Private equity (PE) funding is a general term for investments in private businesses - usually financed from a fund set up by big institutional investment companies.

Venture capital (VC) companies draw on private equity funds to invest in new businesses with high growth potential, eg technology start-ups. In exchange, they take part of the business' ownership, making a profit when they sell their stake and exit the company. VC's typically invest in businesses with:

• a minimum investment need of around £2 million, though smaller regional VC organisations may invest from £250,000
• an ambitious but realistic business plan
• a product or service that offers a unique selling point or other competitive advantage
• a large earning potential and a high return on investment within a specific timeframe, eg five years
• sound management expertise - although VCs tend not to get involved in the day-to-day running of the business, they often help with a business' strategy

Business angel investments are another form of PE investment, where wealthy individuals use their own money to invest in small companies with growth prospects - see business angels.

The BVCA provides further guidance on venture capital.

Types of PE funds

Many PE funds specialise in a geographical area or industrial sector, while a few serve general investment purposes. PE funds usually have an initial lifespan of ten or more years.

There are four main types of PE funds:

• Independent funds - the most common form of PE fund. Their capital is supplied by third parties, with no one party holding a majority stake.
• Captive funds - have one major shareholder, contributing most of the capital. A captive fund can be a subsidiary of a bank or an insurance company, or an industrial company looking to invest in its own sector.
• Semi-captive funds - have a majority shareholder, but also significant minority shareholders. They can be subsidiaries of financial institutions or run as separate companies.
• Public sector funds are made up of capital supplied partly or completely by the public sector.

Find out more about private equity.

Most companies seeking venture capital (VC) private equity (PE) investment are start-ups, or new businesses offering investors a potentially high return.

Common uses of PE funding include:

• launching a new product
• exporting goods or services to new markets
• recruiting senior employees
• selling part or all of a business
• taking over another business

How entrepreneurs can attract private equity investment

Most entrepreneurs will need some form of private equity investment to launch their businesses. To attract interest from PE funds, you must be prepared to:

• make sure the business is well organised
• assemble a talented and loyal team
• give up part of your business to investors
• have ambitious growth plans
• share important decisions with major shareholders
• prove your business has a competitive advantage over your rivals
• agree an effective exit strategy for investors

Find the right kind of private equity funding

There are various forms of PE funding for different phases of a company's development, eg:

• Seed financing - funding while you research and develop a project or concept until you are ready to launch a company. This form of PE is mainly provided by business angels - see business angels.
• Start-up financing - to help you develop a product and begin marketing it. This sort of funding is often based on your business plan and VC investors may often join your company to help bring the product to market.
• Post-creation funding - capital used to finance manufacturing a product and a sales drive, so your company can begin to make profits.
• Expansion and development - investment is used to increase production capacity and sales activity, for companies growing strongly.

Transfer or succession funding

Transfer or succession funding is a form of VC investment used to finance management buy-outs or buy-ins - eg after the retirement of a company's founder or chief executive officer.

It can also be used when:

• a large company sells off a business unit
• investors buy shares in a family firm
• investors from earlier stages of a company's development exit the business

VC fund managers attract transfer funding by creating a holding company - using it to seek funds, in the form of debt, to buy the target business. Once this has been done, they use the target business' dividends to pay off the debt.

Alternatives to private equity funding

You may find that other forms of funding are better for your business than VC funding such as loans and overdrafts or government support - see business financing options - an overview.

Before deciding on venture capital funding, you should consider the possible benefits and drawbacks.

Advantages of venture capital

Raising money through venture capital can have many benefits, including:

• Access to larger amounts of funding - typically over £250,000.
• No monthly repayments - as a venture capital company invests for equity, monthly repayments are not required which ensures working capital is available for your business.
• Expert business management support - most venture capital companies have relevant previous experience so you can benefit from expert advice and problem solving abilities.
• Networking opportunities - venture capital organisations have many connections, including other start-ups and businesses.
• Possibility of future funding - venture capital companies are keen to see your business raise additional funds as it increases the return on their investment.

Disadvantages of venture capital

There are also potential drawbacks to venture capital, including:

• Risk of losing business - if your business underperforms, investors may pull out of your agreement.
• Reduction of ownership - especially if additional rounds of funding are required, founders can gradually lose more equity, their decision-making abilities and control of the company.
• Attention diverted from the day-to-day running of the business - a lot of time has to be put into raising funds and ensuring the business meets the venture capital organisation’s standards.
• It can be difficult to get approved - venture capital businesses will need to see that your business is suitable by accessing your business plan, financial forecasts and other documents as part of their due diligence.
• Expensive process - you may notice the cost of the equity when the business is sold as your shareholders will have a right to a certain percentage of the business.

Before you approach a venture capital (VC) organisation, you should research what sort of private equity (PE) funding would be best for your business needs. Different types of investment - eg seed funding, product development and succession funding - are suitable for different stages of business development.

When choosing a VC fund, look for:

• funds targeting your business sector
• investment criteria
• quality of advice and support provided by investors
• amount of finance - some PE firms specialise in investments below £100,000
• geographical location of PE investors and how near they are to your company

The British Private Equity and Venture Capital Association (BVCA) publishes an annual report on private equity investment and you may find that this is a useful research tool.

Search the BVCA directory of members (registration required).

Matching investment criteria

VC managers will invest only in companies that match their investment criteria. You should carefully check this before making an approach. You should also make sure that your business plan is up-to-date with detailed financial forecasts tailored to the investor concerned.

Business plans are used by investment managers to assess:

• your business' funding needs
• whether your plans for the business are achievable
• whether you need external investment

See write a business plan: step-by-step and tailor your business plan to secure funding.

