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Ace Ventures?

Friday, 22 September 2006

VCs often receive stick from entrepreneurs, but for some it's not just money they provide. Mike Fahy reports.

Talk to entrepreneurs about venture capitalists and horror stories abound – of political manoeuvrings with other members of management teams, of VCs loading a business with debt as it takes out chunks of cash and of financiers selling a business from under the noses of those who brought them into it in the first place.
Moreover, considering the fact that venture capital is expensive – VCs expect an internal rate of return of 30 per cent per annum for their investment – and that success rates for VC-backed businesses are low (only one-in-three can be said to achieve the lofty targets set out for them), it begs the question as to why any self-respecting entrepreneur would think of taking on VC investment?
For Bill Lloyd, the chairman of housing maintenance group Jackson Lloyd, the £30 million investment in September 2005 by private equity house Gresham perfectly suited the needs of him and his two brothers-inlaw. It allowed the family owners to take out some cash (or “de-risk” as he put it) while providing money for investment and a say in the future
direction of a business in a booming marketplace.
The Skelmersdale-based firm provides repair and maintenance services to social housing landlords and it is increasingly being appointed to fulfil major contracts that had once been the preserve of local authority “direct works” departments. Also, an £11 billion Government initiative to improve the social housing stock known as the Decent Homes Initiative caught the eye of several potential backers.
“Although only 30 per cent of our work goes on these planned maintenance contracts, it was an attraction for the private equity houses,” says Lloyd. A private equity buyer like Gresham could also help it to take advantage of changing market dynamics, he says. Bigger contracts require better-resourced companies, and the barriers to entry are increasing. This provides an opportunity for firms like Jackson Lloyd to acquire smaller rivals.
However, the deal that Lloyd and his fellow directors accepted is one that many entrepreneurs may have balked at – particularly as they gave Gresham a majority stake for its investment in the £34 million-turnover company.
“It suited us for tax purposes, and VCs insist on majority stakes, don’t they?” he asks. Well, not necessarily. Although a handful will only invest in companies where they receive most of the equity, others take a more pragmatic approach.
John Walker, who heads the Manchester office of Barclays Private Equity, says that his main concern when dealing with entrepreneurs isn’t the size of equity stake, but whether or not they’ll be able to handle the presence of external shareholders. Investing in management teams that come from plcs or larger groups is often easier, he says, because they are accustomed to reporting structures. Prior to investment, though, entrepreneurs have only ever been answerable to themselves.
Although he says most can make the transition “reasonably easily”, his firm does spend time assessing whether or not a relationship “will end in tears”. “You can do this by employing external assessors, but you do need to get a feel for who you’re dealing with,” he says. Walker adds that the other sticking point between entrepreneurs and VCs is the exit route.
A venture capital fund will typically only want its money to remain in an investment (even one which is doing very well) for a three-to-five year period, after which time it will want to return any gains made to shareholders. However, entrepreneurs have a much stronger emotional attachment to a business and can prove reluctant to sell. Therefore, VCs often use mechanisms included in the legal agreements – things like drag rights,
ratchet agreements or increased dividends – which make its money more expensive and can effectively force a sale.
Mark Crosier, CEO of a Flintshire-based technology start-up which received £10 million in expansion capital from Doughty Hanson in 2004, says that anyone who might not be prepared to sell (or re-buy at great expense) their stake shouldn’t take the money in the first place.
“There’s no point in anyone wanting a lifestyle business which they expect to be in charge of in 20 years' time raising money through a VC,” he says. “You make a promise to provide an exit and you have to live up to that.
“A lot of people complain about it, but that’s the nature of the investment.” His business was created following the takeover of Delta Group by US-based Eaton Corp in 2003. He was part of a ten-man research team paid off by Eaton Corp, which decided to stay together to develop a new type of digital sensor. It can be encased in a 3D membrane and added to circuit breakers, washing machines and all kinds of equipment to monitor the amount of power appliances are using and implement practical saving techniques (such as automatically switching off lights and aircon units in empty rooms).
“It can help to save ten to 15 per cent of a company’s typical energy costs,” he says. Its exit strategy was marked out almost from the outset, and both he and Doughty Hanson expect a potential flotation “within three to four years”, he says.
Tony Walsh may find himself involved in a deal much sooner than that. Last month, The Telegraph stated that his online hotel booking service, Laterooms, had appointed investment bankers at Close Brothers to conduct a review that could eventually lead to a £100 million stockmarket flotation. This would represent a healthy return for private equity firm ECI Ventures, which took a 55 per cent stake in the business in a deal which valued the firm at £21 million in December 2004. However, Walsh says the deal is not as cut-and-dried as it may seem. He has been involved with the business since the very early days, when his brothers Steve and Paul set up Laterooms as a spin-off to their Bury-based marketing agency Walsh Simmons in 1999, but by 2004 it was clear a split was in the offing.
“Myself and our CEO, Chris Allen, had ideas of grandeur and we’d wanted to run around doing all kinds of things, but Steve and Paul had been talking about consolidation – everything had gone to plan and they didn’t feel the need to complicate things. We realised fairly quickly that the only way we’d resolve this was a buy-out.”
Although he and CEO Chris Allen had to give away a majority stake to ECI to complete the buy-out (Steve and Paul had owned 85 per cent of the equity) he says the deal has allowed the business to take risks and expand rapidly. Moreover, ECI’s involvement has been fairly small.
“Apart from reporting to them at the monthly meetings, we’ve just got on with it,” says Tony. “We’ll consult them on any major directional changes, of course, and unless we’ve lost our minds and done something crazy they’ll back us.”
In fact, he says the big issues for Laterooms are staffing, resources and all the other things that need controlling at a firm that’s growing by 50 per cent a year.
“In a way, it doesn’t really matter who owns us, because we’ve still got to meet our targets, and our time will still be taken up by managing growth. We’ll break the £100 million barrier for bookings this year.”
Private equity firms would no doubt cite Laterooms as an example of how a company entering into a transitional period can use their funds to take the business to the next stage.
Another would be the £12 million management buy-out at Stockport-based Music Zone, which saw founder Russ Grainger replaced by a management team led by his MD, Steve Oliver.

