Sources of finance - Venture capital, private equity, and IP...

Learning Outcomes

After reading this article, you will be able to explain and compare major sources of finance for growing companies: venture capital, private equity, and initial public offerings (IPOs). You will learn each method’s process, advantages, limitations, and suitability in various business contexts. You should be able to advise on the choice of finance method and discuss related implications for control, risk, and regulation.

ACCA Advanced Financial Management (AFM) Syllabus

For ACCA Advanced Financial Management (AFM), you are required to understand the main forms of finance available to businesses during growth, the processes for accessing these funds, and the implications for the company. This includes:

• The role and process of venture capital (VC) financing for start-ups and early-stage businesses
• How private equity (PE) provides funding and drives business restructuring, including leveraged buyouts
• The process, rationale, and impact of initial public offerings (IPOs)
• Advantages, disadvantages, and risks of each financing method
• Regulatory and governance issues relating to VC, PE, and IPOs
• Decision criteria for selecting an appropriate funding route

Test Your Knowledge

Attempt these questions before reading this article. If you find some difficult or cannot remember the answers, remember to look more closely at that area during your revision.

1. Which of the following is NOT a typical feature of venture capital financing?
   1. Active involvement of investors in the management
   2. Funding provided only to mature, listed companies
   3. Preference for high-risk, high-growth opportunities
   4. Staged release of funds based on performance
2. What is the most significant difference between private equity investment and an IPO?
   1. Ownership remains concentrated in private equity deals
   2. IPOs involve direct sale to institutional investors only
   3. Private equity requires public financial reporting
   4. IPOs result in a loss of management control

3. True or false? After an IPO, companies are subject to more rigorous disclosure and compliance requirements.

4. In one or two sentences, explain the main objective of a leveraged buyout (LBO) under private equity.

5. List two potential advantages for a company in choosing an IPO rather than continuing to rely on private equity funding.

Introduction

Choosing the right method to finance growth can shape a business’s future. Companies usually start with internal funds, but high-growth or transformative plans require greater investment and specialist knowledge. Three important external sources are venture capital, private equity, and initial public offerings (IPOs). Each source suits different business stages and comes with distinct processes, investor expectations, and impacts on ownership and control. In Advanced Financial Management, understanding these sources enables you to advise on optimal financial strategies while considering risk, governance, and stakeholder consequences.

VENTURE CAPITAL

Venture capital is a form of financing for early-stage and high-growth potential businesses, often where the risks are too high for traditional lenders. It involves both the provision of funding and specialist knowledge from specialist investors, typically in exchange for an equity stake.

Key Term: Venture capital
Capital invested in early-stage or high-growth businesses by specialist funds or investors, in return for a significant ownership stake and often active management involvement.

Venture Capital – Main Features

• Provided by dedicated venture capital firms or high-net-worth individuals
• Funds are typically released in “rounds” as the business achieves agreed milestones
• Investors contribute specialist knowledge, advice, and networks, not just money
• Expected returns are much higher than for traditional investments due to the risk
• Exit is usually planned through a trade sale, secondary buyout, or IPO

Venture Capital – Suitability

Venture capital is most appropriate for companies:

• With innovative business models, products, or technologies
• Unable to access mainstream bank finance due to lack of track record or collateral
• Needing significant funds and specialist guidance to achieve rapid growth

Worked Example 1.1

A biotech start-up, MedNova, has developed promising diagnostic technology but lacks revenue and physical assets. Traditional banks refuse loans due to high risk. MedNova approaches a venture capital (VC) fund, which invests $3 million for a 40% share and a board seat, with staged funding tied to product development milestones.

Answer:
The VC’s investment supplies both finance and specialist knowledge where banks would not lend. In return, the VC takes a high ownership share and influence. If milestones are achieved, MedNova may attract further funding or aim for a public listing.

PRIVATE EQUITY

Private equity (PE) involves investment in established, often unlisted, companies aiming for significant business change, expansion, or restructuring. PE investors, usually funds or consortia, look to improve value and later sell their stake at a profit.

