What do venture capitalists look for look for?

(14/01/2004) Previous Page

What do venture capitalists look for look for in a venture capital deal? – first things first

As with everyone else involved in the deal, the investor will place a great deal of importance on the quality of your initial business plan and the first meeting with your management team. To increase your chances of success, consider the many questions that an investor or bank will ask itself. In any deal, the investor/bank will first want to know the answers to the following basic questions:

What does the company do?
What is the loan for?
Who is the borrowing entity, and what assets do they need to consider?
What is the size of the loan, and how does it fit in with existing credit approval limits?
If the bank is an overseas bank, does it need to go to a foreign head office for final approval, and what implications will this have for the management team?
Will the head office in the foreign country have the same view on the sector as the domestic banking team
In a highly leveraged transaction such as an MBO, does the bank need to focus on cash flow reliability, or does it also need to consider the quality of assets available for mortgage?
Are there two ways out?
If one aspect of the business on which the bank is relying fails, is there an alternative source of recovery for the bank? What is the term of the loan?
Is there an existing loan structure that needs to be considered?
Are there any legal or structuring issues to be considered such as legal jurisdiction, debt subordination, availability of credit support, cash deposits or guarantees?
Are there any issues for the bank in terms of reputation or sector experience?
Is this a sector of the market that the bank wishes to avoid?
Does the bank have specialist expertise or dedicated deal teams for this sector?
Does the bank need to consider its own sector exposure limits?
Does the bank adopt a portfolio approach to the sector and can this deal be accommodated within the particular portfolio limit? Management teams should seek an answer to this question very early in the assessment process to avoid frustrating time delays in their search for finance.
Does the bank have any existing views on the business, the industry, the proposed management team or the ownership structure and entities involved? Does the reward for the bank reflect the risk it is taking and are there any other business opportunities available to other areas of the bank?
management, management, management.

Let there be no doubt: deal decisions start and stop on the quality of the management team.

In most highly leveraged transactions, over half of a bank's decision to proceed is based on its assessment of the management team. Few leveraged transactions are fully asset-backed, so banks need to be sure the operating performance capability of the business can be relied upon. They will always prefer a good management team with a bad business over a bad management team with a good business. Remember, banks are primarily interested in recovering their money over a set time period.

Management buy-outs are viewed as less risky than buy-ins, simply because the management team knows the business inside out, understands the personalities inside and outside the business, knows the industry, is generally aware of what their competitors are up to and has a strong view of the market opportunity.

Regardless of the quality of any team buying into a business, there will be a steep learning curve in understanding the business quickly enough to drive it forward without distraction. Many banks now prefer BIMBOs (Buy In Management Buy Outs) where new blood is injected into an existing management team to either provide additional management impetus or fill a perceived weakness in the team.

So how does a bank assess a management team?

This is based more on industry experience and commercial intuition than step-by-step checklists. The more a bank knows about the background of the management team, the better it is able to make an informed judgement. Banks look for experience relevant to the business where the necessary skills have been previously demonstrated.

Integrity and honesty are extremely important, and any black marks in this regard normally proving fatal. The bank wants to know that if the business gets into trouble, the management team will be honest and communicative. Banks generally undertake thorough due diligence on the management team, but there is no substitute for meeting the team and asking some searching questions to gain a thorough understanding of their expertise, knowledge, trustworthiness and leadership qualities. These meetings are critical and should never be approached lightly or under-prepared.

Banks will also assess the structure of the management team. Are there any weaknesses, or gaps that need filling? Banks generally do not like to be overly reliant on one person, looking instead for strong leaders and an able support team. If there is reliance on certain individuals,is there a succession planning strategy in place? Banks like to see the team looking to grow over time.

Banks also like to see management teams demonstrate their motivation and commitment. The best way to please a bank is for the management team to invest a serious amount of "hurt money" into the business. This amount can vary depending on the net worth of the respective team members. Banks like to see that management won't simply walk away unscathed if the business gets into trouble.

Risk analysis

Banks need to undertake a comprehensive analysis of the risks to understand whether or not to proceed. The principal areas of risk assessment concern business risks, market risks, management risks and financial risks.

The bank wants to know what would be the most likely cause of your business failing, and what are the chances of it happening. This involves identifying all the risks applicable to the business and then discarding those that are not considered significant or are covered by either the business strategy or the deal structure.

If there are key risks, the bank will need to understand what the principal mitigating factors are. These may be as narrow as a well-constructed banking covenant in the loan agreement or as broad as the industry expertise of the management team. Again, as banks principally rely upon cash flows for debt recovery from a leveraged transaction, identification of risks is critical to the ultimate decision.

