Venture capital: what funds look for and the terms they set

How a venture fund works

A venture capital fund raises money from institutions and wealthy investors, known as its limited partners. A team of investment partners then invests that money in private companies in exchange for shares. The fund is set up for a fixed life, written into its partnership agreement. It invests in its early years, backs its companies through later rounds, and has to sell its stakes and return the money to its own investors before the fund ends.

That structure decides what a venture investor wants from you. Some of the companies a fund backs will fail. The fund needs the ones that succeed to return many times what it put in, enough to cover the failures and give its own investors a return. So a venture investor looks for a company that could be sold or listed for a very large sum, and will back a plan that spends heavily now to grow toward it.

Venture rounds are named by stage. A pre-seed or seed round pays for a product and the first customers. A Series A round pays to build a repeatable way of winning customers, and Series B and later rounds pay to scale that up, often into other countries. Each round is priced at a new valuation, and each one dilutes the earlier shareholders.

A company with modest growth plans, steady profits, or founders who want to keep control may find a closer fit with angels, growth capital, a family office or borrowing.

What a venture investor looks for

The first test is the size of the prize. A venture investor asks how large the company could become if things go well, and whether the market is big enough to support that. A profitable company in a small niche can fall outside what a venture fund invests in.

The second is the team: whether the founders know the market, can hire, can sell, and have the stamina for years of growth. The third is evidence. Before revenue, that is a product people use and come back to. After revenue, it is growth, customers who stay, and the margin on each sale.

Investors also look at how far the money will take you. A round should pay for the milestones that let the company raise its next round at a higher valuation, and the forecast should show when the money runs out if sales come in below plan.

A market large enough for a very large company
A team that can build, hire and sell
Evidence that customers want the product
A plan that reaches the next milestone on this round’s money

The terms in a venture term sheet

Valuation: The pre-money valuation, which with the amount invested sets the fund’s percentage. Check whether a new option pool is counted inside it.
Preference shares: A separate class of share carrying the fund’s extra rights. EIS investors in the same round need ordinary shares.
Liquidation preference: The fund’s right to its money back, or a multiple of it, before ordinary shareholders on a sale or winding up. Non-participating means the fund takes the preference or its percentage, whichever is larger. Participating means it takes both.
Anti-dilution: Protection if a later round is priced lower. A weighted average formula gives the fund some extra shares. A full ratchet reprices its whole investment at the lower price and costs the founders far more.
Board seat: A director appointed by the fund, and sometimes an independent chair agreed by both sides.
Investor consents: Decisions that need the fund’s approval, such as new share issues, borrowing, the annual budget, acquisitions and selling the company.
Drag-along and tag-along: Drag lets holders of an agreed majority make the others sell on the same terms. Tag lets minority holders join a sale on the terms the majority gets.
Founder vesting and leaver terms: Founder shares the company can buy back if a founder leaves early, at a price that depends on whether they are a good leaver or a bad leaver.
Exclusivity: A period in which you agree to stop talking to other investors while the fund completes its checks. This clause binds you.

How a liquidation preference splits a sale

Illustrative example

A venture fund invests £4,000,000 at an assumed pre-money valuation of £12,000,000, so it owns 25% after the round, through preference shares with a 1x non-participating liquidation preference. The company is later sold for £10,000,000.

The fund’s preference: its money back: £4,000,000
The fund’s 25% if it took its share as an ordinary holder: £2,500,000
The fund takes the larger amount: £4,000,000
Left for the holders of the other 75%: £6,000,000
With a participating preference instead, the fund takes £4,000,000 plus 25% of the £6,000,000 left: £5,500,000
Left for founders and other holders with a participating preference: £4,500,000

At a sale price of £30,000,000 the fund’s 25% is £7,500,000, more than its £4,000,000 preference, so a non-participating fund takes £7,500,000 and the other shareholders share £22,500,000. The preference decides the split when the company sells for less than the investors hoped.

