Venture capital is a type of private equity capital typically provided to early stage, high-potential, growth companies in the interest of generating a return through an eventual realization event such as an IPO or trade sale of the company. Venture capital investments are generally made as cash in exchange for shares in the invested company.
The European Venture Capital Association has described it as risk finance for entrepreneurial growth oriented companies, and investment for medium or long-term to maximize returns. It is a partnership with the entrepreneur in which the investor can add value to the company because of his knowledge and experience.
The SEBI has defined Venture Capital Fund in its Regulation 1996 as ‘a fund established in the form of a company or trust which raises money through loans, donations, issue of securities or units as the case may be and makes or proposes to make investments in accordance with the regulations’.
Structure of Venture Capital Firms
Venture capital firms are typically structure as partnerships, the general partners of which serve as the managers of the firm and will serve as investment advisers to the venture capital funds raise. Typical career backgrounds vary, but broadly speaking venture capitalists come from either an operational or a finance background. Venture capitalists with an operational background tend to be former founders or executives of companies or will have serve as management consultants. Venture capitalists with finance backgrounds tend to have investment banking or other corporate finance experience.
Although the titles are not entirely uniform from firm to firm, other positions at venture capital firms include:
- Venture partners - Venture partners are expect to source potential investment opportunities ("bring in deals") and typically are compensated only for those deals with which they are involve.
- Entrepreneur-in-residence (EIR) - EIRs are experts in a particular domain and perform due diligence on potential deals. EIRs are engage by venture capital firms temporarily (six to 18 months) and are expect to develop and pitch startup ideas to their host firm.
- Principal - This is a mid-level investment professional position, and often consider a "partner-track" position. Principals are either promote from a senior associate position or have commensurate experience in fields such as investment banking or consulting.
- Associate - This is typically the most junior apprentice position within a venture capital firm. After a few successful years, an associate may move up to the "senior associate" position and potentially principal and beyond. Associates will often have work for 1-2 years in another field such as investment banking or management consulting.
Characteristics of VC
Long Time Horizon – Venture financing is a long term illiquid investment; it is not repayable on demand. VCFs may have to wait long period (7-12 years) to make substantial profits.
Lack of Liquidity – The investments made in the private company are illiquid until the company goes public or is sold. That is why investment is done in stages. First few years, 1-3 years, are of intense investment activity. Promising companies are included in the portfolio. 1 out of 400th company is successful.
Years 4-6th are growth period in which follow on investments are made and a few new investments are added. Partners decided which venture to cut out and which to continue to support.
Years 7-9th is a harvest period and the focus is on exit strategy and cash management. In the maturity period i.e. years 9-12, the sole focus is on the liquidation of the position.
High Risk – Few investments will return many times the initial investments, other will fail completely. Approximately 40% of all investments are losers. Almost 30% become living dead. About 20 % return 2 to 5 times the initial investment. And around 8% return 8-10 times returns. And only 2% of all the investments ends up generating returns of 10 times the initial investment.
Equity Participation – The objective is to make capital gains by selling off the investment once the enterprise becomes profitable.
Participation in Management – This helps VC to protect and enhance the investment by actually involving and supporting the entrepreneur. Apart from finance, a VC provides his marketing, technology, planning and management skills to the new firm.
Investment Determinants
A venture capital; fund studies and critically examines the under mentioned variables to make SWOT analysis of the ventures before it takes financing decision.
- Analysis of Management – Mental Attributes – Behavioral Attributes
- The analysis of Organization Pattern – Management Team – Equity Holders – Trade Union & Industrial Peace – Strengths and Weaknesses
- The analysis of Production Process
- An analysis of Marketing and Sales
- Financial Analysis and Projections
- Analysis of Reference Information
A Study on Investment Criteria
Dr A K Mishra of IIM Lucknow, conducted a detailed study in the year 2001 on the investment evaluation criteria used by the Indian venture capitalists. Even though the study was conducted six years back, its findings are still relevant and confirm the findings of researchers globally.
Mishra found the entrepreneurs' personality (integrity, attention to detail, long term vision, etc.) to be the most important criteria for the VC, followed by growth prospects of the business.
Past research shows that trustworthiness, enthusiasm and expertise of the entrepreneur are the most important factors considered by the VCs. It has also been seen that about 50-60 per cent of the projects which are seriously considered for financing but are ultimately rejected is due to the factors related to the entrepreneur.
Valuation Methods
PRESENT VALUE BASED METHOD / FIRST CHICAGO METHOD
This method takes into account the stream of earnings (or losses) generate during the entire period of the investment from the date of the initial investment to date of maturity at a presumed discount rate.
Three scenarios are assumed: SUCCESS, SURVIVAL and FAILURE.
Each scenario is assign a probability figure which depends on many things which affect earnings: prices of raw material; prices of finish good; marketing factors.
The total of these scenarios gives the present value of the company. Base on such value the venture capitalist makes his investment.
Problem with this method is that its base on a value judgment rather than empirical considerations.
