CHAPTER 4

Investing in the Early Stages of a Company:

Venture Capital

4.1 INTRODUCTION
This chapter describes in detail the private equity deals involving companies at
their earliest stages of life, which is to say venture capital deals. After an over-
view of the business, the chapter presents in detail the three clusters, their
features, and motives leading a private equity to invest in a young company,
where the three deals are:

• Seed financing
• Start-up financing
• Early growth financing.

4.2 GENERAL OVERVIEW OF EARLY STAGE FINANCING

Each entrepreneurial project is developed through several phases according to
the life cycle time of a company (see previous chapters). It is easy to identify in
which development phase a company finds itself by the problems that occur at
different points in its structure and by the needs the private equity financing
aim at filling in. In the first stages of life, the private equity investor, or better,
the venture capitalist is considered more than a simple
supplier of risk capital. As a matter of fact, in this phase, they REMEMBER: There are four effects
support and work to improve the growth of the ventured-back brought by the private equity
company not only by providing money, but also by leveraging investors.
on the benefits deriving from their presence as a shareholder.
How and why the venture capitalist decides to invest in a business idea, that has
to be defined and planned before the company even exists, is reviewed in this
chapter.
To understand the investment activity in the company’s equity capital, it is
necessary to analyze the key management process realized by the investor.
39

Private Equity and Venture Capital in Europe. https://doi.org/10.1016/B978-0-12-812254-9.00004-8

© 2018 Elsevier Ltd. All rights reserved.
40 C HA PT E R 4 : Investing in the Early Stages of a Company

This analysis focuses on critical topics related to the relationship between the
entrepreneur and the venture capitalist and all the steps necessary to orga-
nize the complex structure owned by the venture capitalist initiative. The
classical approach to the venture capitalist investment, realized in the emerg-
ing entrepreneurial initiative, leads to the study of financing and managerial
resources and their importance. The resources are destined to be used for
highly innovative projects with good potential. These are matched with
minority participation to reach capital gains because of the revaluation of
the stakes and the opportunity to differentiate the risk.

It is therefore important to emphasize on those venture capitalists:

• operate with a preestablished and limited period of time, usually

between 3 and 5 years,
• acquire only minority participation because of the entrepreneurial risk
and difficulty selling the control participation,
• point out, from the first time with the target company, the importance
of the return on the investment; their investment is in part remunerated
during the holding period, by dividends and advisory fees, paid by
the target company,
• manage their investment with a hands-in approach as they have to
make sure that their investment will eventually yield a return,
• in the light of their investment profile, they usually protect themselves
with some tools that decrease the likelihood of a write-off of the
investment.

4.2.1 Seed Financing

Seed financing is defined as a participation in favor of a business idea for which
the legal entity has not been founded yet. As there is not a company where the
investor can actually invest in, the injection is made by using a special purpose
vehicle (SPV) specifically meant for developing a research project. In this phase,
there is a person or a team of researchers and the venture capitalist invests
in them in order to develop a project that hopefully will produce a successful
business idea (Fig. 4.1).
Industry sectors typically targeted for seed financing include information tech-
nology, pharmaceutical, chemical, telecommunication, and biomedical.
Regarding the risk profile, it should be noted that investors have to consider
that the management and the risk profile related to a good performance of
the financed project is affected by the following three so-called “golden rules
of seed financing”.
 4.2 General Overview of Early Stage Financing 41

FIG. 4.1 Seed financing within the life cycle of a company.

