Growth Capital Meaning
Growth capital, popularly known as expansion capital, is capital provided to relatively mature companies that require money to expand or restructure operations or explore and enter new markets. So basically, growth capital serves the purpose of facilitating target companies to accelerate growth.
Growth capital is placed on the gamut of private equity investing at the crossroads of venture capital and control buyouts.
We note from above, Kobalt raised $75 million in growth capital. Kobalt plans to use this cash to scale its unique royalty collections platform to meet the demands of the global surge in music streaming.
In this article, we look at what is Growth Capital in detail –
- What a PE fund looks out for when making Growth Capital investment?
- Growth Capital Deals Example
- Minority Interests and Growth Capital
- Majority Interests and Growth Capital
- Growth Capital deal characteristics
- Structuring a Growth capital investment
- Growth Capital vs. Venture Capital
- Growth Capital vs. Controlled Buyouts
What a PE fund looks out for when making Growth Capital investment?
When it comes to Growth capital, these investments provide a different set of opportunities and challenges to PE investors. Not all PE investors would be interested, nor are they active in this area. Few of them are not permitted to invest and provide growth capital based on their fund documentation.
Why so? It is because PE funds would generally not be interested in opportunities that result in cash burn rateCash Burn RateCash burn rate indicates the money exhausted or used in a specific period for carrying out the business operations. It is the negative cash flow represented by the cash flow statement. The formula is "Cash Burn Rate = Cash Balance of Current Month - Cash Balance of Previous Month." in the foreseeable future. It is so as the investors would have little appetite to fund working capital or cash requirements as an ongoing responsibility or to invest where there is a risk of future dilution.
When a PE fund wishes to make a growth capital investment, they would be looking out for concrete, clear plan outlining the capital requirements. However, the requirements would be significantly huge but would be limited and specific such as generating substantial EBITDA growth, international expansion, etc.
Growth Capital Deals Examples
Let’s discuss the following examples.
#1 – Softbank investment in Uber Rival Grab – $750 mn
Softbank making an investment in Uber rival Grab in 2016 of $750 mn was a growth capital investment. It was a Series F round of investment and was led by Softbank along with other investors. Currently, Grab operates in six countries in South Asia and has 400,000 drivers on its platform, with 21 million downloads for its app. The capital was required to compete in an efficient way with Uber and others, particularly in Indonesia, and to focus on technology. Grab plans to refine its algorithms so as to help its drivers to be more efficient, build mapping data and technology, and also work on demand prediction and user targeting.
#2 – Airbnb raises $447.8mn in series F round of funding
Airbnb was able to raise $447.8mn in series F round of funding. Airbnb has, in the past, expanded in the travel sector by launching Trips, which offer customers tours and related activities. It plans to add flights and services in the future.
#3 – Deliveroo raised $275 mn in round 5 funding
Food delivery service Deliveroo raised $275 mn in round 5 funding. This London based company is active in 12 countries in Europe, Asia, and the Middle East. This financing was led by experienced restaurant investor Bridgepoint along with existing investor Greenoaks Capital. The funds were procured for geographic expansion in new and existing markets as well as further investments in projects such as RooBox, which would give restaurants access to off-site kitchen space that will cater to the takeaway demand that cannot be supplied by their own restaurant kitchens.
#4 – Incontext Solutions raises $15.2 mn from Beringea.
Incontext Solutions successfully got $15.2 mn through Beringea. Beringea is a PE firm that is focused on providing growth capital. Incontext Solutions is a global leader in virtual reality (VR) solutions for retailers and manufacturers. This capital would be utilized to accelerate sales, marketing efforts, and expand its geographic footprint. It will also focus on improving the VR product portfolio, and also include further development of solutions for head-mounted devices
Of the total investment deals done in 2016, 2% were for Growth capital/ Expansion as per preqin.
Minority Interests and Growth Capital
Growth investments would ideally take the form of significant minority interestMinority InterestMinority interest is the investors' stakeholding that is less than 50% of the existing shares or the voting rights in the company. The minority shareholders do not have control over the company through their voting rights, thereby having a meagre role in the corporate decision-making.. Compared to the traditional buyout or traditional VC investment, there is no single form of document that is used in such deals.
So what happens is that while some deals would be quite similar to late-stage VC investment, others would have similar characteristics as that of a typical buyout. It would depend on the negotiation among the parties. It would also depend on PE investor’s earlier experience on growth capital and have a minority interest. As many investors are unaware of the dynamics of controlling interestControlling InterestA controlling interest is the shareholder's power to speak in the corporate actions or decisions derived from possessing a considerable chunk of the company's voting stock. However, such a stakeholder may or may not hold a significant portion of the company's common stocks. so they would seek contractual rights else, they would rely on their relationship with the management and forego their protective rights.
If the investors go for control rights, then the investors would have these rights accompanied by the power to intervene when things go wrong or force an exit if the same doesn’t occur in the agreed investment window, say, for example, 3 years from the initial investment. This scenario may cause friction, especially if the founder is successful and has developed business at an early stage.
When an investor goes for growth capital, then it is important that clarity is maintained on such matters. Clarity should be maintained on what would be the steps to be taken if there is friction among investors and founders or when the founder ceases to be involved in the business on an active basis. The key area of the debate would be transferring shares that are founder’s equity and ongoing shareholder protection and board rights of the founder when he decides to go in passive mode.
Majority Interests and Growth Capital
Sometimes there would be Majority Interest in the deal given to PE investor. However, this happens rarely. If this happens then, the contract and investment would resemble a classic buyout. There would be few differences around the operational features and capabilities of the company.
