Venture capital:

Introduction:

After the Second World War, countries realized the importance of technology to compete with
the other countries in terms of politically and economically.

USA was the first country to understand this, better than other countries that technology plays
an important role in development of the country.

So new industries started to do R&D to develop new technology and the new products. So they
came with good and productive ideas but to implement this they needed funds.

Earlier entrepreneur borrowed from the bank by pledging physical assets. At the same time the
new entrepreneur had knowledge and ideas but didn’t have sufficient physical assets to pledge to
borrow funds from the bank.

Therefore, venture capitalist (VC) entered the market with money and invested in this firms
assuming high risk and expecting a windfall profits.

Definition:

“The early stage financing of new and young enterprises seeking to grow rapidly”

“An equity related investment in a high growth business in return for a minority shareholding
the business or the irrevocable right to acquire it”

Meaning:

VC invests in a companies having new ideas or high technology industry who expecting a very
high return on their investment.

VC also finance the turn around companies i.e the loss making companies who are about to
make profit.

This VC invests their money in this above mentioned companies in the form of the equity shares
or quasi equity securities. Thus he becomes the minority shareholder and plays an active role in the
implementation of the project.

He prescribes certain standard of performance for the borrower, if it is not met, he can take
control of the company. After takeover, either a new management is bought in it or it is sold to another
group of promoters.

Venture capital is a risky idea.

Features:
1. Form of investment / equity participation:
VC invests in the form of equity shares in Venture capital unit. He may be also interested to
invest in convertible debentures and convertible bonds. His idea behind this is that once the
company expands, grows and makes profit, then sell off the shares and make capital gain.

2. Long term investment / long term association:

They invest for the period of 5-7 years. Therefore their association is for the long term in
nature. Hence, long term investment is illiquid investment since it is not repayable on the
demand. This fund is used for the project implementation and management.

3. Participation in the management:

The VC helps the firm in the project implementation and management. Hence VC is not
only the provider of the funds but also acts as a first class entrepreneur. He actively participates
in management and also gives his marketing, technology, planning and management skills to a
new firm and it indirectly also helps him to have a watch on his investment.

4. New company:
They focus is on the new company with the products that are totally new to the market.
If not new, the operation of the unit is going to earn high margin of profit. (eg; software
industry).

5. Turn around companies:

(it means loss making company who are going to make profit in future.)Losses in the
recent past company who promises to make profit because of finance restructuring or discovery
of the new area of operation or a new product. VC support such companies so as to share a part
of their super profits that they are going to earn in the future.

6. High risk return profile:

VC assumes high risk which are normally not acceptable to conventional lending. (VC are
adventurous in nature).

7. Exit schedule:
VC fixes a up time limit after which they sell of their shares and exit from the company.
They do not stay invested in a single company. (They search for new company’s to invest).

8. Performance benchmark:
VC establishes benchmark like for sales, profit, market share, area coverage, etc. He
later checks the performance of this established benchmark for different years, and if there are
any variations then he tries to find or rectify the problem and solve through suitable actions and
the benchmark.

9. Taking control:
If the VC feels that management of the venture capital unit in which he invested is not
competent then he can take control over that management for temporary, until he finds a
 competent management. Once the VC finds, he helps the management financially by buying
shares and assumes control.

10. Dealing with the technocrats:

VC’s finance the entrepreneur who have new ideas, qualified engineers, and innovative
ideas. They invest which helps them, if the company doesn’t perform in the later date they can
take control over the management. Where there is a well established business group, they
prevent the VC taking control over the business directly or indirectly.

Stages of venture capital financing:

Venture Capital starts with the financing of the company’s having new ideas, or development of
the new concept with an aim to earn a portion of this company’s super profits. and

Seed financing:

This type of financing is needed for conducting market research, product planning, designing
and development.This type of finance is provided by the High Network Individuals(HNI)( or angel
investors).

Start up financing:

This sort of financing is provided when the borrowing unit is more than 1year old. By this time, it
is able to test market the product. As only expenses are piling up with no revenues, finance is needed to
sustain the activities. Where the industries are large like petroleum refinery, petro chemicals complex,
cement plants, power projects,etc it may take even 2-3 years to reach this stage.Naturally, finance
needed is more in case of such industries.