Key Term: Private equity
Capital provided by specialist investors or funds to acquire, restructure, or expand companies that are not listed on stock exchanges, often leading to significant changes in ownership, management, or strategy.

Key Term: Leveraged buyout (LBO)
The acquisition of a company using a significant proportion of borrowed funds (debt), secured against the target company’s assets, often led by a private equity sponsor intending to improve profitability and later exit.

Private Equity – Main Features

• Investment is typically by dedicated funds specializing in business transformation or expansion
• Transactions may involve buying out founders, divisions, or entire companies (including public-to-private deals)
• High reliance on debt (gearing) to magnify returns (LBOs)
• Fund managers actively intervene in strategic and operational decisions
• Aiming for medium-term exit, via trade sale, flotation (IPO), or secondary buyout

Private Equity – Suitability

Private equity is suitable for:

• Companies seeking expansion, turnaround, or delisting to streamline or improve operations out of public view
• Business owners looking to exit and receive liquidity
• Transitional phases, such as succession planning or strategic redirection

Worked Example 1.2

A family-run food producer, FreshCo, is experiencing slowing growth. A private equity firm acquires 80% of FreshCo via an LBO, replacing management, closing loss-making divisions, and aiming to resell in 4 years at a higher value.

Answer:
Through an LBO, the PE fund uses FreshCo’s assets as security for debt, intensifies operational changes to boost returns, and plans for a profitable exit after transformation or growth.

Exam Warning

A common error is to confuse private equity and venture capital. VC targets new/high-growth firms and accepts higher risks, while PE focuses on established businesses in need of restructuring, expansion, or transition.

INITIAL PUBLIC OFFERING (IPO)

An IPO is the process by which a private company offers its shares for sale to the public for the first time by listing on a stock exchange. This changes the company’s ownership structure and subjects it to strict regulatory oversight.

Key Term: Initial public offering (IPO)
The process by which a private company offers shares to the public through a stock exchange, becoming a listed entity with dispersed external ownership.

IPO – Main Features

• Involves creating a prospectus, appointing advisors/underwriters, and satisfying exchange listing criteria
• Offers liquidity for early investors and employees
• Typically used to raise substantial growth capital and/or enable existing shareholders to sell their stakes
• Requires adherence to ongoing disclosure, corporate governance, and compliance requirements

Advantages

• Access to large-scale funding and potentially lower capital costs
• Improved profile and credibility with customers, suppliers, and lenders
• Creation of a liquid market for shares

Disadvantages

• Costly and time-consuming process (legal, advisory, underwriting fees)
• Loss of privacy; financial and strategic information is disclosed publicly
• Dilution of control; risk of hostile takeovers if ownership becomes fragmented
• Continuous pressures to meet market expectations

Worked Example 1.3

After five years of expansion funded by private equity, FitTech, a wearable technology company, plans an IPO. Its existing investors and founders agree to float 30% of shares to raise $30 million for future growth and allow early backers to realise gains.

Answer:
The IPO enables FitTech to access public markets, diversify its ownership base, raise capital, and gives prior investors an exit. However, FitTech must meet ongoing stock market reporting and governance standards.

Revision Tip

Compare funding options against company goals, growth stage, control, cost, and exit plans. Decision-makers must assess trade-offs, not just immediate funding needs.

Summary

Venture capital, private equity, and IPOs are key methods for securing external finance at different stages of a business’s growth. Venture capital supports early-stage businesses and provides both funding and guidance. Private equity targets established businesses for transformation, often using high gearing and targeting a defined exit. An IPO brings access to public market funding but also regulatory and reporting obligations. Choosing the right source involves balancing access to capital, control, investor requirements, and long-term strategy.

Key Point Checklist

This article has covered the following key knowledge points:

• Identify the characteristics and purposes of venture capital, private equity, and IPOs
• Explain the typical processes for securing each type of finance
• Differentiate between VC, PE, and IPOs in terms of ownership, involvement, and exit strategy
• List advantages and limitations of each financing source
• Advise on factors influencing the choice of funding method

Key Terms and Concepts

• Venture capital
• Private equity
• Leveraged buyout (LBO)
• Initial public offering (IPO)