What is risk capital?

Generally speaking, risk capital is long-term investment into an enterprise’s unlisted equity or provision of equity related loan with the purpose of supporting its rapid growth and development. This type of investment conceptually differs from raising finance in a form of an ordinary loan. If you get an ordinary loan then you have an obligation to repay the principal and accrued interests irrespective of your success or failure, so in this case the lender is not the one who shares your repayment risk. Risk capital investor’s approach is absolutely different, because his or her return is heavily dependent on the prosperity and profitability of your enterprise. Thus, risk capital investment allows you to share and adjust risks associated with the performance of your business and cash flows between you and your lender.

If we consider contemporary investment universe as consisting of two major parts, traditional and alternative, then risk capital will definitely fall into the second category. The main character, which makes risk capital fundamentally different from other types of financing, is the fact that your lender becomes your business partner, who shares your interests, risks and to the certain amount your profit. Strictly speaking, risk capital is not a kind of ordinary bank loan, instead it is the amount of money which investor is ready to change against your equity or equity related debt if he is confident in your future success. It is important to note that risk capital can be both in a form of equity and loan financing, but the latter will eventually be related to the equity of your enterprise. The key fact to mention is that for the purpose of risk capital, equities of your enterprise, which are directly related to the financing, cannot be listed or otherwise traded publicly, instead all transactions with the investor will be of a private nature. This feature makes

risk capital available to wide range of enterprises – not only for large companies, but also for medium, small and even micro-enterprises who are not able to offer their equities or debt publicly.

WHO ARE RISK CAPITAL INVESTORS?

You have probably heard about individuals, private equity or venture capital funds that are ready to invest in promising business opportunities on condition that an enterprise carrying this business meets certain requirements. In general risk capital investors can be divided into wealthy individuals or their representatives and incorporated investment funds, which are run by professional investment managers.

Business angels

According to risk capital terminology individuals who act as investors in privately held equities of enterprises are called “business angels”. Usually business angels are experienced businesspersons in their best age, most likely retired, who have deep knowledge about certain industry and have got free cash for investment. They prefer to invest in companies that operate in the industry of their interest.

Risk capital investment funds

Even though the vast majority of start-up businesses are financed by business angels, incorporated risk capital investment funds play very important role in the financing of enterprises ranging from early to mature stages of development. Risk capital funds are firms, which are created by professional investment managers and institutional investors such as pension funds, insurance companies, investment banks and others.

COMPARE RISK CAPITAL TO OTHER FINANCING SOURCES

RISK CAPITAL	BANK LOAN
Substance of the transaction (financing and support) differs from the legal form (potential or actual equity owner).	Legal form (loan contract) and substance (financing through loan) of transaction are the same.
Mid to long-term. In general term is flexible and can be renegotiated.	Short to long-term. In general term is fixed and has to be fitted.
No obligation for repayments strictly by schedule. Investor oriented to the performance of the business, free cash flow and equity related income.	Has legal rights to periodic interest payments and principal repayment.
Risk capital financing, generally requires certain share of your enterprise to be held by investor in order to protect his high risk in the case your company fails.	Loan does not require any participation in your enterprise by the loan provider.
Current cash flow can be reinvested into the enterprise to support future stronger cash flow to make good dividend payments.	Strong current cash flow needed to meet interest and principal payment requirements.
Investor is interested in success of the enterprise, so is eager to assist and support management actively in order to attain desired performance of a business.	Assistance and consultancy not always available. Usually considered for a seperate charge.
Tight partnership relations with risk capital investor. Investor is likely to have representative in the enterprise's board to provide continuous information exchange.	Mostly technical relationship with loan provider, periodic reporting and individual enterprise checks by the lender.
In the case of failure, investor is in the same situation as all other equity owners.	Lender does not share risk associated with your business. In the case of failure, demand loan repayment through collateral or liquidation.

HOW TO ATTRACT RISK CAPITAL TO MY BUSINESS?

Risk capital investors receive many proposals from different kinds of businesses to invest, but it is true that only several of them are actually financed. Investors are keen to select enterprises whose management has clear goals, thoroughly prepared realistic cash flow projection, carefully developed business plan and good communication and interaction skills. Thus before thinking about steps, which you have to take in order to attract risk capital investment into your business, try to clarify for yourself the following questions:

• Do you consider that your business have enough potential for rapid growth in competitive environment?

• Does your management team is strong enough and has necessary industry experience to develop your business successfully?

• Do you need to take mezzanine financing, which is subordinate to the other loans? Do you have suffcient free cash flow to cover this loan? Do you agree that this loan could be converted into the equities of your enterprise by the investor?

