THE PRACTICALITIES OF VENTURE CAPITAL AND PRIVATE EQUITY – BY DAVID ANDERSON AND SHAHID SULAIMAN
It is an open secret that there is much scope in South Africa for an increase in the funding of business ventures through venture capital and private equity (“venture funding”). This can be attributed to a cautious market approach on the part of suppliers of venture funding. The experience of capital providers in the past several years indicates that an upswing can be expected in the availability of venture funding in the foreseeable future. In addition, venture funding seems eminently suitable for the purpose of realising certain of the black economic empowerment objectives required of businesses in terms of South African legislation.
As with any business venture, the availability of venture funding relies in the first instance on the soundness and viability of the business requiring such funding. A business will improve its chances of obtaining venture funding by developing a thorough and convincing business plan and using this as a basis for applications for venture funding. Due to the risks involved, capital providers search out businesses that have the potential to generate above average returns. There is no limitation on the amount of the investment that capital providers are prepared to make and investments could vary from R500,000 to many millions of rands, depending on the needs of the business.Once a decision has been made to obtain venture funding, it is important to know where and how to obtain such funding. In South Africa, the provision of venture funding is largely unregulated. A certain amount of self-regulation has been introduced by the formation of the SA Venture Capital and Private Equity Association (“SAVCA”). A list of capital providers affiliated to SAVCA is available on the SAVCA website and a directory of organisations providing venture funding can be obtained from Wesgro. On the state level, venture funding is also available from the Industrial Development Corporation.On receiving an application for venture funding, a capital provider will assess the business to establish whether it meets the criteria set by the capital provider. This includes an analysis of the business and its viability, the potential of the business to generate above average returns, the risk profile of the business, and may also involve a more thorough due diligence investigation particularly if the initial investigation is promising. The persons running the business can also expect to be the subject of analysis.If the assessment is positive and funds are available, venture funding will be provided.
Capital providers generally get involved in a business through the acquisition of a shareholding and capital is provided through a combination of debt and equity capital. The advancing of venture funding may also be subject to fairly complicated arrangements relating to the stages of the development of the business. For example, different classes of debt and equity capital may be utilised and may be redeemed or converted by reference to performance milestones. As shareholders, capital providers usually have some involvement in the management and daily operation of the business at board level, and the business benefits not only from the capital injection provided by the capital provider, but also from the expertise of the capital provider in developing businesses. It is important for a business to be comfortable with the ability and expertise of the capital provider.
Since venture funding brings into being complex legal relationships, it is critical that the rights and obligations of the parties are clearly outlined. Capital providers generally provide funding on the basis that they will be involved in the business for a limited period of time, usually ranging from three to seven years. An appropriate exit strategy (which may involve listing the company on the JSE) must be put in place to ensure not only that the capital provider is able to recover its investment along with projected returns, but also that the viability and operation of the business are not affected by the capital provider’s departure. These and other issues may be addressed through a shareholders’ agreement (which can take the form of an investment agreement).
A shareholders’ agreement regulates the relationship between the capital provider and the owners of the business and deals with the acquisition and sale of shares, the declaration of dividends, the acquisition and repayment of loan capital, the exit of the capital provider, the role of the shareholders in the management of the business, and the decision-making process. The warranties and indemnities required by capital providers are often extensive and any breach may have serious repercussions for the owners of the business. Additionally, to protect their investment, capital providers inevitably require the owners and key management of the business to give comprehensive non-compete undertakings.
Specialist law firms are mandated to draft and negotiate shareholders’ agreements. Besides drafting the shareholders’ agreement, law firms will advise on methods of structuring the transaction, the capital gains tax implications arising when the capital provider decides to terminate the arrangement, in addition to the relevant aspects of competition law which may require the parties to notify the competition commission when entering into a venture funding transaction or on the exit of the capital provider. Law firms will also advise on other matters of relevance, such as methods of finance and how best to protect the interests of the party for whom the law firm acts.