Growth Capital

What is growth capital?

Growth capital (German: Wachstumskapital; also called growth equity) refers to equity that financial investors provide to more mature companies to finance their further growth. These companies have a business model that has proven itself in the market and significant, mostly recurring revenue. The investor generally acquires a minority stake, and the founders and existing management keep entrepreneurial control. Put simply, venture capital finances the development of a concept, growth capital its expansion, for example into new countries and customer groups.

Growth capital sits between venture capital and the majority buy-out by private equity. Providers are growth funds, growth units of private equity firms, late-stage funds, family offices and sovereign wealth funds. The funds flow into sales and internationalisation, new products or acquisitions; in some cases the investors additionally acquire shares from existing shareholders. The investment is implemented through a term sheet setting out the key terms, the participation agreement, the shareholders' agreement and an amendment to the articles of association.

Features of a growth financing

• Minority with protective rights: The investor often holds 10 to 30% of the shares. It protects itself by making important decisions subject to its consent, and through information rights and rules for the exit.
• Hardly any debt capital: Unlike in a buy-out, the entry is not financed through loans that the company must then service.
• Valuation on a key figure basis: The value is set as a multiple of revenue or of EBITDA, earnings before interest, taxes, depreciation and amortisation. The level of the multiple depends on growth, gross margin and revenue retention, that is, on how much revenue from existing customers is retained after one year. The Rule of 40 is also widely used.
• Primary and secondary portion: In the primary portion, new shares are created and the money flows into the company. In the secondary portion, investors buy existing shares from founders or early investors, and the money flows to them (secondary sale).

The return expectation also differs from that of an early-stage fund. Growth investors calculate with few write-offs and expect, per investment, a lower but more reliable multiple of their money. Their horizon to exit is often three to six years.

Growth capital and late venture rounds

In practice, the terms overlap. Rounds of Series B and Series C are often described as growth rounds, and many venture capital funds maintain growth vehicles of their own. What matters is less the label of the round than the investment logic:

• Risk: Late venture rounds often still finance proof that a model works at scale. Growth capital presupposes that proof and finances its expansion.
• Review: Growth investors review as thoroughly as buy-out funds, with analysis of earnings quality, of customer cohorts (development of customers by year of acquisition) and of the planning reliability of past years.
• Structure: More often than in venture rounds, minimum returns are agreed, for example a preference for a multiple of the amount invested. The investor often also receives put rights, with which after a certain holding period it can demand the buy-back of its shares, or rights to initiate a sale. They are backed by an obligation of the other shareholders to sell along (drag-along).
• Profitability: Break-even earnings are not a prerequisite, but a reliable path to them is expected.

Implementing a growth round in a GmbH

In a GmbH (German limited liability company), the primary portion flows into the company through a capital increase. It requires a notarially recorded shareholder resolution with a three-quarters majority (Section 53 (2) and Section 55 of the German Limited Liability Companies Act, GmbHG) and takes effect with entry in the commercial register. The investor takes up the new shares at their nominal amount; the amount above that it pays as a premium or as a contractual additional payment into the capital reserve.

The secondary portion is a purchase of shares between investor and existing shareholders. It requires notarial recording (Section 15 (3) and (4) GmbHG) and, if the articles of association make assignment subject to consent, that consent (Section 15 (5) GmbHG). Selling founders pay tax on their gain on privately held shares from a 1% stake under the partial income method, that is, on 60% (Section 17 of the German Income Tax Act, EStG). Via a holding GmbH, it is 95% tax-exempt (Section 8b of the German Corporation Tax Act, KStG). Whether purchased existing shares remain ordinary shares without preferential rights or receive preferential rights is negotiated in the round; preferential rights require an adjustment of the articles of association or the shareholders' agreement.

The protective rights of the minority investor are in the articles of association and the shareholders' agreement. Usual are a catalogue of measures requiring consent, a seat on the advisory board and information rights beyond the statutory right to information under Section 51a GmbHG. Economically, it is protected by a liquidation preference, that is, priority in the sale proceeds, and by anti-dilution protection, which compensates the investor with additional shares in future rounds at a lower price.

Growth capital in valuation and exit

Growth investors pay for growth that can be evidenced in key figures. Companies with high revenue retention, good gross margin and a comprehensible cost structure achieve higher multiples than those whose growth rests mainly on rising sales spending. A valuation that runs well ahead of the business shifts the risk into the next round. If that is financed at a lower share price (down round), the anti-dilution protection of the existing investors applies, which burdens above all the founders.

Because the investor plans its exit within its fund term, the shareholders' agreement often regulates when and by what route a sale or stock market listing can be initiated. If the founders want to run the company themselves for considerably longer, this point belongs before signing.

Worked example: growth capital round with a secondary portion

A software company with EUR 12 million in recurring annual revenue has 100,000 company shares with a nominal amount of EUR 1 each; the founders hold 60,000, earlier investors 40,000. A growth fund values the company before the round at EUR 60 million and invests EUR 21 million. Preferences from earlier rounds are disregarded for simplicity.