Financial strength

After deciding on the quality of management, the bank will next turn its attention to the reliability of cash flows. Management teams can make this process easier by understanding the sort of analysis the bank undertakes. The bank will want to see:

Financial statements for the past three years, including detailed balance sheets, profit & loss statements and cash flow schedules. These will help the bank understand the underlying trends of the business and how they can be projected forward. Information on the causes of major peaks or troughs in past performance is also important. Banks also like details of the performance of the business during the last downturn in the business cycle, to see how the business performed and how it may prevent a similar downturn in performance in the future .
Projections of financial statements for the newly formed company for the term of the loan period, which may be for three to seven years.
A list of the key assumptions underpinning the projections. This may include the awarding of new contracts, rates of growth, rates of inflation, interest rates, asset sales, strategic acquisitions, foreign currency movements, capital expenditure requirements, industry growth forecasts, market share projections and business expansion plans. If a professional adviser is helping the management team prepare these projections, an indicative deal structure will often be built in. This may include increased interest margins, debt repayment schedules, dividend payments to equity providers, repayment programmes for subordinated debt packages such as mezzanine finance, interim loan drawdowns, additional equity injections and possibly even repayment moratoriums.
Comprehensive information on the industry including industry structure, growth trends, competition and principal influences. Banks will assess this information in relation to the company's projections through the outlook period.

Banks derive significant comfort from reviewing information which has been verified by an independent authority. It may be a due diligence report commissioned by the banks from a chartered accounting firm which investigates and tests the robustness of the financial projections, the sensitivities applied in the models, the assumptions behind the projections, breakeven analyses, customer and supplier references, asset valuations and pensions. It also may test various scenarios requested by the banks to determine worst-case and best-case scenarios. Banks may want to know what happens to cash flow when the business is indecline - for example, if the debt is used for working capital management in a distribution business, a decline in revenues may actually throw off cash for use in debt reduction.

Other independent reports which may be commissioned include commercial market reports, environmental reports, insurance due diligence reports, property and business valuations reports and country-specific economic and industry reports. All of these reports help banks understand the key risks and the reliability of cash flows.

Deal structure

Banks focus on three principal areas when assessing the deal structure behind a venture capital transaction

Banking covenants

Banks like to set covenants tightly against the performance projections of the company. This is to ensure they receive early notice of any downturn in the business and then have the legal right to alter or fine-tune their stance in the deal. Covenants set too far below projections are often deemed to be "loose" because they do not allow the bank to act as early as they would like to protect their loan asset. Covenants include working capital ratios, gearing ratios and pre-determined levels of profitability, cash flow, debt servicing and shareholders funds.

Banks also like to introduce drawdown restrictions to ensure deficits or obligations such as dividends and mezzanine payments are not being funded by senior loan drawdowns. It also lets the bank place a cap on any further increases in its exposure.

Security

Banks want to know early on the extent of their rights to secured assets, if any. This assessment is not limited to the identification and valuation of available assets. It may also involve clarifying the priority ranking of the various funders to the transaction. For example, senior debt providers will want to be ranked above high yield bond holders and mezzanine finance providers, who in turn would want to be above pure equity providers.

Issues opposite equity providers

Banks will also assess their position opposite the equity providers to the transaction. While both the banks and the venture capitalists provide the necessary finance to operate the business, they are often very different in the way they seek to protect their own vested interests. This is again because banks primarily want to protect and recover their loan asset, while venture capitalists have an unsecured position and want to see progressive growth in the value of their investment.

For example, the bank will want to negotiate various covenants which will allow it to take corrective action - such as demanding a further equity injection or even instigating a receivership - to limit its exposure and protect its asset if performance declines. However, the venture capitalist will argue against these powers because the only chance it has of realising its investment and achieving a return is to continue to operate the business until performance is restored or it can seek a buyer. Points negotiated between banks and venture capitalists can include covenant setting, legal rights to take action, restrictions on the payment of dividends, various management warranties granting rights to equity contributors and legal rights of recovery.

Venture capitalists and banks will also discuss the level of debt to be contributed by the bank. The higher the debt contribution, the less investment is required by the venture capitalist and the higher the resulting return on their investment. However, banks will only contribute an amount which sits comfortably within their debt-servicing and gearing parameters. If the venture capitalist has over-paid for the company or is unwilling to provide sufficient equity funding, a funding gap arises. Quite often a mezzanine finance provider is used in this instance.