From first meeting to completion

1
First meetings
A partner or associate meets the founders and reviews the deck and the numbers. If they are interested, the founders pitch to the full partnership.
2
Term sheet
The fund offers a term sheet. Negotiate it with a lawyer who acts on venture rounds, because its terms carry into every later round.
3
Due diligence
The fund, its lawyers and its accountants check the finances, the legal position, the market and the technology.
4
Completion
Everyone signs the subscription agreement, new articles and shareholders’ agreement. The fund pays, and the company issues the shares and files form SH01 within one month.

The due diligence a venture fund runs

The accountants rebuild your numbers from the source: the statutory accounts, the monthly management accounts, the forecast, bank statements, the tax position including VAT and payroll, and the compliance from any earlier seed scheme or EIS round. Differences between the pitch deck and the accounts are the first thing they look for.

The lawyers check that the company owns what it says it owns. That means the share register and every allotment filed at Companies House, intellectual property assigned to the company by founders, staff and contractors, employment contracts, the main customer and supplier contracts, any borrowing and the charges securing it, and any disputes.

The commercial checks test the forecast against the market. The fund talks to customers, to people who know the sector, and sometimes to former staff, and compares what they say with the sales the plan assumes.

The company answers through a disclosure letter, which lists the exceptions to the warranties in the subscription agreement. A complete data room before the term sheet arrives means fewer requests at this stage, and getting investor ready lists what goes in it. A fund may also ask for insurance on the founders’ lives or health, which business protection covers.

Questions people ask

What is the difference between venture capital and private equity?

Venture capital buys minority stakes in young companies that are growing, accepting that some will fail. Private equity buys majority stakes in established, profitable companies, often funding part of the price with borrowing, then aims to improve them and sell. A buyout of a business by its own managers with a private equity backer is a typical private equity deal; see management buyout finance.

How much equity do venture capitalists take?

The stake is the amount invested divided by the post-money valuation. A fund investing £3 million at a £9 million pre-money valuation owns £3 million ÷ £12 million, or 25%. Both figures are negotiated, and an option pool created as part of the round reduces the founders’ share further. How much equity to give away works through several rounds.

Do venture capitalists take control of my company?

A single venture fund normally holds a minority stake, but its influence comes from the rights in the term sheet: a board seat, a veto over major decisions, and drag-along rights on a sale. After several rounds the investors together can own more than the founders. Read the board composition and the consent list as carefully as the valuation.

What is a liquidation preference?

The right of a preference shareholder to be paid first when the company is sold or wound up. A 1x non-participating preference returns the investor’s money, or their percentage of the proceeds if that is larger. A participating preference returns the money and then a percentage of what is left. On a £10 million sale, a fund with £4 million in for 25% takes £4 million under the first and £5.5 million under the second.

Can a venture capital round qualify for EIS?

Preference shares carrying a right to be paid first on a winding up cannot qualify, because EIS shares must be ordinary shares with no such right and no right of redemption. A round can still mix the two: the venture fund takes preference shares and EIS investors in the same round take ordinary shares. Some venture funds are themselves EIS funds and invest in ordinary shares only.

What happens if my company misses its plan after venture investment?

The board, which includes the fund’s director, will look at costs, the forecast and the money left. If the company needs more cash at a lower valuation, the anti-dilution terms give the earlier investors extra shares, which dilutes the founders further. The consent rights also give the fund a say over borrowing or a sale. Founders who leave in this period face the leaver terms on their shares.

Finance is subject to status and to the lender’s terms. A personal guarantee makes you liable for the company’s debt if it does not repay, and it can be enforced against your own assets, including your home. Nothing here is a personal recommendation.

Venture capital

How a venture fund works

What a venture investor looks for

The terms in a venture term sheet

How a liquidation preference splits a sale

From first meeting to completion

First meetings

Term sheet

Due diligence

Completion

The due diligence a venture fund runs

Questions people ask

Equity investment

Growth capital

How much equity should I give away?

Getting investor ready

Equity investment

Venture capital

How a venture fund works

What a venture investor looks for

The terms in a venture term sheet

How a liquidation preference splits a sale

From first meeting to completion

First meetings

Term sheet

Due diligence

Completion

The due diligence a venture fund runs

Questions people ask

Equity investment

Growth capital

How much equity should I give away?

Getting investor ready

Equity investment

Start a funding search

Cover for a personal guarantee