Startups III: Alternative financing channels (Part 2)
Following on from our previous post on startups, and turning our attention to the investment process, today we will focus on two of the more complex forms of investment, which are generally used at a later and/or more mature stage: “Venture Capital” (VC”) and “Private Equity” (“PE”).
It is important to know what we are dealing with when we become involved in negotiations for the acquisition of an interest by a VC or PE firm. To this end, there follows a brief rundown of the two concepts, highlighting the main differences between them, as these sometimes tend to be overlooked.
In general, both these investment formulas arise when a startup needs a boost in the marketing and development of its products or services and, where appropriate, in the internationalization of its business. VC and PE share common ground in that they are both high-risk financing formulas, where the startup receives capital and, in return, the investor receives a percentage stake in the company.
VC can be defined as investments by private entities which, in exchange, receive shares in the startup, although they do not always become majority shareholders. While they do not become directly involved in the day-to-day running of the company and/or the business, they generally demand: (i) a seat on the board of directors to allow them to influence or veto decisions; (ii) an anti-dilution clause; and (iii) a preferential right on liquidation (among others).
In turn, PE can be defined as high-value investments by private bodies which, in exchange, receive shares in the startup which generally grant them a majority shareholding, most likely with restrictions or limits on share transfer rights, by means of drag-along or tag-along rights, among others. Their overriding aim is to sell their shareholding, obtaining substantial capital gains.
There are, therefore, certain similarities between the two, but there are also a number of key differences:
- Investment sector. PE investment ranges across all industries, especially traditional industries and consumer goods, whereas VC investment is concentrated in the new technology sector, apps, biotech, telecoms, internet of things, etc. Accordingly, a startup is more likely to receive VC investment than PE investment.
- Amount and consideration. PE firms generally make a more aggressive entry, investing more capital and receiving more in exchange. They also tend to demand a majority shareholding in the company.
- Investment timing. Although both VC and PE investment is generally made when a startup needs a boost for development, VC firms tend to enter earlier, closer to the company’s beginnings, whereas PE firms generally enter at a later stage, when the company is on a sounder footing. Thus, VC investments are long term, while PE investments are medium term.
- Target return. They also operate with different return targets: an investment return of 40%-60% per annum for VC, as opposed to 20%-40% per annum for PE. This is because VC investment entails greater risk, since it will probably be made at an earlier stage of the company’s development.
In short, whether an offer of investment is received from a VC or a PE firm, it is important to understand both concepts well, to be able to tell them apart, to identify the defining characteristics of each and, above all, to know what we are negotiating in each case. In the words of Sir Francis Bacon, “knowledge is power”.
Garrigues Corporate/Commercial Department
