Structuring venture capital investment deals

I\’ve already written about choosing investments in the stock marketing, but one of my preferred types of deal is the venture capital, or \’angel\’ investment. The reason I enjoy these types of deal is the flexibility which they allow to provide significant benefits to all parties involved. As the capital partner, I\’m looking to maximise profits whilst maintaining a firm handle on the risk profile of the deal.

Traditional investments such as stocks, bonds and funds usually have no room for negotiation. You are offered a price at which to invest, and either you accept it or you decline it. You have no say over the running of the investment, or the return, and as such simply have to look to \’buy\’ the best yield at the best available price.

Venture capital investments can be structured in a variety of different ways however. Each deal has it\’s own management and legal requirements, with an array of structures available for your consideration. As an investor, I generally try to avoid any obligation outside of a financial one, although I do prefer to have transparency into operational decision-making and performance.

In one deal I\’m currently assessing, an off-shore entrepreneur is looking for financing to develop a smartphone app. They\’re looking around £10,000 of venture capital, which they will use to fund development of their app and growth of the company. In this instance, I might look at a straight forward equity investment, where my cash buys me a percentage of the business in return for a share of all future profits.

In an equity investment, we each own shares of the company, and my cash is used to fund the development, marketing and delivery of the app, but the company is the party which \’owns\’ the app at the end of the day, and any decisions taken by the company are made by vote of the shareholders (of which I am one). Consequently, if profits are to be disbursed, this is a decision by vote, as is the decision on the value and frequency of said disbursements.

As a part owner of the company, I have direct input into the decision making process of the company, helping to secure my capital by sensible decision making. I also get the opportunity to earn revenue from my investment and am guaranteed to receive further income if the company if acquired by another party.

Despite this, if the company collapses, or the app does not sell, I stand to lose all my money; especially if it collapses despite my investment, as the money would have been spent (and therefore not able to be withdrawn).

Likewise, if I only have a small share of the company, I may not have sufficient power to influence key decisions.

If I didn\’t want to buy a share of the company (or if one wasn\’t available for sale), I could make a debt investment, whereby I simply loan the company the £10,000. I would charge a rate of interest on the loan which is how I get my return. In this instance, I don\’t get usually get any say in management decisions, but I do have legal recourse for repayment of the debt.

There are multiple ways to ensure repayment (or add security to it), including guarantees, security agreements, collateral pledges and promissory notes. If the company collapses, I would also be amongst the first to have a claim on remaining assets, and would be entitled to them before the owners.

In return for my inability to take a management stake, I can also charge a higher interest rate, which I can request payment of on a regular basis (monthly or quarterly is typical), but if needed I could require the management team consult me before making an significant decisions (in the event of a cash expenditure of over £1000 for example).

The drawback to a debt investment is that I will not receive an income from the performance or sale of the company, simply the interest owed on the cash provided until repayment. A slight variation on this is Royalty Financing, where instead of charging interest on my cash, I become entitled to a proportion of the revenue generated from sales by the company.

If I am confident about the performance of the app, I could still earn a very lucrative return, and the loan must still be repaid even if sales are not successful. If they\’re not, I\’ve essentially earned little (maybe even nothing) on my investment, and if I get too greedy, I could make damage the financial viability of the company due to over-extraction of income.

Alternatively, I could request a Convertible Debt Investment, whereby I lend my money as a loan, but retain the right to convert my loan to shares of the company at a future date. This would allow me to limit my risk whilst maintaining income and wait until performance has been proven. If I mistime the conversion, I could significantly increase my risk (a sudden boom in sales could prove temporary), and if the company later collapses I could still lose all of my investment.

These are just a handful of ways deals can be structured, and obviously sophisticated investors will include different clauses in their venture capital investment agreements which will protect their capital. I usually prefer to be the first to be paid when I\’m taking a stake as a capital partner in an investment, which usually means I\’ll get all of my money back with some extra before the recipient of my funds can earn a salary or withdraw profits themselves.

In exchange for this, I allow them to receive the majority share of earnings after I have reached an agreed level of profit. Whether making a debt or equity investment, try to structure the venture capital deal around maintaining the viability of the investment, but balance this with your need for security.

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