Venture Capital: Process, Advantages and Disadvantages

WhatsApp, Facebook, Groupon - the ranking of the most successful VC bets lists iconic companies whose names stand for success. They are usually young, innovative, tech-oriented, often based in the Silicon Valley. And they have achieved unbelievable growth very quickly. Along with this quick growth, they have generated large profits and proven highly rewarding for their investors.

The VC industry in Bulgaria is maturing. Data for 2019 shows 25 closed VC deals, and venture capital investments totalling EUR 13 million. Four new investment funds were launched in that year with a total capacity estimated at EUR 94.2 million.

A risky yet potentially very profitable venture capital deal involves a complex and well regulated process. Lawyers specialising in finance provide valuable counsel at various stages. They support both sides all the way: from due diligence checks, through drawing up of investment contracts and term sheets. The VC process also involves stock purchase  agreements and the exit of the investor - either through an IPO, a merger or an acquisition.

Successful candidates for venture capital funding

Venture capitalists are institutional investors, wealthy individuals or corporations who invest in start-ups. VC firms typically invest in companies that are new, privately held. These entrepreneurs or small businesses usually have an innovative idea or invention and need to raise capital. A good candidate would also have the potential for quick growth and large profits.

Companies interested in venture capital are usually innovators who are seen as a risky investment and therefore have no access to bank loans or the capital markets. They can approach a VC firm with a business plan. After examining and approving it, the investor may choose to provide capital, technical and managerial support, becoming a mentor for the start-up. In return, VC investors get equity in the company and are also actively involved in all decision-making.

Legal Counsel in Venture Capital Deals

Legal counsel is needed throughout all stages of a venture capital deal.

• The first stage involves a thorough due diligence check. This is an investigation of the business model of the start-up, as well as its management, the product, the operating history.
• The second stage involves the preparation of the VC investment contracts. These are:
  • Term sheets detailing the terms of the investment, matters like corporate governance and liquidation
  • Investor rights agreement detailing the rights of shareholders, including reporting and financial disclosures.
  • Stock purchase agreement regarding the investment. The capital can be provided all at once or in rounds.

Other important aspects include the valuation of the company. This may be a crucial stage in the negotiations between the founders and the investors.

Venture Capital: Advantages and Disadvantages

VC investments have a number of advantages for entrepreneurs and small businesses.

Advantages

First of all, VC investors offer valuable expertise and guidance. They are actively involved in the quick and dramatic development of the company and help manage all risks in the process.

Secondly, venture capitalists help start-ups build a network and establish important connections in the field. This is a wonderful opportunity to meet the business community, establish alliances or have access to potential partners and customers.

VC investors are also reliable. The industry is well regulated, different countries have established regulatory bodies and a legal framework. There are anti-money laundering regulations in place to protect the rights of entrepreneurs and start-ups.

VC investment involves no debt. The start-up is not burdened with the obligation to repay its investor in case the enterprise fails.

VC funds are accessible. VC investors and firms can be found quickly and easily with a simple search online.

Venture capitalists offer an expansion opportunity to small businesses with growth potential.

Drawbacks

One of the main disadvantages is that founders of the start-ups have less control over the company. VC investors gain shares  and become part of the board so they take part in decision-making. Founders may find themselves pressured into making decisions they are not happy about.

Secondly, VC investors may choose to pull out too early. As their focus is on quick gain, they spend 3 to 5 years in the start-up. Therefore VC funding is not suitable for companies with a longer business plan.

VC investments often require high return on their original investment within 3 to 5 years.

And finally, the VC process is rather long and complicated. A start-up needs to:

• Develop a detailed business plan
• Attend a number of meetings with the investors to discuss the deal
• After analysing the plan, the investor does thorough due diligence
• If the investor is happy with the due diligence analysis, he offers a terms sheet.

This may take some time and also requires the expertise of a lawyer specialising in finance.

Angel Investors or Venture Capital Firms

Angel investors are usually high net-worth individuals who fund typically early stage companies. The type of capital they provide may be a one-time seed investment or it could be ongoing financial support in difficult times.

Angel investors are often recently retired entrepreneurs. They usually support start-ups in a familiar business sector or an industry similar to the one they have expertise in. The reason is that apart from capital, they offer business advice, technical expertise or support for the management teams.

Venture funds on the other hand, are structured as limited partnerships. They own a stake in the companies in their VC portfolio (say 20% of each portfolio company).

The investors in the VC firm are either individuals or institutions, they are called Limited Partners. Investors in venture funds include wealthy families, pension funds, sovereign wealth funds, etc.

The venture fund General Partner is responsible for raising and managing the funds, as well as for making investment decisions.

The venture fund Management Company is the one that receives management fee (usually about 2%).

Venture Capital or Private Equity

Venture capital is a form of private equity financing and the same laws apply in most cases. However, there are some considerable differences.

Venture firms or funds typically invest in start-ups that have the potential for dramatic growth. In many cases, the investors work closely with the company as mentors providing support.

VC firms are typically interested in small businesses that are not well-established. They often offer advice throughout the whole process of developing the product, marketing it and managing the risk  in the dynamic growth of the company.

The second difference is related to the amount of money invested. VCs usually invest up to $10 million.

Note that all venture capitalists typically invest in more than one start-up to minimise risk. As about 3 out of 4 entrepreneurs ultimately fail, investors need to make sure they can generate sufficient profit from the successful ones to cover their losses.

The last distinction is in the percentage of equity in the company the investor claims. Angel investors or venture capital firms invest in up to 50% of the new company.

Private equity, on the other hand, involves investors or funds that invest directly into already established businesses. In this case the expected return and year-on-year growth is predictable.

So, unlike venture capitalists, private equity investments target mature companies. The invested capital may be used to boost the company’s balance sheet, to expand the working capital or to finance an acquisition.

As they target mature established companies, private equity investments are typically over $100 million.

And finally, private equity firms typically buy 100% ownership in the companies they invest in.

The right time for a venture capital deal

Although venture capitalists typically invest in start-ups with significant growth potential, the investors may choose to back up companies at different stages. This will depend on the risk they are willing to take, as well as the return they expect to make.

Seed - in this case the investor chooses to finance a company at its earliest stage. This means that the start-up most likely needs support throughout the whole process of developing its business. The venture capitalist is therefore a mentor involved in important decision-making.

Series A - these are companies that already have a product. They also have found a market and their customer base is growing.

Series B companies are already making revenue. They have a product, customer base and they are looking to expand.

Series C and onwards include companies that have already grown and are probably operating on a global scale. In this case the investors will support the company with its initial public offering (IPO) or a merger/ acquisition.

If you need assistance with Due Diligence or any Venture Capital deal matters, simply contact our law firm in Bulgaria.