Making your business investment ready

Your business also needs to be investment ready, which means providing:

• audited accounts for the past two years
• evidence of current performance
• profit-and-loss forecast for next year
• business bank statements for the past six months
• profiles of each partner or director in your business

See secure equity investment.

Data confidentiality

Once a VC investor firm has shown interest in your outline proposals, you can prepare a letter of confidentiality. This should be signed both by your business and the potential investors before you send them your full business plan.

Negotiations for investment with a private equity venture capital (VC) business can last up to a year, and follow several key stages, from presenting your business plan to final negotiations and sign-off for the investment agreement.

Special advisers

Most companies seeking VC funding employ specialists to advise them on the various stages of the negotiation process. They can include:

• accountants - who can help you draw up and review your business plan
• legal and tax advisers - for legal planning and fiscal aspects of the deal

Six stages of a venture capital investment deal

1. Presenting your business plan

Use your first meetings to try to decide whether you would feel comfortable working with the investors long term. You should also research the fund's investment performance with similar companies, and how it operates.

After you present your business plan, the investor will decline your proposal, request more information, or ask for another meeting.

2. Initial negotiations

If they are happy with your outline proposals, the fund managers may offer you an initial memorandum. This is a programme of further negotiations, based on your business plan.

3. Company valuations

Price negotiations centre on the amount of equity you are prepared to give up in exchange for investment. The agreed price forms the basis of the fund's return on investment.

Both you and your potential investors can use analytical tools to determine values.

Common valuation tools include:

• measuring discounted cashflows - comparing positive cashflows with risk-free investments such as a government bond, and building in a risk factor 'discount'
• comparing your company to similar companies - eg in terms of profit, cashflow and turnover
• opportunity cost analysis - comparing the likely profitability of your proposal with that of investments with similar risks

4. Offer letter

After agreeing a valuation, the fund will give you an offer letter, detailing its proposed investment. The document summarises the interim terms of the deal, subject to due diligence. Once you have accepted the letter, due diligence and final negotiations can take place.

5. Due diligence

Fund managers must ensure they have exercised due diligence before they invest in your company. This involves audits by lawyers and other consultants of both your company and your proposal.

6. Final negotiations

During final negotiations, the terms of the deal are agreed and signed off.

At this stage, you and your senior management team can negotiate your personal equity stake in the company, post-investment. This should take into account issues such as the company valuation and the investors' exit strategy.

Investment deal documentation

After sign-off, lawyers for the parties will draw up acquisition documents, detailing the terms of the negotiated contracts according to legal requirements. These include:

• shareholders' agreement - the rights and obligations of each party
• investment protocol - share prices and numbers of shares
• changes to company statutes
• warranty letters
• contracts with senior and junior members of staff

All parties should then sign the final agreement. At this point, the capital funds will be released to your company. For a management buyout, sign-off marks the point where the holding company acquires the target company.

If you accept funds from an external investor, you must share information about your company with them and delegate some decision-making. You can draw up a shareholders' agreement to establish how joint decisions will be made, and to balance the interests of different shareholders.

The shareholders' agreement will also cover the rights and duties of your investment fund managers, eg:

• receiving regular company performance reports
• consultation on important decisions, eg business acquisitions and disposals
• control of the exit process

Day-to-day operations

You should keep in contact with your fund managers, as they can help you with strategic decisions and issues such as:

• organising further investment
• negotiating with banks
• negotiating the sale of the company to partners in the sector

Investing fund managers generally leave day-to-day operations and growth strategies to the company's senior management. They may, however, take a more hands-on role if there is a crisis, if the company is a start-up, or if the investment is a complex one, eg a debt-financed operation.

Company committees and boards

Most fund managers will expect to be present or be represented on a company's board, subject to normal corporate governance standards.

Financial board members are subject to their own professional codes of conduct, including those which cover conflicts of interest between different investments. Fund managers can also play an active role in important committees, eg for audit or remuneration.

Liability

A fund manager sitting on a company board has a duty of care to its shareholders and creditors. They will generally avoid involvement in day-to-day operations, as this will increase their liability should the company collapse.

Experienced fund managers should be able to identify signs of crisis in a company, such as a sharp rise in fixed costs or high staff turnover.

Exit strategies

Venture capital (VC) investors may decide to sell their investment and exit a company. Alternatively, the company's management can buy the investor out (known as a 'repurchase').

Other exit strategies for investors include:

• sale of equity to another investor - secondary purchase
• stock market floatation
• liquidation - involuntary exit

Private equity firms may decide to not sell all the shares they hold. In the case of a flotation, they are likely to hold the newly-quoted shares for at least a year.

The exit value of a company must be mutually agreed between all parties, and will depend on:

• the type of operation
• the number of shares sold
• the original valuation of the company

Private equity funds have either a limited lifespan - usually ten years - or they can continue to operate as long as they have capital to invest.

For further information see secure equity investment.

Communications with potential investors - eg sending a business plan to them - are classed as financial promotions and regulated under the Financial Services and Markets Act (FSMA).

Under the Act, anyone carrying out a financial promotion must be authorised by the Financial Conduct Authority (FCA), although most proposals sent to private equity houses seeking funds are exempt from the restrictions.

Under FSMA rules, you are not allowed to include 'misleading statements' in documents, such as a business plan, designed to induce or persuade people to:

• enter into investment agreements
• buy or sell shares in companies

You must be able to prove any statement, promise, or forecast, contained in any communication or document you send to potential investors.

You should consult your legal adviser to ensure compliance with the rules on financial promotions, before approaching potential investors.