Startups: Understanding Funding and Venture Capital

Victoria Pikovsky
May 27
8 min read

The United Kingdom has evolved into a prominent venture capital hub, attracting investors from around the globe. The UK's venture capital landscape is characterised by a diverse investment focus across multiple sectors. This multi-sector approach mitigates risks and taps into a broader range of high-growth opportunities. Driven by its robust financial sector, innovation-friendly policies, and dynamic startup ecosystem, London became a leading centre for venture capital activity. Fintech, in particular, receives significant attention due to the UK's strong financial heritage and regulatory environment.

This article explores the symbiotic relationship between venture capital investors and startups. Understanding the nature of venture capital is essential for navigating the world of high-growth startups.

Startups Funding

Startups are built on big ideas. Big ideas need fuel to grow. That fuel is funding. Whether hiring top talent, developing a groundbreaking product, or scaling operations, startups require capital to bring their vision to life and realise their potential.

Depending on their stage, industry, and growth strategy, startups have various funding options.

Bootstrapping - using personal savings or revenue from early sales allows founders to retain full control over their enterprise.
Friends & Family – a.k.a. Friends, Family and Fools -people willing to give you money for no other reason than that they like you.
Angel Investors – attracting high-net-worth individuals who invest in early-stage startups and may offer mentorship alongside funding.
Venture Capital (VC) – inviting institutional investors who provide funding in exchange for a substantial equity stake.
Crowdfunding - raising small amounts from a large number of people via platforms like Crowdfunder or Seedrs.
Government Grants & Subsidies -applying for non-repayable funds that governments provide to support innovation. These are often industry-specific and highly competitive.
Bank Loans & Credit Lines - getting traditional financing, which requires repayment with interest, and is mainly suitable for startups with predictable revenue streams.
Corporate Investment & Strategic Partnerships – seeking large companies to invest in a startup which aligns with their business interests.
Startup Accelerators & Incubators – participating in programs that offer funding, mentorship, and networking opportunities, often in exchange for equity.
Private Equity (PE) – seeking institutional investors offering significant operational involvement in exchange for a minority or majority equity stake.

The choice of funding depends on personal circumstances, the size of the investment, the company’s business model, growth strategy, stage, industry, and luck. Admittedly, not all startups require capital funding. Some can utilise the revenue generated by early sales to finance their growth.

Startups in tech, fintech, defence, and biotech that require large amounts of capital to develop products or enter competitive markets often require external funding and turn to VCs or PEs.

However, if a startup has low overhead costs or can grow sustainably without outside investment, it may never require either.

Funds, Returns and Trusts

Independent PE firms and VCs are investment vehicles that raise capital from institutional investors, including pension funds, insurance companies, family offices, and private individuals. This money is committed to a fund that will be invested over a period of time.

The fund, which is often structured as a limited partnership (LP), is managed by a private equity or venture capital firm, known as a ‘General Partner’ (GP).

The capital is used to invest in companies typically not listed on a stock exchange, either for a minority or majority equity stake. To better align the VC or PE company’s interests with those of its investors, the firm usually invests its own money into the funds it manages.

Due to the illiquid nature of their investments, private equity and venture capital funds usually have an initial lifespan of 10 years or more. By the end of this period, the funds intend to distribute the investors’ share of the original money, plus any additional returns made. This necessitates exiting the investments for cash or publicly traded shares before the end of the fund’s life.

Fund investors are the first to receive any distributions generated by the fund. When these returns pass a certain point, known as the ‘hurdle rate’ (typically around 8%), the private equity or venture capital firm receives this excess profit, known as ‘carried interest’.

This profit distribution structure means that the management company – PE or VC – carries the biggest risk, compared to the other investors in the fund, but is compensated for it with the largest and uncapped return potential.

All PE and VC firms in the UK are regulated by the Financial Conduct Authority (FCA). In 2007, the industry set up an additional self-regulatory body, the Private Equity Reporting Group (PERG), which established oversight and disclosure requirements comparable to those faced by FTSE 350 companies.

In 1995, Venture Capital Trusts (VCTs) were introduced to encourage investment in entrepreneurial businesses by offering tax incentives to investors. VCTs are publicly listed companies that provide tax-efficient investment opportunities in early-stage businesses. VCTs operate similarly to investment trusts and are managed by professional fund managers.

Venture Capital and Private Equity

The main difference between private equity and venture capital lies in the age of the company they invest in.

Private equity typically invests in mature companies that have been in operation for many years, whereas venture capital tends to invest in new companies. Most of the latter are not making a profit but have a disruptive business offering with the potential for robust growth.

VC funding involves investors taking substantial and often controlling equity positions in the company. Thus, investors become partners in the startup’s journey, helping startups navigate challenges and accelerate their growth in pursuit of a significant return.

VCs’ investment may provide a startup with:

access to capital - the necessary funds for growth and expansion, well beyond what traditional financing can offer
strategic support - offering valuable expertise, resources, and networks that can help guide a startup’s strategic direction
credibility and validation - boosting a company's credibility and making it easier to attract additional investors, partners, and customers
accelerated growth – expediting a startup’s development, marketing, and scaling efforts with substantial funding
On the other hand, VCs may obtain the right of first refusal and anti-dilution provisions in subsequent rounds, allowing them to maintain their percentage share in the company as it grows.
VCs take a stake in the company and, consequently, share in its future success or risks. They are betting on high-risk, high-reward opportunities.
Founders approach VCs when they need significant backing to accelerate product development, expand their business, hire talent, and scale and compete in their market.