Oliver uses the VC’s own stock phrase – that they have “added value” – to describe LDC’s involvement in the business. It has brought in Terry Norris, an experienced value retailer, as a non-executive chairman, and it introduced an ambitious 100-day financial plan.
“We really enjoyed doing the first one and after that the management have taken it upon themselves to do a second this year. I’m damn glad we did it.”
A charge often laid against VCs is that they are too slow and cumbersome when compared to entrepreneurial bosses who have to make deals in an instant, but Oliver says that in his
experience this doesn’t ring true. “They’re always at the end of the phone and it’s not like we have to wait until the next monthly meeting to get a decision on something,” he says. He can also point to the deal that had to be put together hastily over the Christmas period last year which led to Music Zone acquiring 41 former MVC stores from the administrators. This has helped Music Zone to increase store numbers from 52 to 102, while annualised turnover has jumped from £70 million to more than £135 million.
“We have an open and friendly relationship. I know that Carl (Wormald, LDC’s investment director) wouldn’t want me ringing him every day, but you do need to keep them informed of what’s going on and we wouldn’t take any major spending decisions without consulting them first. We both know what’s expected and we haven’t had the file out once in 18 months,” he continues.
Crosier agrees that unless a company is underperforming, a VC will largely stay out of its affairs. “VCs aren’t interested in running a business,” he says. “They’ll guard their investment closely, but they don’t want to run it. That’s why they spend so much time looking at entrepreneurs rather than technologies.”
Having said that, though, he added that he felt it was “crucial” that his management team held onto its majority stake in Deepstream, particularly because it means they have the final say over when (and to whom) the business is sold.
Oliver believes that recent investments made in the Music Zone business, which includes a 53,000 sq ft distribution centre in Denton, means that, given the chance, it can grow to double the number of existing stores with the infrastructure it has in place, but as a minority shareholder he is at the mercy of his backers if they receive a fantastic offer.
“You have to believe that they’ll act in the best interests of all shareholders, otherwise you’d be in a very ropey situation, and I’m sure they’d involve us fully in any big decision like that,” he says.
You’d hope so, wouldn’t you?