The golden rules of seed financing are:

• 100/10/1 rule. In the business world, this rule describes the level of risk of
investing in a company in its seed phase. On average, the investor has
to screen 100 projects, finance 10 of them so that he will be lucky (and
able) enough to find the one that will turn out to be successful. This
activity is so risky that an investor must invest on many more than one
project, as by the time the investors find the winning project they will have
lost much of their beginning investment.
• Sudden death risk. Because this investment occurs before the company is
even founded, the investors have to protect themselves in case the person
owning the project’s idea suddenly can no longer perform his job for
whatsoever reason. On the other hand, the inventor in the very early stages
of development of the idea is not much prone on sharing the ideas
with other people. The solution to this tension is an Incubator Strategy, an
ad hoc infrastructure in which the inventor can work without worrying
about the ideas being stolen. In this protected environment, the investor
may share the invaluable know-how with other persons.
• Size of the market. In being an extremely risky investment per se, the
investors have to limit the possibility of the product/output that is being
created by the inventors will not be sold. That is the reason why the
venture capitalists tend to invest in seed financing only in the industries
that they know best. Additionally, not only should they be able to
recognize the possibility of a good investment in very difficult markets,
but they also should be able to acknowledge the possibility of the
marketability of the generated product. As a matter of fact, in this stage of
42 C HA PT E R 4 : Investing in the Early Stages of a Company

the investments, two are the levels of difficulty in the creation of the
output:
 Will the team generate an output?
 If so, will there be a market for the output generated?

There are two strategies used to manage investment return: diversification,

possible thanks to the large amount of resources divided between different
business initiatives and mitigate the potential risk on the capital invested by
having subproducts guaranteed by the project. There can be potential ethical
problems with the second tool.

4.2.2 Start-Up Financing

This type of deal comes in the picture when the legal entity of a start-up com-
pany has already been set. In this phase not only is the legal entity founded, but
there is a sound business plan. Nonetheless, the risk in investing in a company
at this stage is still very high. The risk is based on launching a company built on
a well-founded business idea and not on the gamble of discovering a new busi-
ness idea (Fig. 4.2).
At this point in the business, risk depends on two variables: the total amount of
the net financial requirement and the time necessary to reach the breakeven
point of the activity financed. The risk is not strongly connected with the entre-
preneur or the validity of his business idea, which are preconditions for the
participation. What is really important is the potential growth of the industry
in terms of capital intensity required and the forecasted trend of the turnover.
The high level of risk is due to the investment realized at the time (t0) when it is
uncertain whether the business will reach the breakeven point.

FIG. 4.2 Start-up financing.

 4.2 General Overview of Early Stage Financing 43

The performance profile of a private equity in a start-up initiative, in terms of

IRR, is connected with the ability and capacity to re-sell the participation on the
financial market. The track record and credibility of the private equity investor
is a key factor in the success of the exit strategy when obtaining the desired
return from the investment realized. The main investor’s goal (a good and suc-
cessful exit from the investment) can be facilitated by drawing up agreements
with other private equity funds regarding their availability and commitment
to buy the participation after a predefined period of time. Another solution
is to sign a buy back agreement with the entrepreneur or other shareholders
who agree to repurchase the venture capitalist’s participation in the company
after a predefined period of time (put option). However, the drawback of this
possibility is that it assumes that the entrepreneur will have money enough to
buy the stake back once the exit time will come. This is why the entrepreneur
may be required to put some money in an escrow account. An alternative to a
put option may be the pledge of some collaterals of the entrepreneurs. In the
end, to create the right incentive for the entrepreneur to fully exploit the financ-
ing given by the investor is to grant him some stock options. In this way, the
entrepreneur is incentivized to work to enhance the profitability of the com-
pany as much as possible.

4.2.3 Early Growth Financing

Early growth financing is the financing of the first phase of growth of a new
company that has started generating sales (Fig. 4.3).
The founders’ need of cash derives from the necessity to buy inventory to foster
the company’s growth and to bridge the gap existing between the level of cash

FIG. 4.3 Early growth financing.

