Venture capital - step by step
Venture capital investments offer tax breaks, huge potential and lower risks than you might think. Vlada Tkach and John McLeod explain how VC can work for you

Venture capital: due diligence
Last year broke all records for venture capital funding, But despite the subsequent downturn, there is no shortage of funds to invest in. What's different now, says Keith Arundale, director of Pricewaterhouse-Coopers venture capital unit, is that: "Venture capitalists are much more prudent– They are looking for strong management teams, strong business plans, a well-researched market proposition, and, ideally, for seed capital to already be in place." In last years internet boom, investors sometimes skimped on the due diligence.

Oleg Kaganovich is more direct. As a senior associate at Sun Ventures, the investment group of Sun Microsystems, he witnessed the height of the dot-com boom first hand. "The year 2000 was a year of Ždrive-by investing. Normally it takes two to three months of due diligence before anyone commits to anything. Last year, people would meet a company once, and within a week the money would be thrown in."

Venture capital: quality of management
Since then. it has become a buyer's market, says Mr Kaganovich. "What we see is a serious flight to quality - most weaker deals have fallen by the wayside and management teams are now putting together extremely strong pitches. We dont see nearly as many business plans, but those we see are of much higher quality. And everyones mantra, once again, is quality management."

Jon Auerbach, principal partner with Massachusetts-based Highland Capital, agrees. "We dont invest in technology - we invest in people. Entrepreneurs are the heart and soul of this industry. You may have great technology, but if you dont have the humility to adjust your business plans when market conditions change, you are lost. Venture capital is not about glamour; its hard work. Most of the companies we fund are 12 to 18 months away from the product release. And we only fnd companies that can stand alone - we dont make investments based on acquisition model."

Venture capital: European and US markets
Because Europe was lagging behind the venture capital boom in the US last year, it got burnt less by the downturn, says Prof Cochrane. "If you go to a US university, students are no longer talking about starting their own companies. They are talking of getting a job in Merrill Lynch or Ford. In the UK, and in a lot of European countries, students are still thinking about starting their own companies." Conceptlabs is being approached with start-up companies propositions every day - not now from the US, but from Europe. In less than a year, the company has turned from a US-centric business to one with much more focus on Europe and south-east Asia.

Venture capital: diversifying risk
Investment in venture capital is high risk because early-stage companies are particularly vulnerable, especially if a start-up technology fails or does not find a market. So it makes sense to diversify risk through a fund or a portfolio of holdings.

One way to gain exposure is through a straightforward venture and development capital investment trust (VDCIT). Alternatively, you can use venture capital trusts (VCTs) or buy a portfolio of individual companies under the enterprise investment scheme (EIS). Both VCTs and EIS investments are tax-free and could save you up to 60 per cent of your invested capital in tax relief (see table).

Venture capital: investments with tax breaks
Both VCTs and the EIS are intended to encourage investment in new companies by giving tax breaks to compensate investors for taking on the extra risk of fledgling enterprises. But despite the perceived risk, the failure rate has been low. Since the first VCT started up in September 1995, just 5 per cent of all investee companies have failed, says John Harrison of independent financial adviser (IFA) Paul Young. There have now been 48 VCT launches.

"High risk is correlated with high return and, where investments are successful, there can be returns of 15 times the original investment, easily outweighing the effect of any failures in the portfolio," argues Alastair Conn of Northern Venture Managers.

Beyond the promise of chunky returns, venture capital represents a unique asset class, distinct from equities, so it can also help to diversify risk within a portfolio.

"Venture capital investments are less volatile than equities because they are valued rationally on net asset value (NAV) under the conservative rules laid down by the British Venture Capital Association (BVCA), unlike equities which are repriced daily by market sentiment," points out Patrick Booth-Clibborn of venture capital specialist Noble Capital. In fact, Ben Yearsley of IFA Hargreaves Lansdown believes that investors should consider holding 5 to 10 per cent of their portfolios in venture capital.

That doesnt mean equities and venture capital have no connection. According to Nick Greenwood of broker Christows Current, depressed markets make this a bad time to buy into a VDCIT because "the delay in reporting NAVs means that some of the bad news has yet to feed through".

Much of the uplift from venture capital investments tends to come when companies are sold on, either floated on the market at an initial public offering (IPO), or through a trade sale to another company. Since the collapse of the tech bubble in March 2000, there has been something of a drought of IPOs and the stream of new venture capital investment opportunities has become a trickle. But depressed valuations mean that there are buying opportunities for fund managers and trade sales remain a healthy exit route.

Venture capital: opportunities for investors
At the moment, low venture capital valuations represent an opportunity for bold investors. Small companies tend to have a higher exposure to domestic consumption than larger companies and, therefore, should benefit if the UK escapes the worst of any recession in the US. Since many venture capital investments are in the growth areas of technology, they will be less affected by an immediate economic downturn than value companies, whose fortunes are more dependent on immediate earnings.

New VCTs have three years to invest up to 70 per cent of their assets in qualifying companies - allowing time for markets to recover. However, while most VCTs hold uninvested funds in cash, gilts and fixed interest, a few have invested in unit trusts, thus taking on market risk, cautions Jason Hollands of IFA Bestinvest.