REVENUE MULTIPLIER METHOD
Revenue multiplier is an assume factor use to estimate the value of an enterprise. By multiplying the annual estimate sales by such factor, the valuation figure is derive. This method is base on sales income and not on earnings.
The multiplier M is obtain by using the following equation:
M = (1 + g) n (e) (PE)
1 + d n
g – growth rate
N – number of years between initial investment and exit date
e – expected profit margin (post tax) percentage at the exit date
PE – expected price earnings ratio at the exit date.
d – appropriate discount rate for venture capital investment & risk.
Deal Structuring
Its an important step of the overall process. Terms are negotiate with respect to amount, form and price of the investment. The agreement also includes the protective covenants and earn-out arrangements.
Covenants include the venture capitalist’s right to control the company and to change its management, if need, buy-back arrangements, acquisition, making initial public offering, etc.
Earn-out arrangements specify the entrepreneur’s equity share and the objectives to be achieve.
The venture companies like deal to be structure in such a way that their interests are protect. They would like to earn reasonable return, minimize taxes, have enough liquidity to operate their business.
Pricing
The Pricing is the most sensitive part of the negotiation process. A Pricing involves valuation of a company before and after financing base on an analysis of risk and return. In seed capital and early stage investment, VC expect a compound annual return of 50 percent. Second stage investment VC may be satisfy with an annual return of 30-40 percent. In later stage financing they would expect something like 25-30 percent. The pricing of the deal is done by valuation. Different valuation methods are use in structuring and pricing deals.
Venture Financing
There are typically six stages of financing offer in Venture Capital, that roughly correspond to these stages of a company's development.
- Seed Money: Low level financing need to prove a new idea
- Start-up: Early stage firms that need funding for expenses associate with marketing and product development
- First-Round: Early sales and manufacturing funds
- Second-Round: Working capital for early stage companies that are selling product, but not yet turning a profit
- Third-Round: Also call Mezzanine financing, this is expansion money for a newly profitable company
- Fourth-Round: Also call bridge financing, 4th round is intend to finance the "going public" process
The financing pattern of the deal is the most important element.
Equity
It is the most desirable form of financing, as it does not put any pressure in the initial teething period. Ideally the support should be through equity to reflect an approach of sharing risk and rewards. The normal limit of assistance by way of equity is to be at a level slightly lower than of the promoter’s equity.
Conditional Loan
It is repayable in the from of royalty after the venture is able to generate sales. No interest is paid on such loans. In India royalty charges are between 2 to 15 %; actual rate depends on various factors such as gestation period, cost flow patterns, risk and other factors of the enterprise. Some VCs give a choice to the enterprise of paying a high rate of interest ( well above 20 %) instead on royalty on sales.
Income Note
This method is unique to India. It’s a hybrid security which combines the feature of both conventional and conditional loan. The entrepreneur has to pay both interest and royalty on sales, but at substantially low rates.
Participating Debenture
Such security carries charges in 3 phases. In the start-up phase, before the venture attains operations to a minimum level, no interest is charge, After this, low rate of interest is charge up to a particular level of operation. Once the venture is commercial, a high rate of interest is require to be paid.
A variation could be in terms of paying a certain share of the post-tax profits instead of royalty.
Quasi Equity
Quasi equity instruments are convert into equity at a later date. Convertible instruments are normally convert into equity at the book value or at certain multiple of EPS, i.e. at a premium to par value at a later date. The premium automatically rewards the promoter for their initiative and hard work. Since it is performance related, it motivates the promoter to work harder so as to minimize dilution of their control on the company.
The different quasi-equity instruments are as follows:
- Cumulative convertible preference shares.
- Partially convertible debentures.
- Fully convertible debentures.
Project Monitoring
The VC carry out close monitoring through various devices like periodical reports, appointing nominee directors on the boards of the assist companies, carrying out periodical inspections and at times appointing their own management personnel. Three styles of monitoring are in use:
Hands-on style
Involves supportive and direct involvement of VC in firm through representation on matters of technology, marketing and general management. They make active contribution to strategies and policies of the firm, rather than only acting as financial watchdogs. In India VC do not involve themselves on the hands-on basis and do not interfere much in management.
Hands-off style
Also know as passive style and involves occasional assessment of the assist firms management and their performance with no direct assistance being provide.
The VC would receive periodic post-investment information from the entrepreneur. Indian VC generally follow this practice
Intermediate style
This is intermediate style between hands-off and hands-on. VCs are entitled to obtain on regular basis information about the assist projects. VCs are also entitle to be consult on key decisions such as major capital expenditure, acquisitions and board appointments.
Exit Route
Initial Public Offer
The most prefer exit route for a venture capitalist is the Initial Public Offer.
Trade Sale
In a trade sale the venture capitalist sells his stake to a strategic buyer that already owns a business similar or complementary or plans to enter into the target industry. This helps the strategic buyer to produce a synergistic increase in value.
Promoter Buy Back
In this the promoter buy back the venture capitalist stake at a predetermine price. Acquisition by another company
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