cash to keep going.
Chinese walls
Arrangements that prevent sensitive information being passed between different parts of the same organisation, to prevent a conflict of interest or breach of confidentiality.
Dividend cover
Calculated by dividing earnings after tax by the net dividend and expressed as a multiple. It shows how many times a company’s dividends are covered by posttax earnings.
Part of the price of a transaction, which is conditional on the performance of the company following the deal.
Gearing, debt/equity ratio or leverage
The total borrowings of a company expressed as a percentage of shareholders’ funds.
Initial Public Offering, “flotation”, “float”, “going public”, “listing” are just some of the terms used when a company obtains a quotation on a stock market. Stock markets include the Official List of the London Stock Exchange (where around 40% of trading company flotations are venture backed), the Alternative Investment Market (AIM), NASDAQ Europe, NASDAQ (USA) and other overseas exchanges.
A structure whereby the eventual equity allocations between the groups of shareholders depend on either the future performance of the company or the rate of return achieved by the private equity firm. This allows management shareholders to increase their stake if the company performs particularly well.
Calculated by dividing the gross dividend by the share price and expressed as percentage. It shows the annual return on an investment from interest and dividends, excluding any capital gain element.