• In the case of pure equity financing, do you wish to sell part of your equity to risk capital investors, who will become co-owners of your business and will be actively involved in management process?

If you finally considered obtaining risk capital financing then you have to make thorough preparation before addressing the potential investor.

Intermediary organisations

If you do not have any experience in negotiating with investors or if you intend to structure a complicated transaction with risk capital investors, then it is recommended to use services of intermediary organisations. These organisations can perform consultancy, advisory, arrangement and other related services and make it easier for you to perform a risk capital transaction. As a matter of fact risk capitalists also can choose to use the services of intermediary organisations depending on the complexity of the transaction. Such intermediaries generally specialise in providing audit, accounting and legal services, which are very important in structuring risk capital transactions. Besides they can help you to identify list of risk capital funds, whose criteria you potentially meet and who actually meet your investment requirements. Further, intermediaries can play important role in such key stages of risk capital transaction as due diligence process, investment structuring, discrete and continuous monitoring and closing the investment.

RISK CAPITAL FINANCING STEP BY STEP

Usually risk capital investors have their investment schedules, which can be customized individually for enterprises in different stages of their development. Time for getting financing can last form 3 month (in rare cases less) up to 1 year or more depending on many factors.

Typical risk capital investment schedule

• Preliminary negotiations;

• Business plan consideration;

• Due diligence;

• Valuation;

• Financing;

• Closing the financing.

Business plan

As in many types of financing business plan plays important role for presenting your business to the potential investor. It clearly shows the investor how well do you know your business and what are your planning abilities. It is suggested that you have well prepared business plan, and keep in mind that the more track history your business has the more detailed should be business plan.

Due diligence

Due diligence is the process of investigation and evaluation, performed by investors, into details of a potential investment, such as an examination of operations and management and the verification of material facts.

For investor due diligence is very complex process, as here they access your business in details, check weather it is actually the case as is described in your business plan. Due diligence is usually carried out by parts comprising from operational due diligence, legal due diligence, accounting due diligence, technical due diligence and others if needed. Each of those parts are designed to provided comprehensive information for the investor which is keen to quantify the risks he will carry out while investing into your enterprise. During due diligence your investor also will perform legal analysis of possible cooperation between you, paying attention to the local legislation and the legal status of your enterprise and its owners.

Valuation

The next step investor will take is the valuation. Strictly, valuation answers the question “How much does your business cost?” and ”How much does investor have to pay in the case if he or she will acquire certain part of your equity?” As a financing seeker you are interest in high value of your enterprise, which will enable you to get more money from the investor, but investor will always tend to have more conservative view towards the value of your enterprise. The younger your business is the harder for the investor to perform a valuation, as you will probably not possess significant amount of tangible assets as well as intangibles, such as brands or some goodwill. Also you will not have a borrowing history, which could help investor to determine discount rates suitable for your business.

Structuring the investment

If you have already succeeded to this stage then the probability that you will get the financing is very high. Structuring the investment means defining the financial instruments that will be used in order to provide your business with necessary money on the one hand and to minimize the risks of your investor on the other. In this stage you will also define all the legal aspects of cooperation. Because risk capital can be in various forms, including loan and equity financing, financial instruments can also differ significantly.

The simplest risk capital transaction is when investor privately acquires part of your ordinary equity, which is not listed publicly, thus becoming minor owner of your enterprise. In this case investor seeks to support your business in order to share your profit for a certain period of time and afterwards sells its share in your business for a sum significantly exceeding the purchase value.

Monitoring and Managing

This stage is the longest one in terms of time and interaction with your risk capital investor. After you have structured the investment and performed risk capital transaction your investor will continuously monitor performance of your business. Risk capitalists usually assign one or more members in the board of your enterprise, who represent the interests of the investors and support your management team. You should remember that risk capital investors not only provide financing but also support in many cases related to your business. Their goal is the success of your business and growth of your enterprise in value. They are ready to do any supportive action in the frame of the transaction in order to fulfill this goal.

Closing the financing

Risk capital investors refer to this stage as “exit” or “divestment” which means closing the investment process and finishing the transaction with your enterprise. This stage is equally important for you and your investor and should be done carefully. The exit occurs as a final stage of risk capital financing process, where investor sells owned equities of your enterprise or gets back the principal and all accrued interests of the provided mezzanine loan and ends all legal relations with your business. The methods how you and risk capital investor can bring your relationship to the end vary and in general depend on the preliminary agreement between both of you.