• Price per share: EUR 60 million / 100,000 = EUR 600
• Primary portion: EUR 15 million / EUR 600 = 25,000 new shares; share capital rises by EUR 25,000, EUR 14,975,000 goes into the capital reserve
• Valuation after the round: 125,000 shares × EUR 600 = EUR 75 million
• Secondary portion: EUR 6 million for 10,000 shares of the founders; the purchase price flows to the founders, not to the company
• Stakes afterwards: fund 35,000 of 125,000 shares = 28%, founders 50,000 = 40%, earlier investors 40,000 = 32%

The 25,000 new shares carry a simple, non-participating liquidation preference of EUR 15 million: for them, the fund receives either its investment upfront or the pro rata proceeds, not both. The purchased existing shares remain ordinary shares. Two sale scenarios show the effect:

• Sale for EUR 150 million: EUR 1,200 per share. The pro rata proceeds exceed the preference. The fund takes them and receives 35,000 × EUR 1,200 = EUR 42 million, twice its investment. The founders receive 50,000 × EUR 1,200 = EUR 60 million.
• Sale for EUR 50 million: Pro rata, only 25,000 × EUR 400 = EUR 10 million would fall to the preferred shares. The fund chooses the preference of EUR 15 million; the remaining EUR 35 million is distributed over 100,000 shares at EUR 350 each.
• Result in the second scenario: The fund receives EUR 15 million + 10,000 × EUR 350 = EUR 18.5 million. The founders receive 50,000 × EUR 350 = EUR 17.5 million, the earlier investors 40,000 × EUR 350 = EUR 14 million.

In the weak case, the founders thus receive EUR 17.5 million instead of the EUR 20 million that would correspond to their 40% stake. The fund gets EUR 18.5 million instead of EUR 14 million. The preference thus protects the investor precisely when the sale price disappoints; in the good case it plays no role.

Distinctions: growth capital, venture capital and private equity

• Venture capital: finances companies whose model still has to prove itself and reckons with many write-offs. For growth capital, the market must already be evidenced.
• Private equity in the narrower sense: majority acquisition, usually with loans for the purchase price (acquisition financing), in which the money flows mainly to the sellers. In growth capital, the investor remains in the minority, without debt leverage, and the money flows mainly into the company.
• Venture debt: a loan instead of a stake. It finances growth without significant dilution but must be repaid.

Common mistakes

• Capital before reliable unit economics. Unit economics describe what a single customer brings in and costs. If growth capital flows into a sales operation whose customer acquisition does not pay off, revenue and losses grow together. Investors therefore examine the ratio of customer value to acquisition costs particularly closely.
• Valuations compared without structure. A higher valuation with a minimum return or multiple preference can be worth less to the founders than a lower offer with simple terms.
• Exit horizon not aligned. The investor's put and sale rights take effect only after years, but then determine whether and when the company is sold.
• Secondary portion too high. If founders sell a large part of their shares, their commitment declines from the point of view of new investors. At the same time, this part of the round is not available for growth.
• Reporting not prepared. Monthly closing, variance analysis and key figures must be available in the agreed form from the first month after completion.

Frequently asked questions

Is growth capital the same as a Series B round?

Not necessarily. Series B describes the sequence of rounds, growth capital the type of investment. A Series B can still have a venture character, and a growth financing can take place without a series name, for example for a profitable company that has so far grown without investors.

Does a company have to be profitable for growth capital?

No. What is expected, however, is a proven business model and a comprehensible path to positive cash flow. Growth and margin are considered together; the Rule of 40 is widely used for this: growth rate and earnings margin should together reach at least 40%.

Does growth capital belong to private equity?

In the broad sense, yes. In market statistics and with many fund providers, growth financing counts as a segment of the private equity market, alongside venture capital and buy-outs. In the narrower sense, however, private equity means the majority acquisition with acquisition financing, whereas growth capital remains a minority stake and mainly finances the company itself.

Can founders sell shares as part of a growth round?

Yes, this is common in growth rounds. Investors usually limit the secondary portion, however, so that the founders stay economically committed. The sale is notarially recorded and is, for the founders, a taxable disposal.

How large are growth rounds usually?

They often range in the double-digit millions, with larger rounds above that. What decides is the capital requirement of the plan and the share the shareholders want to give up, not a fixed market limit.

The Roemer Capital view

Growth rounds are a focus of Roemer Capital's work: it supports technology companies with ongoing revenue in rounds of Series A to C with volumes of up to EUR 100 million. In preparation, it concentrates on the key figures on which growth investors base the valuation. These include the development of customer cohorts, revenue retention and unit economics with a ratio of customer value to acquisition cost (LTV/CAC) of at least 3 to 1. Added to this is a financial model over at least three years with base, cautious and optimistic case.

When comparing offers, Roemer Capital sets the structure next to the valuation and calculates preferences, exit rights and a secondary portion in several sale scenarios for every shareholder. The company's law firm implements the participation agreement and articles of association.