First stage financing:

Finance needed if for establishing full production facilities, manufacturing systems, establishing
dealer’s network, or launching a major advertisement campaign. No revenue generation is possible even
at this stage. Finance needed is highest among all the stages except in case of a manager.

Second stage financing:

Sale begins at this stage. Naturally expenses are incurred for the shipping and distribution.
Funds are needed for selling the goods at credit basis. Finance is provided by the VC so that it generates
enough working capital. Though the sales is effected, the VC unit does not generate enough profit. No
stabilization is there either in the production or in marketing.

Mezzanine financing:
 VC helps the business in the organic growth. So here funds are required in huge amounts since
the capital expenditure is very high.In India, pharmaceuticals industry, TV channels, consumer
electronics industry, cement, banking, cell phones manufacturing and cellular service providing etc, are
undergoing the phase of such consolidation.

Bridge financing:

This finance is needed b the companies that are in the threshold of going public. Making the
Initial Public Offer (IPO) of equity share is expensive involving the service of many financial
intermediaries. To meet these expenses, the VC unit can take bridge finance from the VC for a short
period. This finance will be repaid out of the proceeds of the public issue of shares.

Management buyouts( MBO):

VC’s also helping the VC units to buy the controlling interest in any other company or business.
This may happen mainly because the VC unit has the needed competence to run other businesses. To
have a free hand in managing, the VC unit needs a controlling interest in the other company. Hence, the
VC units can takeover the competing companies or the other companies.

Management buying:

There are many MBI, where the VC finds the investee company is not achieving the required
performance standard; it can provide the finance to an outside management to acquire a controlling
interest in the VC unit.

Turnaround finance:

This is in the sphere of a private equity investor. A sizeable percentage of shares of a loss
incurring company are purchased. Funds are used in R & D. better technology is employed with the
better production facilities. If the need arises, the manufacturing process is computerized with the use
of the industrial robots. Investment is also made to developing dealer network, media planning and
marketing campaign. All these funds are running after ‘saving a sinking ship’. If the ship is saved, there is
profit. If not, the additional funds sink along with the ship.

What do VC's look for?

Venture capitalists are higher risk investors and, in accepting these risks, they desire a higher return
on their investment. The venture capitalist manages the risk/reward ratio by only investing in
businesses which fit their investment criteria and after having completed extensive due diligence.
Venture capitalists have differing operating approaches. These differences may relate to location of
the business, the size of the investment, the stage of the company, industry specialization, structure
of the investment and involvement of the venture capitalists in the companies activities.
The entrepreneur should not be discouraged if one venture capitalist does not wish to proceed with
an investment in the company. The rejection may not be a reflection of the quality of the business,
but rather a matter of the business not fitting with the venture capitalist's particular investment
criteria. Often entrepreneurs may want to ask the venture capitalist for other firms that might be
interested in the investment opportunity.

Venture capital is not suitable for all businesses, as a venture capitalist typically seeks :

Superior Businesses:
Venture capitalists look for companies with superior products or services targeted at large, fast
growing or untapped markets with a defensible strategic position such as intellectual property or
patents.

Quality and Depth of Management:

Venture capitalists must be confident that the firm has the quality and depth in the management
team to achieve its aspirations. Venture capitalists seldom seek managerial control; rather they want
to add value to the investment where they have particular skills including fund raising, mergers and
acquisitions, international marketing, product development, and networks.

Appropriate Investment Structure:

As well as the requirement of being an attractive business opportunity, the venture capitalist will also
seek to structure a deal to produce the anticipated financial returns to investors. This includes making
an investment at a reasonable price per share (valuation).

Exit Opportunity:
Lastly, venture capitalists look for the clear exit opportunity for their investment such as public listing
or a third party acquisition of the investee company.
Once a short list of appropriate venture capitalists has been selected, the entrepreneur can proceed
to identify which investors match their funding requirements. At this point, the entrepreneur should
contact the venture capital firm and identify an investment manager as an initial contact point. The
venture capital firm will ask prospective investee companies for information concerning the product
or service, the market analysis, how the company operates, the investment required and how it is to
be used, financial projections, and importantly questions about the management team.