Private + public = patient: how the traditional sources of growth capital bred a hybrid

Enabling investors to guide a startup’s direction while removing the pressure for entrepreneurs to secure an early exit, patient capital provides the best of both worlds

Private + public = patient: how the traditional sources of growth capital bred a hybrid

Way back, if you were seeking institutional capital for a young company you had just one option: equity from a venture-capital partnership. You couldn’t raise debt without at least three years of profitable trading – and even if you did you likely had to risk your home as collateral. About 20 years ago, an alternative appeared: listing the company on a junior stock market – AIM or, before that, the smaller USM – getting funding directly from a number of institutions. Neither approach is perfect so as a result a hybrid of the two approaches has become increasingly popular of late that looks to offer the best of both worlds.

Private capital is the original form of growth company financing and remains the most popular choice today. Since diversification – buying securities whose prices move mostly independently of one another – is the one free lunch in finance and limited partnerships invest in multiple companies, investors benefit from this set-up. This allows riskier companies to be backed, resulting in higher average returns. However, as their money is normally tied up for 10 years plus extensions, if an investor wants it back they have to sell their interest, usually at a deep discount.

For a company receiving investment there are consequences to be considered too. The shares VCs buy usually have preferential terms and the VCs have a great deal of influence over the company, not only because they own a significant stake in the business but also via preferential rights and controls written up in shareholders’ agreements. Most entrepreneurs are sanguine and look on these factors as part of the cost of capital injection but exercising a little more caution makes sense. The interests of investors and founders can diverge and these preferential terms usually make it very hard to fight VCs’ decisions. Finally, with partnership time limits, there is a deadline by which companies have to be sold regardless of whether it is the right time or not.

Going public – say on AIM or Nasdaq First North – delivers a different dynamic.  On the downside, investors own shares in only one thing and reporting on its progress results in more work, regulation and cost for the company. On the upside, shares all get the same deal and a lead investor with special rights is rare so management teams have more freedom regarding strategy. Valuations often are more generous and there are no time limits on how long the company can stay independent. So listing appears to be the best choice but the fact that the startup doesn’t have a lead investor can actually cause a couple of wrinkles.

If a listed company fails to meet expectations, which sadly happens a fair bit on junior exchanges filled with young companies, a loss of confidence combined with no clear leadership often means the company doesn’t get a second chance. This is a poor outcome for all. In a private situation with concentrated shareholdings, bad luck can be recognised for what it is and additional funding provided to enable a company to access the talent it needs to break through. Take Foursquare, which enjoyed a meteoric early rise then stumbled badly. When faced with this setback, the lead investors in the company gave it the capital and time it needed to recover and thrive again. With the dispersed shareholder base in a public company, it can be hard to reach an agreement about the way forward and the terms for raising capital.

There are also cases where management are genuinely underperforming and without a lead investor it is hard to change personnel or strategy. Left to their own devices, such teams can continue to underperform for a long time and squander the cash on the balance sheet, especially if they succeeded in raising a sizeable amount of capital. Unless they’re very large shareholders, UK institutional investors – with a few notable exceptions like Kestrel Investment Partners and the specialist team at Henderson – tend not to have the time or inclination to challenge management teams and effect change.

Evidently each solution has its drawbacks but fortunately with time a new solution has emerged that offers the best of both worlds: patient capital. Pioneered by IP Group and now copied by many, it is a hybrid of public and private structures. Buying stakes in many companies enables investors to diversify and having significant ownership means they have influence and the incentive to use it. Conversely, being listed, if investors want their capital back they can cash out on reasonable terms and as the company isn’t considered a partnership, it has no artificial sell-by date.

This is particularly important when investing in deep technology companies or university spin-outs where going from proof of concept to thriving business takes longer than the lifespan of most limited partnerships. Oxford Nanopore, an emerging star in a number of patient capital vehicles, first raised funds in 2005 and is now really beginning to hit its stride with sights on a multi-billion dollar valuation.

So while private or public funding don’t always offer the best deals for the investor or entrepreneurs, with a little patience the great results can be achieved for all involved. 

Edward Snow
Edward Snow

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