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Concept of Venture Capital. Introduction. Meaning. Origin of Venture Capital. Venture capital in India.


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Features of Venture Capital.


Venture Capital Spectrum/Stages.


Venture Capital Investment Process.


Method of Venture Financing.

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Advantages of Venture Capital. Disadvantages of Venture Capital.

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Capital is the lifeblood of businesses. While no amount of money will make a bad business successful, no business can survive without enough money to develop products, hire employees, establish markets and attract customers. For many businesses, particularly in the early stages before profits become predictable, traditional sources of capital such as banks and credit unions are simply unavailable. For those businesses, venture capital may be the best hope to raise the money needed to succeed. Venture capital is not the answer for all businesses in need of capital. But for those businesses that offer the potential of rapid growth and the potential for considerable profit, informed investors are ready to open their checkbooks. Venture capital investing is also about a desire to build a small company into a large one, to build a company that no one has ever heard of into a company that makes headlines. Venture capital can also include managerial and technical expertise. Most venture capital comes from a group of wealthy investors, investment banks and other financial institutions that pool such investments or partnerships. This form of raising capital is popular among new companies or ventures with limited operating history, which cannot raise funds by issuing debt. The downside for entrepreneurs is that venture capitalists usually get a say in company decisions, in

addition to a portion of the equity.

MEANING OF Venture Capital

Venture capital is money provided by an outside investor to finance a new, growing, or troubled business., Simply stated venture capital is money provided by individual investors or entities seeking a high return on their investment in privately owned business ventures. In order to get those high returns, venture investors are willing to accept a relatively high degree of risk of loss of their investment. Venture capitalist long-term risk capital to finance high technology projects which involve risk but at the same time has strong potential for growth. Venture capitalist pools their resources including managerial abilities to assist new entrepreneur in the early years of the project. Once the Project reaches the stage of profitability, they sell their equity holdings at high premium. The venture capitalist provides the funding knowing that theres a significant risk associated with the companys future profits and cash flow. Capital is invested in exchange for an equity stake in the business rather than given as a loan, and the investor hopes the investment will yield a better-thanaverage return. Money provided by investors to startup firms and small businesses with perceived long-term growth potential. This is a very important source of funding

for startups that do not have access to capital markets. It typically entails high risk for the investor, but it has the potential for above-average returns.

Origin of Venture capital

In the 1920's & 30's, the wealthy families of and individuals investors provided the start up money for companies that would later become famous. Eastern Airlines and Xerox are the more famous ventures they financed. Among the early VC funds set up was the one by the Rockfeller Family which started a special fund called VENROCK in 1950, to finance new technology companies. USA is the birth place of Venture Capital Industry as we know it today. In 1946, American Research and Development Corporation (ARD), a publicly traded, closed-end investment company was formed. ARD's best known investment was the start-up financing it provided in 1958 for computer maker Digital Equipment Corp.ARD was eventually profitable, providing its original investors with a 15.8 percent a n n ua l r a te o f r et ur n o v er i ts tw e n ty - f i v e y e a r s a s a n i nd e pe n den t f i r m. T h e nu m b er o f s u c h s p e ci a l i ze d i n v es tm e nt f i r m s , ev en t ua l l y t o b e ca l l e d v e n tu r e capital firms, began to boom in the late 1950s.The growth was aided in large part by t h e c r e a ti o n i n 1 9 58 o f

t h e f e d er a l S m a l l B us i ne s s I nv es tm e n t Co m pa ny pr o g r a m. Hundreds of SBICs were formed in the 1960s.

Venture Capital in India

In India the Venture Capital plays a vital role in the development and growth of innovative entrepreneurships. Venture Capital activity in the past was possibly done by the developmental financial institutions like IDBI, ICICI and State Financial Corporations. These institutions promoted entities in the private sector with debt as an instrument of funding. For a long time funds raised from public were used as a source of Venture Capital. This source however depended a lot on the market vagaries. And with the minimum paid up capital requirements being raised for listing at the stock exchanges, it became difficult for smaller firms with viable projects to raise funds from public. In India, the need for Venture Capital was recognised in the 7th five year plan and long term fiscal policy of GOI. In 1973 a committee on Development of small and medium enterprises highlighted the need to faster VC as a source of funding new entrepreneurs and technology.

VC financing really started in India in 1988 with the formation of Technology Development and Information Company of India Ltd. (TDICI) - promoted by ICICI and UTI. The first private VC fund was sponsored by Credit Capital Finance Corporation (CFC) and promoted by Bank of India, Asian Development Bank and the Commonwealth Development Corporation viz. Credit Capital Venture Fund. At the same time Gujarat Venture Finance Ltd. and APIDC Venture Capital Ltd. were started by state level financial institutions. Sources of these funds were the financial institutions, foreign institutional investors etc.