Founders may seek VC investment during:
early-stage growth - to validate their idea, build a prototype, or to build, refine or expand their team
scaling operations - accelerating growth, expanding into new markets, or increasing production once a startup has achieved product-market fit
competitive positioning - to stay ahead of competitors, if a startup is in a fast-moving industry
technology development - to develop their technology (especially in deep tech, biotech, or AI) before generating revenue
Startups typically seek PE funding when they have moved beyond the early-stage growth phase and need substantial capital to scale operations, expand into new markets, or prepare for a liquidity event, such as an acquisition or initial public offering (IPO). PE investors typically enter the scene after a startup has demonstrated product-market fit, revenue traction, and operational maturity.

Founders may seek PE funding to:

expand aggressively - whether through acquisitions or international growth
improve profitability - by optimising operations and increasing efficiency
access liquidity – by allowing founders and early investors to cash out some of their stake without going public
Private equity adds value to a company in a variety of ways:
- thorough due diligence exposes a company’s strengths and weaknesses
- targeting growth sectors and new markets helps focus on enhancing revenue generation and addressing operational efficiencies
- implementing various strategies like buy-and-build, financial engineering, strategic reorientation, and others stimulates growth by acquisition

Innovation Ecosystem

Startup and early-stage companies raise money in rounds - Series A, B, C, etc.

Many startups receive funding prior to Series A through angel investments, crowdfunding, grants, incubators, etc, as pre-seed or seed investments.

This funding chain, known as the Innovation Ecosystem, provides capital and business expertise to early-stage, fast-growing companies at various stages of their life cycle.

VC investment typically progresses through several stages:

Seed Stage - initial funding to develop the startup’s idea and create a prototype
Early Stage - funding for early operations and market entry, often including Series A and Series B rounds
Growth Stage - substantial investments to scale the company, expand market share, and enhance product offerings, usually Series C and beyond

Several key stages mark the venture capital journey:
Initial Contact - startups engage with VCs through pitches and presentations
Due Diligence - VCs conduct thorough evaluations of the startup’s potential and viability
Investment Decision - VCs decide on the level and terms of investment
Post-Investment Support - VCs provide ongoing strategic support and resources

Venture capital houses are seeking startups that exhibit several key attributes:
Innovative Solutions - startups that offer unique, novel solutions to existing problems or unmet needs
Scalable Business Model - a startup’s business model must be effectively scalable to achieve substantial growth
Strong Leadership Team - the experience, expertise, and vision of the startup’s leadership team are critical in securing VC investment
Market Potential - startups operating in large or rapidly growing markets must offer significant expansion opportunities
Competitive Advantage - a clear competitive edge over existing players in the market is essential
Compliance Hygiene - a startup must be risk-aware, regulatory-compliant, governancefocused and have an investor-friendly cap table

VC firms typically hold their investments for between five and seven years. At this point, the business will either be floated on the stock exchange or acquired by a large corporation, a competitor, or another investor, such as a PE house.

Tax-efficient Investment

Private capital is instrumental in unlocking economic growth. Funding high-potential startups drives job creation, innovation, and competitiveness, thus significantly contributing to the overall economy.

Venture capital is crucial in bridging the scale-up gap by providing startups the necessary funds and support to transition from early-stage ventures to established businesses.

The UK continues to refine its policies to offer better incentives, reduce barriers to entry, and create an environment conducive to innovation and growth.

The UK’s tax policies aim to provide favourable conditions for entrepreneurs, encouraging them to establish and grow their businesses within the country.

The UK provides a competitive tax system for attracting and retaining startups.

Tax Relief for Investors: Venture capital schemes like the Enterprise Investment Scheme (EIS) and Seed Enterprise Investment Scheme (SEIS) offer income tax relief, capital gains tax deferral, and loss relief to encourage investment in startups.

Capital Gains Tax (CGT): CGT on gains from selling shares in a Venture Capital Trust may be exempt, provided certain conditions are met.

Pass-Through Taxation: The structure of VC funds places the tax burden on the general partners and limited partners, rather than on the fund itself. Taxes depend on factors like management fees, realised gains, and dividends.

Loss Deductions: If a startup fails, investors may be able to claim tax deductions on their losses, reducing their overall tax burden.

Inheritance Tax Relief: In some jurisdictions, startup investments may qualify for Business Property Relief (BPR), reducing inheritance tax liabilities. Depending on the structure of the investment, some VCT investments may also be eligible for inheritance tax relief.

Income Tax Relief: VCT investors can claim specific upfront income tax relief.

Tax-Free Dividends: Any dividends received from VCT investments are exempt from income tax.

Recent pension reforms in the UK allowed pension funds to invest in high-growth startups, thereby unlocking new sources of capital, bolstering the VC ecosystem and fostering economic growth.

Recent tax increases are driving the surge in venture capital trust investment. Investors increasingly turn to VCTs to capitalise on tax advantages while supporting high-potential startups.

Whether you are an entrepreneur seeking funding or an investor looking for opportunities, it is essential to seek professional advice to help you navigate complexities, ensure compliance, and achieve sustainable growth.

LEXeFISCAL provides comprehensive tax advisory services to ensure your business complies with tax regulations and optimises its tax liabilities.

Invest in your success by partnering with LEXeFISCAL.

info@lexefiscal.com & fintech@lexefiscal.com