The role of venture capital firms from the perspective of the research bench

1. What is the role of venture capital?
2. Who are the venture capital firms?
3. How does a venture capital firm invest in a project?
4. What are the risks for venture capital investors?
5. What do venture capital investors expect in return?
6. What about the motivation of the entrepreneur / inventor / researcher?
7. How do venture firms spread their risks?
8. What qualities do venture capitalists consider for an investment?
9. What is due diligence?
10. How do venture capital firms get their money back?

The British Venture Capital Association can provide more information on venture capital in the UK.

1. What is the role of venture capital?
Venture capital provides a source of funds through investment, usually in companies or projects that are start-up or at a very early stage of product development. These projects and organisations usually would not attract sources of finance such as loans and could not raise money in the major public stock markets (such as the London Stock Exchange). Limited equity capital is available to some early companies via AIM or Ofex markets.

2. Who are the venture capital companies?
Venture capital is an international activity but the UK does have a well-established venture capital sector (the British Venture Capital Association) that is one of the most active in Europe, particularly in biotechnology and healthcare. Major firms involved in the biomedical sector include 3i, Abingworth, Advent, Apax, Merlin Bioscience and Schroder Ventures.

3. How does a venture capital firm invest in a project?
The usual mechanism for venture investment is through the formation of a new company. The company will own rights to the intellectual property (patents etc.) that stem from earlier research activities and will probably employ or have consultancy contracts with the scientists behind the research work. The venture capital firm buys a shareholding in the new company, thereby providing the company with money for development work. Frequently, more than one venture capital firm may invest in a company, even at an early stage in its development.

Venture capital firms are often instrumental in 'assisting' the founders to develop their business. This may involve a range of activities including:

• Strengthening and broadening the management team by recruiting individuals with specific expertise
• Working with the management team to raise further finance from other investors or by listing on a stock exchange
• Combining specific technologies or projects to expand the company's portfolio

4. What are the risks for venture capital investors?
Venture capital firms specialise in investments that bear a high degree of risk. Investing in research-based activities is intrinsically risky because, by definition, one is dealing with the unknown or barely known. Compounding that risk are the uncertainties of product development, of healthcare markets, of the law (regulatory authorities and patents), of economic cycles and of management. Furthermore, even if a company succeeds in its endeavours, the venture capital firm's money could be tied up in the company for many years.

5. What do venture capital investors expect in return?
Venture capitalists need high returns on those projects that do succeed because not all projects they back will succeed. Venture firms normally manage money that originates in less-specialised investment institutions, such as those which manage pension funds. The venture capital companies need to deliver a good rate or return to those investors. In evaluating investment prospects, the venture capital firm will weigh up the various risks (see 'due diligence'), length of time their money is likely to be tied up, and the level of return they need to deliver to their investors.

6. What about the motivation of the entrepreneur / inventor / researcher?
Venture capital firms are investors in people. They have to be. Early in their lives, the most valuable assets venture-backed new companies have are intellectual property and the people needed to develop it. In structuring a new company, venture professionals ensure that the researchers and management have shares or share options that will grow in value if the company develops.

7. How do venture firms spread their risks?
Venture firms invest in a diverse portfolio of companies to avoid 'putting all their eggs in one basket'. This cushions the impact of failure by any one company in their portfolio. In biotechnology, a portfolio might include companies involved in bioinformatics, functional genomics, combinatorial chemistry, biopharmaceutical, pharmaceutical or drug-delivery-based companies. Importantly for those seeking venture capital, if a venture firm has already invested extensively in a particular type of company, it may be less willing to raise funds for a directly competitive company. Conversely, if a venture investor sees synergies with a company already in its portfolio, it may have an additional reason to back a new project.

8. What qualities do venture capitalists consider for an investment?
Venture capitalists will need to be satisfied with a company's management or potential management and their plans. In the event that there are gaps in the management team, the venture capital firm may provide assistance with recruiting additional team members. The management must also have the right resources available, such as strong patent position, access to skilled employees and facilities, and a technological or product advantage that addresses ideally a substantial unmet market need. In addition, the high rate of biotechnology products that fail during development means venture capitalists will expect that a company will develop a range of technologies or products so that the failure of one does not bring down the whole enterprise.

Venture firms generally seek to sell most of their shares within about five years of their initial investment; typically, they will sell after the company floats its shares on a public stock market. Alternatively, investors will also consider a trade sale or merger as their exit route. Therefore, the management's business plan needs to take this timeframe into account

9. What is 'due diligence'?
'Due diligence' is investment jargon for the process by which a venture firm will analyse and evaluate any investment prospect. After assessment by its own experts, it will seek a range of outside advice. Lawyers will review any legal agreements and assess the strength of patents; auditors will check the financial status; scientific consultants will assess the technology; industry experts will consider the product development hurdles; clinical advisors will look at the demand for, and benefits of, any medical product; and recruitment consultants may advise on the company's management. Due diligence is a process of risk assessment. It allows the venture capital firm to understand what actions need to be undertaken to reduce the risk and maximise the chance of a return.

10. How do venture capital firms get their money back?
The value of a venture firm's shareholding may increase as a new company grows but this is just 'paper money' until there is an opportunity to sell the shares. Typically this comes when a company makes a public offering or when it is acquired by another company. Venture capital firms will expect to sell their shares at many times the price they originally paid.

Most of the UK biotechnology companies that have 'gone public' have offered their shares through the London Stock Exchange. Other stock markets (such as Nasdaq in the USA; Nasdaq's European counterpart, Nasdaq Europe; the Alternative Investment Market in London; or European markets, such as the Frankfurt Neuer Markt or the Paris Nouveau Marché) have raised money for biotechnology companies.