High Risk
By definition the Venture capital financing is highly risky and chances of failure are high as it provides long term startup capital to high risk-high reward ventures. Venture capital assumes four types of risks, these are: a. Management risk - Inability of management teams to work together. b. Market risk - Product may fail in the market. c. Product risk - Product may not be commercially viable. d. Operation risk - Operations may not be cost effective resulting in increased cost decreased gross margins.

High Tech
As opportunities in the low technology area tend to be few of lower order, and hi-tech projects generally offer higher returns than projects in more traditional areas, venture capital investments are made in high tech. areas using new technologies or producing innovative goods by using new technology.

Not just high technology, any high risk ventures where the entrepreneur has conviction but little capital gets venture finance. Venture capital is available for expansion of existing business or diversification to a high risk area. Thus technology financing had never been the primary objective but incidental to venture capital.

Equity Participation & Capital Gains

Investments are generally in equity and quasi equity participation through direct purchase of shares, options, convertible debentures where the debt holder has the option to convert the loan instruments into stock of the borrower or a debt with warrants to equity investment. The funds in the form of equity help to raise term loans that are cheaper source of funds. In the early stage of business, because dividends can be delayed, equity investment implies that investors bear the risk of venture and would earn a return commensurate with success in the form of capital gains.

Participation In Management
Venture capital provides value addition by managerial support, monitoring and follow up assistance. It monitors physical and financial progress as well as market development initiative. It helps by identifying key resource person. They want one seat on the companys board of directors and involvement, for better or worse, in the major decision affecting the direction of company. This is a unique philosophy of hands on management where Venture capitalist acts as complementary to the entrepreneurs. Based upon the experience other companies, a venture capitalist advise the promoters on project planning, monitoring, financial management, including working capital and public issue. Venture capital investor cannot interfere in day today management of the enterprise but keeps a close contact with the promoters or entrepreneurs to protect his investment.

Length of Investment
Venture capitalist help companies grow, but they eventually seek to exit the investment in three to seven years. An early stage investment may take seven to ten years to mature, while most of the later stage investment takes only a few years. The process of having significant returns takes several years and calls on the capacity and talent of venture capitalist and entrepreneurs to reach fruition.

Illiquid Investment
Venture capital investments are illiquid, that is, not subject to repayment on demand or following a repayment schedule. Investors seek return ultimately by means of capital gains when the investment is sold at market place. The investment is realized only on enlistment of security or it is lost if enterprise is liquidated for unsuccessful working. It may take several years before the first investment starts to locked for seven to ten years. Venture capitalist understands this illiquidity and factors this in his investment decisions.


Stages of Venture Capital

There are five distinct stages of venture capital funding: start-up stage, seed or early stage, growth stage, late stage, and buyouts/recapitalizations. These are discussed as below:-

Start-up Stage
Newly formed companies without significant operating histories are considered to be in the start-up stage. Most entrepreneurs fund this stage of a companys development with their own funds as well as investments from angel investors. Angels are wealthy individuals, friends, or family members that personally invest in a company. Angels are the most common source of first round funding for technology businesses and angel rounds usually less that $1 million. They often will back companies that are at the concept stage and have a limited track record with respect to customers and revenue. These investors tend to invest only in local companies or for people that they already know personally.

Seed or Early Stage


Seed or early stage rounds often involve investments of less than $5 million for companies that have promising concepts validated by key customers but have not yet achieved cash flow break-even. Organized groups of angel investors as well as early stage venture capital funds usually provide these types of investments. Typically, seed and early venture capital funds will not invest in companies outside their geographic area (usually 100-150 miles from the VCs office) as they often actively work with management on a variety of operational issues.

Growth Stage
Growth stage investments focus on companies that have a proven business model and either are already profitable or offer a clear path to sustainable profitability. These investments tend to be in the $5-20 million range and are intended to help the company increase its market penetration significantly. The pool of potential venture capital investors is very robust for growth stage investments, with firms across the United States willing to participate in investment rounds at this stage.

Late Stage
Late stage venture capital investments tend to be for relatively mature, profitable companies seeking to raise $10+ million for significant strategic initiatives (i.e. investment in sales & marketing, expansion overseas, major infrastructure build-outs, strategic acquisitions, etc.) that will create major advantages over their competition. These opportunities are usually funded by syndicates of well-established venture capital firms who manage large funds.

Buyouts and Recapitalizations


Buyouts and recapitalizations are becoming more prevalent for mature technology companies that are stable and profitable. In these transactions, existing shareholders sell some or all of their shares to a venture capital firm in return for cash. These venture capital firms may also provide additional capital to fuel growth in conjunction with an exit for some or all of the companys existing shareholders.

Venture Capital Investment process

The venture capital investment activity is a sequential process involving five steps, which are discussed below:1. Deal origination 2. Screening 3. Evaluation or due diligence 4. Deal structuring 5. Post-investment activities and exit

1. Deal origination
A continuous flow of deals is essential for the venture capital business. Deals may originate in various ways. Referral system is an important source of deals. Deals may be referred to the VCs through their


parent organizations, trade partners, industry associations, friends etc. The venture capital industry in India has become quite proactive in its approach to generating the deal flow by encouraging individuals to come up with their business plans.

