The ‘small is beautiful’ cry has been heard frequently in British business over recent decades, and various initiatives have emerged to provide finance for smaller companies and start-up enterprises. Several of the more serious national daily papers regularly carry features on small businesses.
Bank loans and overdrafts traditionally provide the finance for businesses in their very early years and the stockmarket allows more mature companies to raise debt or equity capital. But between the two, it is argued, lies a financing gap. Businesses that are too large or too fast-growing to subsist on bank finance, yet too small to launch on the stockmarket, may be held back by lack of funds. In particular, smaller businesses find it very difficult to raise equity finance as opposed to loans.
We have seen, too, the phenomenon of the management buy-out or MBO. A group of managers within a large industrial company, say, decide that they would like to own the particular part of the business they run and to operate it as an independent entity. It may suit the large company to sell it to them if the division in question is peripheral to its main business. Alternatively, managers might put in a bid for parts of a business when the parent group has got into trouble and landed in the hands of the receiver.
Sometimes, too, an existing business is acquired with a view to putting in a new management team not previously associated with it who will have a stake in the operation (a management buy-in). A variation on this theme occurs when a new management team links with existing managers and employees to acquire the business. The name for this operation – buy-in management buy-out – may, we suspect, have been chosen mainly for its usual acronym of a BIMBO. Finally, in another variation, the managers of a listed company may decide they would like to run and part-own the whole of the enterprise they currently manage on behalf of the public shareholders by turning it back into an unlisted company in a public-to-private deal (see below).
But in all cases we have described, the managers themselves rarely have the money to acquire an established business and they require help in the form of outside equity and loan finance.
To satisfy these different financing needs, there has been rapid growth in venture capital funds: organizations that provide finance – sometimes a mixture of equity and loans, but often just one or the other – for unquoted companies. Because it is provided to finance unlisted companies, equity finance of this kind is often referred to as private equity. Many of the venture capital funds are offshoots of existing financial institutions: clearing or merchant banks, insurance companies or pension funds. Around the turn of the millennium there were over 120 full members and a roughly equal number of associate members (the latter including advisers and companies for which venture capital is not the principal business) of the British Venture Capital Association (BVCA), the umbrella body for these funds in the UK.
According to BVCA figures, the British venture capital industry has invested over £35 billion (of which £29 billion was in the UK) in around 19,000 companies since 1983. In 1999 alone a record £7.8 billion was invested. Since these figures represent mainly the equity element of the investment, which will generally be geared up with bank loans, the scale of total investment is considerably higher and funds committed to private equity now bear comparison with money raised for listed companies on the stock exchange.
The biggest venture capital organization in the UK, however, has a longer history than the BVCA. It is the 3i group (previously Investors in Industry), whose original venture capital arm was known as Industrial and Commercial Finance Corporation (ICFC) and was founded shortly after the last war. Originally wholly owned by the clearing banks and the Bank of England, but now with a stock exchange listing, it currently provides most forms of banking and finance service, other than overdrafts, and in 1999 had gross assets of around £5.25 billion. It has invested more than £10 billion in over 13,000 businesses during its life.
The typical venture capitalist puts up money for a growing business or to finance a management buy-out in return for a proportion of the share capital. Individual funds rarely want control of the companies they back, and where the funds required are large the financing may be syndicated among a number of venture capitalists. Each puts up part of the money and collectively they may control the enterprise they finance.
The original entrepreneurs, or the managers in the case of a buy-out, thus concede a large part of their ownership of the business in return for the money that they needed to buy it in the first place or the additional finance they need if it is to grow. Often their eventual stake in the business is geared to how well it performs (a ratchet arrangement). The venture capitalists usually want to cash in on their stake in successful businesses after five years or so and at this point will want an opportunity of selling the shares – a take-out – possibly via a stockmarket launch of the company. Alternatively, the company may seek a trade buyer: another company that is prepared to offer a good price for the business.
In the most successful buy-outs the managers who backed the venture may emerge as multi-millionaires within a relatively short period as the revamped business is floated on the market or sold to a trade buyer within a few years. If some of these ‘instant riches’ stories seem incomprehensible, just think how the gearing works when all goes well. Suppose the buy-out of a £100m business is financed with £20m of equity funds and £80m of debt. After three or four years, say, the business has prospered and is now worth £160m and the debt remains unchanged. Thus that £20m of original equity is now worth £80m. The venture capital investors are delighted and the managers – who may have paid relatively little for their original share stake – can be very rich indeed.