44 C HA PT E R 4 : Investing in the Early Stages of a Company

flow and the financial need. As a matter of fact, in this phase, the cash flow may
still be very low, if not negative, even though the level of cash is enhancing with
respect to previous stages of life of the company.
For an external investor, as the private equity, the risk in buying stakes of
the equity of a company in this phase is still high as the venture is still very
young and when the injection is made, the investors do not exactly know
how the company will turn out. The hype in the company’s revenues that
characterizes this stage that dragged the company from a start-up phase to
an early growth one may either be a bubble, or driven by a financial one, or
a temporary phase.
In this phase, the investor has to adopt a hands-on approach. If the investor
thinks that the company business model is based on a good idea, but the
business plan is still not adequate, they help rewrite it (this is in fact a possible
consequence of the knowledge effect).
For this reason, the private equity investor usually has a high amount of shares
in the equity of the company when undertaking this kind of deal.
On average, this financing may occur until the end of the first 3 years after the
start-up stage. In this kind of investment, the private equity may also not have
any protections, due to the high stake in the equity of the company and due to
the adoption of a hands-on approach that, combined, create a very powerful
investment in the company.

4.3 OPERATION PHASES DURING EARLY

STAGE FINANCING
Different stages of a company’s development need different types of capital
investment. From the origination to the implementation up to the exit strategy,
each phase needs different capital and know-how. During the start-up phase,
the venture capitalist has an intense and complex interaction with the entrepre-
neur to verify the necessary financial and managerial support. During the seed
financing phase the technical validity of the product or service is still unproven,
so the venture capitalist offers limited financial resources to support the devel-
opment of the business idea and the preparation of the commercial feasibility
plan. Consequently, there is huge risk faced by the investor.
Start-up financing provides the capital necessary to start operations without
commercial validity of the product or service offered. During this stage, the
entrepreneurial risk is huge, but there is also risk connected to the financial
resources provided. This is usually higher than the ones invested during the
seed phase.
 4.4 Structure of Venture Capitalists in Early Stage Financing 45

Financing in the first stage of the life cycle of a company is linked to the
improvement of production capacity after it is completed but the commercial
validity of the business idea is still not totally verified. This requires a large
amount of financial resources, but is less risky and managerial support is still
limited.
Due to the high level of complexity that exists in the markets today, it is not easy
to classify clearly these investments; it is more logical to classify them in relation
to the potential emerging strategic needs of the company, industry problems,
specific threats or opportunity, and final goals of the investor.

4.4 STRUCTURE OF VENTURE CAPITALISTS

IN EARLY STAGE FINANCING
Financial markets are often unable to finance projects presented by companies;
especially those with innovative, hence risky, initiatives. Because of this, the
venture capitalist is an interesting and important opportunity to develop entre-
preneurial projects. The specific remuneration structure of the venture capitalist
is different when compared with a typical bank. The professional investor who
invests risk capital wants to be reimbursed, but at the same time, the ultimate
goal of the equity investment is to share the potential success of the business.
On the contrary, a bank is uniquely interested in reimbursement.
On the other hand, for as much as the private equity is keen on bearing a high
level of risk, they are however accountable to the investors, from whom they
have to be able to pay off the capital invested and yet with the highest return
possible. This is why two types of organization structures are typically used in
venture capital operations during either seed or start-up initiative: Business
Angels and corporate venture capitalists. A Business Angel is a private and infor-
mal investor who decides to bring risk capital to a small or medium firm during
its start-up or first development phase. Business Angels are sustained by net-
works that match them with companies to meet the demand and supply of
financial funds. This type of financial operator is common in the United States,
but faces problems in Europe. Because of this situation, which directly affects
new business, the European Strategy was launched in Lisbon in 2000. It defined
the central role of Business Angels as concrete contributors to the improvement
of European competitiveness and productivity.
Corporate venture capital is an investment in risk capital executed by very large
industrial groups. The necessity to strengthen research and development to
continue the high-tech evolution has created investment opportunities. Unfor-
tunately, increasing investments is not linked with satisfactory results. Small
companies have shown a high level of efficiency and competence in the
46 C HA PT E R 4 : Investing in the Early Stages of a Company

innovation sector so several industrial groups have started to specialize in the

development of new projects; either founding them directly or acquiring par-
ticipation. These groups have also acquired minority participations in small
enterprises that are technologically qualified. This form of financing allows
small or medium firms to collaborate in a positive way with the big industrial
groups (they will be explored more in detail in Chapter 9).
The private and venture capital system is a financial tool with potential to
accomplish the competitiveness, innovation, and growth objectives implemen-
ted by the Lisbon protocol. The venture capitalist is motivated by the potential
quality and long-term growth of industrial leverages operating in innovative
industries as well as the ability to improve management skills.
Private equity operations realized during seed and start-up financing have to
focus their attention on:

• Supporting the development of an entrepreneurial environment.

