Dr McDeal title Getting the right deal from your VC

There seem to be hundreds of venture capitalists to choose from.How do I select a short list?

VCs are differentiated by preferred size of transaction; sector preference and experience; timescale to exit; and degree of involvement with investee companies. The right VC is likely to be one that matches your own circumstances and outlook. If, for example, your deal is smaller than most undertaken by a particular VC, you may struggle to keep their attention both while the deal is completing and subsequently. If on the other hand you desire to grow by acquisition, the appropriate VC will need both the necessary extra funds and the appropriate timescale to exit.

The experience of your financial adviser is crucial here. Venture capitalists are becoming increasingly differentiated, and picking three or four with a genuine hunger to do the deal is vital. This requires personal, firsthand experience of completing transactions with VCs across a range of circumstances. When you are at the point of picking your preferred partner, make sure that all significant legal and financial issues are agreed. Once the decision is made, you will have to work as a team, so do not leave difficult issues un-addressed.

We have attracted a number of competing offers of support, but their complexity and the amount of jargon leaves us little the wiser.

Funding for buy-outs has become highly specialised and inevitably complex. It boils down to finding the right balance between risk and return for each of the parties involved. The venture capitalist will seek to maximise its return and ensure, at the least, that it gets its investment back. In most cases, its investment will consist of a small amount of ordinary equity to provide the bulk of the return and a large amount of loan notes that are there to reduce risk.

For the management, return comes solely from their holding of ordinary shares. Their main risk, apart from losing their original investment, consists of employment security (and as a consequence, their shareholding) and control of the business.

The detailed negotiation of these issues will require expert legal and financial advice.

How important is it for management to get over 50 per cent of the equity?

In most situations, control of more than 50 per cent of the equity is an important financial, legal and emotional hurdle. In a buy-out, however, the position is more complex. The financial institutions will seek to impose a veto on anything that falls outside the broad conception of what the business was at the time of the transaction. In addition, they will want to ensure that the management team does not get rich out of the deal before they do and will want the right to take control if things go wrong. They will seek these rights regardless of the equity split.

In terms of day-to-day management, equity holdings are relatively unimportant. Very few VCs want to get involved in the running of the business and even fewer could do it if they tried.

From a financial standpoint, the value of the management equity only crystallises upon exit and is determined by the value of the business at that time and the amount that has to be repaid to institutions before the management share comes into effect. Therefore, the value of an equity stake can only be assessed in light of the overall financial structure.

What happens if one of us wants to leave?

VCs approach this issue with two principles. The first is that they did the deal with a certain management team in mind and much of the value lies in that team. Secondly, they do not want a manager to realise value before they do - a point of view that the other managers may share.

From the management team’s perspective, there are two opposing points of view. An individual manager who leaves wants some reward for his efforts. The other managers, however, need to be able to deal with underperformers and do not want to reward someone who is about to join a competitor.

It is in no-one’s interest to have former managers remain as shareholders, so “good leaver/bad leaver” rules should be agreed at the outset to determine how a departing manager’s shares are to be valued. Different VCs will have different approaches to this issue, ranging from the ruthless to the indulgent. The issue and all its ramifications need to be considered carefully at an early stage.

Who has the final say when it comes to an exit?

Most exits are by way of trade sale and the attitude of the management to a particular purchaser will affect that buyer’s appetite and the price they offer. Things will have to have gone very wrong for a business to be sold against the wishes of the management.

No purchaser is likely to be interested in buying less than 100 per cent of a company’s shares, so the respective powers and obligations of investors and management in the case of an approach should be agreed at the time of the buy-out. Referred to in the business as “drag-along, tagalong,” these provisions will specify the circumstances in which dissenting shareholders are obliged to accept an offer that the others find acceptable. The threshold for the ability to “dragalong” dissenting shareholders needs to be considered carefully. Once again, the search is for common ground between management and investor.