What is venture capital?

Venture capital refers to a relatively risky capital injection, which is, however, associated with potentially high returns on investment.

Venture capital investments are short-term investments, as the venture capital company prepares for an exit from the outset – i.e., the sale of its newly acquired equity interests, for example, after the target company is listed on the stock exchange.

Traditional venture investments usually last only between 2 and 10 years. Venture investments involve the injection of share capital, which has the apparent advantage that the company does not become indebted due to capital injection, unlike debt capital such as loan capital.

The apparent disadvantage of a venture capital investment is that the investor will make the investment conditional on obtaining special rights in the target company.

Venture investments are usually made at the request of a relatively new target company that lacks the liquidity to take the next step in its development, such as the production, development, or marketing of a new product. These development companies are often innovative businesses with significant growth potential, which can offset the venture investor's risk in the investment.

The venture company

In this context, a venture company or venture fund is a privately owned company that acquires equity interests in development companies with a view to selling those equity interests at a later date when they are valued higher. This will often take place via an M&A transaction, such as a sale of the company, a merger with an existing company, or similar.

Companies usually take the legal form of a limited partnership, but it may also be a partnership or an ordinary limited company.

After the investment, venture companies usually participate in the management of the development company, and the investments provide both capital and skills, such as industry knowledge or other know-how, to the newly established target company.

To secure their investment as best as possible, venture investors will, therefore, make the investment conditional on special rights in the target company that they deem necessary and appropriate to protect their investment as best as possible. Consequently, It can be burdensome for the target company to allow a venture capital firm to invest, as the company's existing owners and management are often forced to relinquish significant administrative and financial powers.

In return, the venture capital company assists in creating growth until it finds it most advantageous to dispose of its shares in the target company. The venture investor thus often disposes of its shares to a later, less risk-averse investor or in the event of the target company's initial public offering (IPO).

Venture companies often syndicate investments, whereby several venture companies invest together in a target company.

The venture investment process

The venture investment process is similar to the ordinary acquisition of equity interests, where the parties often enter into pre-contractual agreements.

Examples include confidentiality agreements, which are particularly relevant when sending pre-screenings to several potential investors, conducting due diligence investigations, preparing letters of intent, negotiating price and contractual terms, and closing the investment agreement.

Unlike ordinary acquisitions of capital shares, the target company will often initiate contact and will have prepared a pre-screening in this connection. A pre-screening is the target company's presentation of the company, which is provided to potential investors so that the venture investor can assess the potential investment. A pre-screening includes, in particular, the company's financial statements, market potential, competitive situation, employees, etc., and the pre-screening may resemble a prospectus under capital market rules.

It also differs from the ordinary acquisition of a minority shareholding in that, after the investment agreement, the venture investor will usually receive special reports on the company and may participate in the work of the management.

Therefore, the venture investor will often require regular reports on matters relating to the company that the investor cannot monitor to observe and, if necessary, protect its investment in the best possible way.

A venture investment process may look like this:

• Pre-screening – possibly accompanied by a confidentiality agreement
• Pre-contractual agreements
• Due diligence
• Negotiation of valuation and contractual terms
• Signing of the agreement
• Fulfillment of conditions
• Closing – the investment is made
• Ongoing reporting

Particularly relevant considerations for venture investments

It is relevant—both for the selling entrepreneur and the investing venture company—to determine how decisions are made in the company and how the financial rights are distributed between the investor and the seller.

These matters can be regulated in the articles of association and a shareholders' agreement using various tools.

In venture investments, the development company's articles of association and any shareholder agreements between the parties contain provisions that attempt to give the venture investor management powers in the company so that the investor can control and protect its investment as best possible.

In this regard, there is a difference in the legal effect of whether the relationship is regulated in the ownership agreement or the articles of association, so professional advice should be sought on dealing with this. The following tools are often used: Pre-emptive rights and subscription rights for the venture investor, board positions for venture investors, and veto rights for the venture investor in connection with several essential decisions in the development company.

In addition, there will often be provisions on co-sale rights and co-sale obligations for the parties so that all shares in the target company can be sold on identical terms. Furthermore, the venture investor will often make an investment conditional upon the target company and possibly the seller and members of the management, issuing special declarations and guarantees regarding the company's business conduct.