Knowledge-based firms are still not widespread in Europe because there
are no structured and uniform legal regulations. The prevalence of
innovative businesses is possible due to the acquisition of financial,
strategic, and corporate knowledge, which can be offered by a professional
financial investor with international experience.
• Implementing research and development and the ability to spread the
innovation through centers of excellence by firms focused on research.
A key factor toward this evolution is a structured relationship between
firms and universities.

4.5 SELECTION OF THE TARGET COMPANY

The first aspect the venture capitalist has to consider, to guarantee the optimal
composition of his investment portfolios, is the effectiveness of the deal flow.
In American markets, where risk capital is widespread and well established,
deal flow is represented by a relevant number of well-structured business
proposals formalized with business plans. These are sent by start-ups to specific
groups of venture capitalists selected based on their previous investments and
their industry and/or geographical areas of interests. In financial markets where
risk capital is not so widespread, the venture capitalist needs specific ways to
promote this form of financing; for example, his network of relationships is
an effective and useful tool to create financial business opportunities.
An element that always catalysts a venture capitalist’ attention is the opportu-
nity to analyze the largest number of business projects, which allows a better
range of choices, and proposals that include the optimal and ideal require-
ments needed by investors. For example, in the developed and complex risk
 4.6 Supporting Innovation Development 47

capital markets, competition among venture capitalists to finance the best pro-
jects led the specialization for many operators concentrating their investments
in different clusters of activity such as the specific stage of a company’s life cycle,
the average size of the funds required, and the industry.
Each venture capitalist decides the minimum and maximum investment entry
size. The minimum investment has to cover fixed costs during the screening
of all business projects such as due diligence and monitoring and managerial
advisory costs. The setting for the maximum investment considers the size of
the financial funds owned by the venture capitalist and the need to keep an
equilibrium among the portfolio of investments realized in terms of risk and
return profiles. Minimum entrance level investors operate in the seed or
start-up financing phase. Early growth operations, such as those in the high-
tech industry, are always strongly supported by extra financial services that
require special and advanced preparation to guarantee the success of the target
company, especially during the screening phase.

4.6 SUPPORTING INNOVATION DEVELOPMENT

The venture capitalist is a financial intermediary whose mainstay is the finan-
cial and managerial support of firms in the start-up phase. These firms operate
in markets with huge information asymmetry regarding their valuation and
guarantee of financial support from traditional lenders such as banks. The first
example of information asymmetry is represented by what is known by the
entrepreneur or management team and what is known by the investor. To
understand better this situation, high-tech industries must be identified:

1. Software applications
2. Pharmaceutical technologies
3. Biotechnology

These industries need to concentrate their resources in research and develop-

ment to reach their performance potential. Because of this, it is impossible
to represent a valid guarantee for traditional banks.
The high level of uncertainty, typical for a company with a high level of inno-
vative development, makes it difficult to use traditional financing for two rea-
sons: it is impossible to forecast, with a high degree of certainty, the success of
a highly innovative business project and the very real possibility of negative
economic results for a long period of time. These conditions introduce a high
level of complexity into the firm’s valuation. The chances to select business pro-
jects with a positive net present value and a long-term view are low. This makes
it possible for the venture capitalist to invest financial resources in highly
48 C HA PT E R 4 : Investing in the Early Stages of a Company

innovative projects that are very risky, but may generate high economic return if
the supported firms are successful.
The venture capitalist, because of a highly specialized knowledge in multiple
investment areas, is able to collect and analyze all available financial informa-
tion and to undertake the most conscious and optimal investment decision.
The successful venture capitalist must be a highly specialized investor with
topnotch managerial skills to work successfully with entrepreneurs and man-
agers. He must also know the most important changes financed firms need:
• Easy improvement of the organization including planning and
development of the company’s informative flows and processes. This
allows for wider contractual power and a better company image. These
improvements make it easier for the shareholders to exit without
damaging or taking resources away from the company.
• Introduction of advanced systems for management and budgeting to
increase the rationalization of the target company due to joint ventures,
acquisitions, and mergers that represent important solutions for the
company’s development.

