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Finance - Taking the risk

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Magazine Article, Source : British Industry
Zone : Leadership and Lean
Published : September 2002

When is risk capital the answer to a company’s prayer, and when is it a fate worse than debt? ROBERT POLS takes a look at equity finance

It almost sounds romantic - ‘venture capitalism’. It’s a term for private equity funding that’s rich with associations of perilous enterprise and piratical daring. Equity funders, however, face risk with a calculator in the pocket rather than a cutlass between the teeth: they are backing their hard-won business judgement, and though they may offer a lifeline rather than a plank, it’s a lifeline that not every company can grasp.

Debt finance - loans, hire purchase and leasing - takes assets as security and increases your liability. Equity finance, or risk capital, involves raising money by selling a share in your business, and thereby diluting ownership. It can come from a range of sources. “At one extreme, there are the pension funds that, by and large, are not interested in the riskier investments,” said Tom Franks, a partner in KPMG. “At the other, there are the private equity businesses that accept the fact that one in three ventures will go under.”

Noel Guilford, of Guilford Consulting, gave an overview. “The first thing is to distinguish between the public and private equity markets. The public starts with the stock exchanges, and quite a substantial range of European finance can be available for companies large and attractive enough to want to be in the public arena. At present, however, the stock markets are quite depressed, so raising funding there is currently rather difficult. In the private equity market there are both big institutional investors and the fund managers, whom pension funds, for instance, would use when wanting to invest in private markets.”

The problem, of course, lies in bringing together the right sort of equity, the right business, the right project and the right time. “You might seek public equity to raise finance and establish your marketability,” commented Guilford. “You would be looking to remind investors that there’s a market out there, where, in due course, they will be able to sell their shares. Another reason for approaching the public market is that that you are aiming to grow by acquiring other companies. But you might not want to be in the spotlight. If you need to spend a few more years, perhaps investing in research and development (R&D), before showing results, you’d probably avoid the public market and go for private equity. That tends to invest in smaller, less mature companies with more volatile earnings, but with the prospect of doing good business over a longish period.”

Nevertheless, he continued, different kinds of private equity providers have different agendas. “Fund managers raise a fund that has a finite life - typically ten years - and, in that time, the company they invest in has to deliver profits and become mature enough to be floated, so that the investor can get money back by selling shares. The institutional types of private investor use their own money rather than somebody else’s and don’t have the same requirement to exit quickly. So, if there’s no obvious exit for a fund manager, or if your business will need fixed capital for a long period of time, an institutional, or ‘captive’, type of investment may be better.”

To complicate matters, there are sources of equity funding that fail to fit neatly into the categories so far identified. There are individuals, business angels, who have money to invest in private companies. There are also various regional funds, which share the concept of serving a geographical area, but which may differ widely in their structures and procedures.

“The South Yorkshire Investment Fund covers a range of finance from £15,000 debt up to £500,000 or more with equity options,” said chief executive Tony Goulbourn. “With a combination of bank, pension fund, private investment and EU money, we’ve put together a package of

£50 million funding.” Connect Scotland also draws on varied sources, as director Ian McDonald explained: “We try to provide a network which a new company can use to accelerate the skills and resources needed to grow, and, of our 60 or so sponsors, 13 are funders. Finance deals are normally a mixture of debt and equity, and, if it’s a first round deal, there may well also be a grant element, such as a Smart Award.”

Such mixed packages are not uncommon. “Anyone looking to raise equity finance today will find the links between equity and debt increasingly blurred,” Franks pointed out. “It’s almost a feature of a bear market: when the going becomes tough, you have to devise ingenious packages to earn your returns.” MBOs, he added, often provide classic examples of mixed funding. “There could be half a dozen elements involved, ranging from bank debt (the senior element) to pure equity, and with several shades in between.”

A company’s chances of securing equity investment may relate both to size and to prospects for growth. “The trend amongst private institutional investors over the last five years has been away from small companies,” observed Guilford. “They are looking for returns of 25 to 30 per cent per annum, which represents a doubling of their investment every three years, and a company has to grow very quickly to give them that.”

Smaller companies, therefore, might do better to approach a regional funding organisation. But they would still have to make a convincing case. “We do expect a company to be at or near market,” said Goulbourn, “for we provide neither seed-corn nor very high risk finance. We’re looking for investment from the owners themselves, as evidence of their commitment to the project; we’re looking for a skilled management team that can demonstrate a track record; and our expected returns are likely to amount to around 40 per cent over five or six years.”

Underlying everything else is the need for growth, and, to ensure that occurs, finance providers will probably wish to be represented on the board. “Fund managers and private equity institutions will always, in their agreement, provide for a right to appoint directors,” Guilford confirmed. “Some will automatically exercise this right, appointing an executive from the investment house or somebody from outside their organisation to look after their interests. Others may not take up their right, but will require information on a full and regular basis.”

He also emphasised that, though equity finance tends to be much longer term than debt, investors will eventually want a way out. “The company will, in due course, have to be sold or go public, in order to provide investors with an exit, and any agreement would include provision for forcing an exit if necessary.”

Alan Richardson, director of Cambridge Consultants Limited (CCL), offered a finance-seeker’s perspective on the process. “Getting venture capital is not just to do with money: it’s about the relationship between the parties, about the non-executive directors the funders will provide, and about the particular input they can give. When our recent MBO was being set up, CCL dealt with over ten venture capital providers, in order to find partners who could have a shared vision of what we wanted to do with the business.”

This did not, he conceded, mean that fund seekers could always pick and choose. “The climate is rather different from a couple of years ago, when so many dotcoms were starting up, and getting venture capital for new projects is harder than it has been for a long time.”

McDonald agreed that there is change. “Quite a lot of investors are moving up into the £3 million to £5 million deal range. But if there is a funding gap, there will be players moving in to fill it. At the moment there’s a degree of over-caution, and we won’t go back to the mad dotcom days of overvaluations, but companies can still do deals. There may be a downturn in the cycle, but there’s a lot of money out there still to invest.”