However, there are failures as well as successes in the management buy-out business, and the returns that venture capital funds seek are quite high – perhaps in the region of 30 per cent – to compensate them for such failures. While the participating venture capital fund (or funds grouped under a lead fund where the finance is syndicated) may provide only the equity portion of the money required, they will probably also organize the bank loans that complete the package. You might read in a description of a £10m buy-out that £3m of the money required was provided as equity by a venture capital fund and that the remaining £7m came from a bank loan.
With a large buy-out the structure could be more complex with, say, 30 per cent of the money coming as equity from venture capital funds, 60 per cent coming as senior debt from a consortium of banks and 10 per cent provided as mezzanine debt. This mezzanine layer is a form of halfway house between debt and equity: debt offering a high return which may also include some rights to share in equity values. The ratio between debt and equity will vary with market conditions. In a recession where business confidence is low the proportion of equity may need to rise as the banks will be less willing to take risk. Be a little careful, too, when you read that 30 per cent of the money for a buy-out was provided as equity. The term is used in a somewhat loose sense in the buy-out world. It is unlikely in practice that all of this 30 per cent was subscribed as ordinary capital. For structural and taxation reasons it is more likely to have been provided by the venture capitalists as a mixture of ordinary share capital and preference capital or subordinated loans. It is, however, all risk money.
Most of the major venture capital funds do not consider it worth investigating a financing proposal unless the sums involved are quite large and they are generally wary of business start-ups (entirely new businesses) where the risk is highest. Occasionally, however, a venture capitalist might be prepared to provide some seedcorn capital to see a new project through its very early stages. In general, venture capitalists prefer to provide money to buy an existing business or development finance for companies that are already past the initial stage and need more equity if they are to advance to a bigger league. The same is generally true of another type of fund providing capital for unquoted companies – the Enterprise Investment Scheme fund – although these funds will sometimes provide finance in smaller quantities.
Leveraged buy-outs and leveraged takeovers were very popular in the United States in the late 1980s. Fortunately, perhaps, the principle spread rather late to Britain, just as America was beginning to worry about some of the consequences around the turn of that decade. ‘Leveraged’ simply means ‘geared up’ in British terminology.
As we have seen, most buy-outs and buy-ins are geared or leveraged to some extent in that bank loans are used as well as equity capital. But the term leveraged buy-out or public-to-private deal is used particularly to describe an operation where an investor group, using mainly borrowed money, makes a public takeover bid for a listed company with a view to taking it private. The amount of equity finance used may be very small. Typically, the debt portion will be in several layers: senior debt which is reasonably well secured, some intermediate layers and perhaps an issue of high-yielding high-risk junk bonds (see Chapter 10, and below).
A company acquired by way of a leveraged bid (80 per cent and sometimes a lot more of the finance may be in the form of debt) finds that interest charges absorb most of its profits and it is probably under pressure to dispose of parts of its business to raise cash to reduce its borrowings as rapidly as possible. Leveraged buy-outs are a very high-risk game whose dangers become more apparent when economic activity turns down, the cost of servicing bank debt rises and it becomes impossible to raise cash by selling parts of the business at acceptable prices. The biggest leveraged operation of the late 1980s was the $25 billion buy-out of food and tobacco group RJR Nabisco in the United States. It turned out to be less than an unqualified success.
The biggest attempted leveraged bid for a UK company – Sir James Goldsmith’s 1989 attempt to acquire and break up the BATS tobacco-to-financial-services group – was eventually abandoned in the face of regulatory hurdles in the United States and lack of enthusiasm in the UK. Experience with leveraged bids for UK listed companies that did go through was far from reassuring, as we saw in the previous chapter. But there was, nonetheless, a resurgence of this type of activity in the UK in the late 1990s and high-yielding (not to say junk!) bonds sometimes played an important part in the financing. Industry watchers shook their heads at the high prices paid and the financing methods used, and predicted trouble if economic activity turned down.
Of the tax-favoured schemes to encourage investment in growing businesses, the Enterprise Investment Scheme (or EIS) has the longest history. It is a replacement for the earlier Business Expansion Scheme (or BES), which itself first saw the light of day in 1981 as the Business Start-up Scheme.
The idea is to encourage higher-earning individuals to subscribe for new ‘full risk’ ordinary shares in private trading companies. Anyone with a sufficiently high income can gain income tax relief on up to £150,000 a year invested in this way. But the income tax relief is not at the higher rate and the shares must normally be retained for at least five years to gain the full relief. If the investor holds the shares for the qualifying period he would not normally pay capital gains tax on any profit, while losses he makes (less the original tax relief) would be offsettable against taxable income or against gains elsewhere for capital gains tax purposes. The scheme also offers some rollover capital gains tax reliefs for investors who put the proceeds of another profitable investment into an EIS investment or who cash in on one EIS holding and reinvest in another.