2. Screening
VCFs carry out initial screening of all projects on the basis of some broad criteria. For example the screening process may limit projects to areas in which the venture capitalist is familiar in terms of technology, or product, or market scope. The size of investment, geographical location and stage of financing could also be used as the broad screening criteria.

3. Evaluation or due diligence

Once a proposal has passed through initial screening, it is subjected to a detailed evaluation or due diligence process. Most ventures are new and the entrepreneurs may lack operating experience. Hence a sophisticated, formal evaluation is neither possible nor desirable. The VCs thus rely on a subjective but comprehensive, evaluation. VCFs evaluate the quality of the entrepreneur before appraising the characteristics of the product, market or technology. Most venture capitalists ask for a business plan to make an assessment of the possible risk and expected return on the venture.

4. Deal Structuring
Once the venture has been evaluated as viable, the venture capitalist and the investment company negotiate the terms of the deal, i.e. the amount, form and price of the investment. This process is termed as deal structuring. The agreement also includes the protective covenants and earn-out arrangements. Covenants include the venture capitalists right to control the investee company and to change its management if needed, buy back arrangements, acquisition, making initial public offerings (IPOs) etc, Earn-out arrangements specify the entrepreneurs equity share and the objectives to be achieved. The investee companies would like the deal to be structured in such a way that their interests are protected. They would like to earn reasonable


return, minimize taxes, have enough liquidity to operate their business and remain in commanding position of their business. There are a number of common concerns shared by both the venture capitalists and the investee companies. They should be flexible, and have a structure, which protects their mutual interests and provides enough incentives to both to cooperate with each other. The instruments to be used in structuring deals are many and varied. The objective in selecting the instrument would be to maximize (or optimize) venture capitals returns/protection and yet satisfy the entrepreneurs requirements. The different instruments through which a Venture Capitalist could invest a company include: Equity shares, preference shares, loans, warrants and options.

5. Post-investment Activities and Exit

Once the deal has been structured and agreement finalized, the venture capitalist generally assumes the role of a partner and collaborator. He also gets involved in shaping of the direction of the venture. This may be done via a formal representation of the board of directors, or informal influence in improving the quality of marketing, finance and other managerial functions. The degree of the venture capitalists involvement depends on his policy. It may not, however, be desirable for a venture capitalist to get involved in the day-to-day operation of the venture.Venture capitalists typically aim at making medium-to long-term capital gains. They generally want to cash-out their gains in five to ten years after the initial investment. They play a positive role in directing the company towards particular exit routes. A venture capitalist can exit in four ways Initial Public Offerings (IPOs) Acquisition by another company Repurchase of the venture capitalists share by the investee company Purchase of the VCs share by a third party.


Methods of Venture Financing

Venture capital is typically available in three forms in India, they are:

1.Equity :
All VCFs in India provide equity but generally their contribution does not exceed 49 percent of the total equity capital. Thus, the effective control and majority ownership of the firm remains with the entrepreneur. They buy shares of an enterprise with an intention to ultimately sell them off to make capital gains.

2Conditional Loan:
It is repayable in the form of a royalty after the venture is able to generate sales. No interest is paid on such loans. In India, VCFs charge royalty ranging between 2 to 15 percent; actual rate depends on other factors of the venture such as gestation period, cost-flow patterns, riskiness and other factors of the enterprise.

3.Income Note :


It is a hybrid security which combines the features of both conventional loan and conditional loan. The entrepreneur has to pay both interest and royalty on sales, but at substantially low rates.

4.Other Financing Methods:

A few venture capitalists, particularly in the private sector, have started introducing innovative financial securities like participating debentures, introduced by TCFC is an example.


Advantages of venture capital

Venture capital provides the funding that a company needs to expand its business. It also offers a number of value added services. The primary advantage of venture capital is that they allow entrepreneurs to build their company with other OPM.

The venture capitalist then hopes that your company increases in value and ultimately has a liquidity event ( e.g. IPO sells to another company) so that they can get a return on their invested capital.

It injects long term equity finance which provides a solid capital base for future growth. The venture capitalist is a business partner, sharing both the risks and rewards. Venture capitalists are rewarded by business success and the capital gain.

The venture capitalist is able to provide practical advice and assistance to the company based on past experience with other companies which were in similar situations.



You must generate the cash needed to make the agreed payments of capital, interest and dividends. This can create great financial pressure. You will have to agree to certain restrictions as the part of the deal, such as the amount you are paid and your involvement with other businesses, and you will usually need your investors consent to major decisions. Your investor may insist on putting a representative on you board(or having power to o so if financial targets are not met). For VCs this is usually a non-executive director who will only taken an active part if things go wrong. A business angel will usually want to be on the board himself, and will play a more active part.

Your investor will expect regular information and consultation to check how things are progressing. For e.g. monthly management accounts an minutes of abroad meetings.