4.7 PRIVATE INVESTOR MOTIVATION AND CRITERIA

Private investors are motivated by:
1. Return on investment—Venture capitalists have building operations that
allow a minimum ROI of 30%.
2. Improved self-image, self-esteem, and recognition—Private investors
desire satisfactory economic returns from their investments as well as the
opportunity to increase the value of their brand to guarantee a successful
investment, which will in fact be of help when they have to launch
another fundraising.
3. Alleviating concerns and helping others—This is especially seen in
Business Angels. Because early stage financing seems like charity,
Business Angels very often decide to invest money in business ideas
connected with an emotional past experience (if a relative of the investor
dies due to a cancer, the investor might finance projects that can help
find a cure).
4. Getting the “first crack” at the next high rise stock, prior to IPO; they
realize this is the way to acquire higher economic return without dealing
with public securities.
5. Having an aptitude for high risk; critical element distinguishes this type
of investor from all others. Without it, this aptitude they would not
consider such high-risk business ideas.
6. Having fun and leading challenging projects to economic success.
 4.7 Private Investor Motivation and Criteria 49

When studying how private equity investors operate in early stage firms, it is
important to understand not only their motivation, but also the criteria they
apply during their investment activity. Usually, venture capitalists want to
know all about the businesses in which they invest, particularly the technology
and the market, to execute due diligence with higher awareness of the people
and the business idea. They especially search for investments that allow propri-
etary advantages for unique technology and leaps in innovation leading to
growth opportunities to pass the competition.
Private investors have important criteria for selecting business ideas and start-
up firms. These include a solid financial forecast leading to a return of 5–10
times their original investment with a minimum ROI of 30%. To ensure these
requirements, private investors evaluate the existence of possible future profit-
ability, because it demonstrates the ability of the Business Angel to select a good
idea and improve their image in the financial market. According to these cri-
teria, venture capitalists decide and select the investment opportunity based
on a business plan, even if they must face the difficulties of analyzing just an
idea and not an operating business. This makes forecasting the future perfor-
mance of an investment formidable and a wrong evaluation plausible.
During the fundraising phase, the quality of the management team and the
equity investor’s track record, personal financial commitment, and the desire
to achieve success are important to collect financial and economic data. It is
easy to understand the value of managers who work hard and collaborate
constructively and enthusiastically with the investors to build a trustworthy
relationship between the funds provider and the team of promoters or
researchers.
The level of commitment from Business Angels changes depending on how
they wish to invest. We can identify, in terms of active and direct participation
in the business project, four main types of Business Angels:
1. Angels who sit on a working Board of Directors—They are passive and
not looking for operating management responsibility, but usually
require periodic financial reports.
2. Angels who act as informal consultants—They are investors who provide
consulting help when needed and requested.
3. Angels who are full- or part-time manager investors—They are investors
who create value from the support provided, market knowledge, and
contacts offered to the entrepreneur or to the research team.
4. Angels who are investor-owners—They assist founders by bringing
other financing after presenting and promoting the business initiative
to new investors and establishing strategic alliances with other
companies that represent future clients or potential providers of
technologies and manufacturing enhancement.
50 C HA PT E R 4 : Investing in the Early Stages of a Company

In early stage deals, private equity investors use these criteria to choose an
investment:
• Possibility of entry in new markets
• Cost advantages
• Proprietary advantages or unique technology
• Business idea easily understood by investors
• Opportunity to have fun from the investment
• High level of ROI linked with solid financial indicators
• Business idea that is both innovative and profitable
• Management teams with competences, good track records, ability to
financially commitment, and the desire to succeed
• Geographically close
• Clear exit strategy