Venture Capital, also called Private Equity, is a part of the financial sector dedicated to investing in unlisted companies, either by acquiring outstanding shares or by subscribing to capital increases. The objective of these investments is to multiply the money in a given period of time, usually between 3 and 5 years.
It should be noted that the term “venture capital” is not synonymous with “ruin capital”. The objective is to generate returns primarily from the capital gains obtained by selling the shares acquired, and, therefore, the investor does not assume as usual the loss of the investment without consequences. It is vital for the investor to visualize the growth possibilities of the business in which he is investing and a successful exit, by achieving a multiple of his investment appropriate to the level of risk assumed. If the investor, does not visualize on paper the development plan to achieve a successful sale within the target timeframe, he will not invest.
To guarantee investor security, Private Equity is regulated and supervised by national institutions such as the Spanish National Securities Market Commission (CNMV) and international institutions. Leaving aside informal capital (to which we will refer in a future post), the actors in the sector are: (1) the fund management companies that must meet certain requirements of experience, qualifications, and capital to be authorised and (2) the investment vehicles, the Venture Capital Funds (VCFs) or Venture Capital Companies (VCSCs).
The investment risk and the type of investor is classified according to the business development stages the target (project or company) stands, establishing three categories: (a) Seed Capital investment, (b) Venture Capital and (c) Growth Capital (Private Equity). Please, see the chart below:
The graph shows the path that an entrepreneur must take to reach a certain size, and always from the profitability premise (above the Break-even point). In the initial stages, Business Angels also invest, providing small money amounts, their know-how, dedication, and contacts. In recent years, business project accelerators have been created sheltered by companies, business groups foundations or Business Angels that seek to promote business initiatives with growth potential.
Seed Capital Funds are normally created or promoted by Public Entities that have funds to stimulate the business fabric and invest small amounts of money (tickets) in incipient projects that will require from professional support and training to the entrepreneur in addition to money, with the hope that some of these entrepreneurial initiatives produce capital gains, although being aware that many of them will cause losses.
Business growth and development, by nature, requires the contribution of capital by its partners, or obtaining it through debt.
Capital contributions are made through shares issuances, which can be of two types: ordinary shares or preferred (privileged) shares. Ordinary shares grant economic rights (right to profit through dividends) and political rights (decision-making capacity and intervention in the management of the company, the General Shareholders’ Meeting). Preferred shares only grant economic rights.
The success in the placement of the issued shares in the successive financing rounds that may occur in a company, will depend on its evolution so that, if the company has created value by generating profits or raised favorable expectations, the demand for subscribing the issued shares will be higher than otherwise. If this is the case, the value of the company will have increased according to its favorable evolution, and therefore, the value of the pre-existing shares will be higher on the occasion of a new issuance. In these cases, successive capital issues will be made with a “share premium”, that is, they will have a premium over the nominal value to be subscribed. Otherwise, the demand to subscribe to a capital increase will be lower and the pre-existing shareholders will see the value of their shares reduced, which is why they will possibly be diluted when new shareholders are admitted. There will not be an issue premium in this last case.
The dilution of the pre-existing shareholder supposes a reduction of the percentage of participation in the property of the company, and therefore, in the economic and political rights.
The fact that each financing round has a share premium requires creating different types of shares in addition to the ordinary and preferred ones mentioned. Hence, they are categorized as class A, B, C, etc., and the nominal value and the share premium are specified in the issue (the specific economic rights to which the subscriber / investor is entitled in the case of preferred shares).
Venture Capital investment stages
We can classify them into three: (a) Start-up and validation of the business model, (b) growth and development of the company, and (c) maturity and expansion.
The Start-up stage (“birth”) and validation is the one that involves the greatest risk and volatility. It is called the seed stage, where individual investors called Business Angels and sometimes institutional managers of Seed Capital operate.
The growth and development stage is known as Venture Capital. It involves the structuring process, investment in equipment, processes, etc. The level of risk is still high because the company does not have a consolidated and broad business base. The series A are known for being the first time that companies face a financing round of a certain size, and the possibility of investment is offered to vehicles managed by Venture Capital professionals, the Investment fund management companies, through their vehicle’s investments (FCR or SCR). Series B and C occur when the company is more established, proves its viability by generating cash and requires funds to expand the business, gain market share, improve the margin, etc.
In the maturity and expansion stage, the amounts of the investment tickets are higher, and this is where the Private Equity managers that have large Funds intervene and can aspire to take a majority stake together with the entrepreneur, in order to internationalize the company or structure it to make it more competitive by integrating forward or backward in the value chain.
The usual typology of capital issues and the series of shares are shown in the following table:
The last stage of the investment rounds is the ideal one, the exit to a stock market, where the last investors to enter the capital will multiply their investment in a Public Offering of Sale (IPO) process in an organized market.
At Delicias Capital we look for companies in Venture Capital and Growth Capital stages. However, without ruling out startups with great growth potential, even if they do not have relevant business figures but they prove the solidity of their business model (positive EBITDAs) and the capacity to generate cash for the recurrence of their income.