Compared to a mature buyout, most of the target companies wouldn’t be ready for the requirements of PE investors. It is quite unlikely of shareholder debt being re-payed during earlier years of investment. It would result in a loan noteLoan NoteA loan note is an instrument issued by the lender to the borrower when granting a loan. It contains payment terms and conditions, interest rate, tenure and all the legal bindings and obligations of both a lender and a borrower. getting compounded. Also, these target companies wouldn’t have the right infrastructure to provide the requisite financial reportingFinancial ReportingFinancial Reporting is the process of disclosing all the relevant financial information of a business for a particular accounting period. These reports are used by the stakeholders (investors, creditors/ bankers, public, regulatory agencies, and government) to make investing and other relevant decisions. to PE investors. Failure to comply with provisions of providing requisite financial informationFinancial InformationFinancial Information refers to the summarized data of monetary transactions that is helpful to investors in understanding company’s profitability, their assets, and growth prospects. Financial Data about individuals like past Months Bank Statement, Tax return receipts helps banks to understand customer’s credit quality, repayment capacity etc. can lead to operational and economic consequences. In such a scenario, it is necessary that the agreements are drafted in such a manner that target companies have the time to develop the systems required for reporting.
Issues such as no HR policies in place, lack of health and safety compliance, data protection policies need to be in place when a PE investor would step in and invest. These issues would not break the deal between the two parties but would require operational change.
Any investor is looking out for profitable investments. PE investors would be interested in growth capital investments if the business has the potential, and the investment is made at the crucial point of the growth curve of Target Company. Also, management of the finances is of utmost necessity for making the investments profitable.
Apart from financial performance, it will be necessary that issues such as those mentioned above are sorted to ensure that PE investor makes a successful exit, as a successful business is easy to sell or attractive enough to be introduced to public markets.
Growth Capital deal characteristics
Each deal would have specific terms. These terms would be decided based on several key metrics such as past financial performance, operating history so far, market cap, etc. However, these terms would be similar to the traditional deal made for late-stage venture capital financingVenture Capital FinancingVenture Capital Financing, also called Venture Capital Funding, is a private equity funding type that investors offer to early-stage companies with high-growth potential. Moreover, it is planned for 3 broad stages, i.e., Idea, Expansion, & Exit stage. .
The key characteristics would be -:
- Just like a deal with a venture capitalist, even in Growth Capital, the investor would acquire preferred security in the target company.
- These would be a minority stake using little leverage.
- The deal would give redemption rights that are designed to create liquidity on triggering events such as IPO.
- The deal would be designed to give operational control over significant matters. These provisions give investors consent rights on the important transaction such as any debt or equity transactions, transactions relating to M&A, any change in tax/accounting policies, any deviations from budget/business plan, changes in key management personnel that hiring/firing, and other significant operational activities.
- The growth capital deal gives the investor rights such as tag-along rights, drag-along rightsDrag-along RightsDrag-along rights refer to an agreement clause whereby the majority shareholder has the right to compel the minority stakeholder to participate in the company's sale at the time of merger or acquisition., and registration rights. These rights are given as deemed appropriate for the size and scope of the transaction and the lifecycle of the issue.
Structuring a Growth capital investment
The trend in the market is that companies adopt private equity-style structures so as to secure key assets in the growth of capital space. These would be those assets which are essentials from an investor perspective and have the potential growth potential that he or she wants to deliver and earn the benefit of through retained share ownership. Hence growth capital investment would have many of the features of a secondary buyout, including from a commercial, legal, and tax perspective.
Growth Capital vs. Venture Capital
From the private equity investor’s perspective, there are several key distinctions between growth capital and venture capital. These are -:
- Growth capital focuses on investing in mature companies, whereas a VC would focus on early-stage companies that have an unproven business model.
- In the case of venture capital, investments are made in multiple early-stage companies of a specific industry or sector. However, Growth capital investment would do in a market leader or a perceived market leader within a specific industry or sector.
- The investment theses in venture capital are underwritten on substantial growth projections of revenue of Target Company. However, when it comes to growth capital investment, the investment logic is on the definite plan to achieve profitability potential.
- In Venture capital investments, future capital requirements are undefined. However, this would not be the case in growth capital investments that Target companies would have no or minimum future capital requirements.
Also, have a look at the difference between Private Equity vs. Venture Capital.
Growth Capital vs. Controlled Buyouts
When it comes to growth capital, it differs in several manners such as -:
- In control buyouts, the investment is a controlling equity position, whereas, in Growth capital, this is not the case.
- PE investors invest in highly profitable operating companies in controlled buyouts. These are those companies that have free cash flowCash FlowThe cash flow to the firm or equity after paying off all debts and commitments is referred to as free cash flow (FCF). It measures how much cash a firm makes after deducting its needed working capital and capital expenditures (CAPEX).. However, growth capital investments are made in those companies that have limited or no Free Cash Flow.
- Often in controlled buyouts, debt financing is employed to leverage the investment. However, in growth capital investments, the companies have no or minimum funded debt.
- An investment in controlled buyouts is made at a point where there is growth stability that is projections point towards stable revenue & profitability. However, as mentioned above, growth capital investments are made at a junction where the investment made will boost the revenue and profitability of the target company.
Growth capital is lesser-known investing as compared to traditional venture capital and controlled buyout. However, it represents a low-risk cost of capital for the investor as compared to traditional private equity investments. Target companies, in turn, get the benefit of an attractive source of financing that helps them to accelerate their revenue and profitability growth.