Those who are already directors or employees of a company cannot qualify for tax relief under the EIS when they invest in that company – the idea is to bring in new money from outside rather than give tax relief to those who may already have an interest. But there are provisions to allow business angels to invest in a private company and benefit from the EIS, provided they were not already connected with it. These ‘angels’ are individuals who want to invest in a company and also have something to offer by way of business expertise. They may both invest and become paid directors.
As far as the company is concerned, to rank for the EIS it must carry out, normally for at least three years, a qualifying activity. This broadly rules out a number of financial and investment activities and dealing in securities or property, plus the investment in rented residential property that had been allowed under the BES. The company must not be listed on the stock exchange though it may be traded on the AIM market. The new ordinary shares it issues to EIS investors must not have any preferential rights.
How does the prospective EIS investor locate a suitable company? Ideally he would know of one from his personal experience. In practice, many investors will invest via the medium of an EIS fund: a fund set up to invest in a range of qualifying companies. The investor still receives his tax relief and has the advantage of a spread of risk and more or less professional management. Unfortunately, as with many tax-favoured investments, things are not always as rosy as they seem. Investment in unquoted companies, direct or through a fund, carries a fair degree of risk. And there is a danger, as with any form of subsidy, that the price charged for the product rises to take some account of the tax relief available to the buyer.
Another tax-favoured investment vehicle designed to encourage risk investment in private businesses is the venture capital trust. A venture capital trust needs to hold at least 70 per cent of its investments in unquoted trading companies: broadly, the same sort of company as would qualify for EIS investment. Not more than 15 per cent may be in any one company. But the trust is not limited to investing in equity. Up to half of its investment in qualifying companies can be in the form of loans with at least five years to run. If the companies in which it invests subsequently float on the stock market, the trust can count them as unquoted for a further five years.
The venture capital trust itself is much like an ordinary investment trust and must be quoted on the stock exchange. Within prescribed limits – investment of £100,000 in a year – investors in the trust pay no tax on dividends received or on capital gains arising on disposals of investments. Probably more significant, if subscribing for new shares issued by a venture capital trust the investor receives tax incentives similar to those for the EIS.
Given the costs of researching investments in smaller, unquoted companies, venture capital trusts are generally set up under the auspices of existing venture capital organizations or fund management groups rather than as stand-alone operations. There were around 45 of them in the year 2000 and the British Venture Capital Association reckoned that they had raised funds of over £900m in total at that point.
Another government initiative was aimed at helping small companies that had found it difficult to borrow money from normal banking sources, often because neither the company nor its founders could provide the security considered necessary for a loan. Most owners of small companies which want to borrow money are required to offer their houses and other assets as security for the debts of the business.
The scheme – the government small firms Loan Guarantee Scheme or LGS – does not itself provide money for businesses but it removes part of the risk for traditional lenders. A bank can advance a loan of up to £250,000 to an existing small business or £100,000 to a new business starting up, secured on the assets of the business but without personal guarantees from the owners. The bank charges its normal interest rate plus a premium of one-and-a-half percentage points on the loan (or half a percentage point if the rate of interest is fixed), which goes to the government to provide the guarantee element. In return, 70 per cent (or 85 per cent for loans to existing businesses) of the value of the loan is covered by the government guarantee. Businesses in qualifying inner-city renewal areas receive broadly the terms applying to established businesses, even if they are start-ups, and the interest rate is also lower. If the business goes to the wall and the whole of the loan is lost, the government reimburses the lending bank 70 per cent or 85 per cent of its advance.
The LGS has undoubtedly helped some businesses that would not otherwise have got off the ground. Its terms have been frequently amended since it was first established in 1981. The main disadvantage of the LGS is that it supplies loan finance in circumstances where equity is often what is needed, with the result that the business becomes excessively highly geared, which may hasten its demise. Failures among companies taking advantage of the scheme were high in the early years.
The British Venture Capital Association is the representative body for UK providers of venture and development capital. Its website at www.bvca.co.uk/ provides some statistical background to the business and some information on the Enterprise Investment Scheme and on venture capital trusts. It also provides pointers for entrepreneurs towards venture capital sources of finance and business angels. For small and medium-sized businesses looking for sources of financial advice or help, the Department of Trade and Industry website at www.dti.gov.uk/ provides a fair bit of information and also links to other sources. Among related sites offering help or information in the same areas are those of Business Link at www.businesslink.co.uk/ and the Enterprise Zone at www.enterprisezone.org.uk/. Details of the Small Firms Loan Guarantee Scheme are available on the DTI site at the address www.dti.gov.uk/support/sflgs.htm. There are also a number of individual websites offering to put (mainly high-tech) entrepreneurs in touch with sources of finance.