Venture Capital

What is Venture Capital?

• It is a private or institutional investment made
into early-stage / start-up companies (new
ventures)
• is money invested in businesses that are
small; or exist only as an initiative, but have
huge potential to grow.
• typically comes from institutional investors
and high net worth individuals and is pooled
together by dedicated investment firms.
 What is Venture Capital?

• Recently focused on technology-heavy companies:

– Computer and network technology
– Telecommunications technology
– Biotechnology
• Types of VCs:
– Angel investors
– Financial VCs
– Strategic VCs
 Angel Investors
• Typically a wealthy individual
• Often with a tech industry background, in position
to judge high-risk investments
• Usually a small investment (< $1M) in a very early-
stage company (demo, 2-3 employees)
• Motivation:
– Dramatic return on investment via exit or liquidity event:
• Initial Public Offering (IPO) of company
• Subsequent financing rounds
– Interest in technology and industry
 Financial VCs
• Most common type of VC
• An investment firm, capital raised from
institutions and individuals
• Often organized as formal VC funds, with
limits on size, lifetime and exits
• Sometimes organized as a holding company
• Fund compensation: carried interest
• Holding company compensation: IPO
• Fund sizes: ~$25M to 10’s of billions
• Motivation:
– Purely financial: maximize return on investment
– IPOs, Mergers and Acquisitions (M&A)
 Strategic VCs
• Typically a (small) division of a large
technology company
• Examples: Intel, Cisco, Siemens, AT&T
• Corporate funding for strategic investment
• Help companies whose success may spur
revenue growth of VC corporation
• Not exclusively or primarily concerned with
return on investment
• May provide investees with valuable
connections and partnerships
• Typically take a “back seat” role in funding
 Historical Development of
Venture Capital as an Institution
 Venture Capital New Commitments
Venture Capital New Commitments

$50,000

$45,000

$40,000

$35,000
Millions of Dollars

$30,000

$25,000

$20,000

$15,000

$10,000

$5,000

$0
1969

1971

1973

1975

1977

1979

1981

1983

1985

1987

1989

1991

1993

1995

1997

1999
Year
Sources: Statistical Abstract of the U.S. (various issues), Venture Economics Investor Service, Sahlman (1990).
 Sources Sources
of Venture Capital
of Venture Capital Funds Funds
100%

90%

80%

70%
Foreign Investors
Percent of Total

60% Individuals
50% Corporations
Endowments
40%
Insurance Companies
30%
Pension Funds
20%

10%

0%
1986

1988

1996
1978

1980

1982

1984

1990

1992

1994

Year
Sources: Statistical Abstract of the U.S. (various issues), Gompers and Lerner (1996, 1997).
 Organizational Structure of
Venture Capital Investment
General Partners
– Generate deal flow – Negotiate deals
– Screen opportunities – Monitor and advise
– Harvest investments

Effort and Annual Carried

1% of Management Interest 20-
capital Fee 2-3% 30% of Gain Investment
Capital and
Portfolio
Effort
Venture Capital Fund Companies
Financial –Value creation
99% of Investment Capital Appreciation Claims
Capital 70-80% of Gain

Limited Partners
– Pension plan – Corporations
– Endowments – Individuals
– Life insurance companies
 Percent of time

Source: Zider (1998)

10%
15%
20%
25%

0%
5%
Soliciting Business

Selecting Opportunities
Allocation Allocation

Analyzing Business Plans

Negotiating Deals

Directing and Monitoring

of Venture

Activity
Consulting

Recruiting Management
of Venture Capitalist

Assisting in Outside
Relationships
Time

Exiting
Capitalist Time
 The Venture Capital Investment
Process
Development of Fund Concept

Secure Commitments Generate Deal Flow

from Investors

Year 0
Closing of Fund
First Capital Call

2-3 years Screen Evaluate and Negotiate Additional Invest

Business Conduct Due Deals and Capital Funds
Plans Diligence Staging Calls

Value Creation and Monitoring

4-5 years
– Board service – Assist with external relationships
– Performance evaluation and review – Help arrange additional financing
– Recruitment management

2-3 years Harvesting Investment Distributing Proceeds

or more – IPO – LBO – Cash – Other
– Acquisition – Liquidation – Public Shares

7-10 years plus extensions

 Key Covenant Classes
Key Covenant of Venture
Classes
CapitalCapital
of Venture Limited Partnerships
Limited Partnerships
Overall Fund Management
Investment in a single firm
Use of debt
Coinvestment by Venture Capitalist’s Other Funds
Reinvestment of profits
Activities of General Partner
Personal investing in portfolio companies
Sale of interest by General Partner
Fund-raising
Outside activities
Addition of General Partners
Types of investments
Restrictions on asset classes

Based on Gompers and Lerner (l997).

 Features of Venture Capital
investments
• High Risk
• Lack of Liquidity
• Long term horizon
• Equity participation and capital gains
• Venture capital investments are made in
innovative projects
• Suppliers of venture capital participate in the
management of the company
 Methods of Venture capital
financing
• Equity
• participating debentures
• conditional loan
THE FUNDING PROCESS: Approaching a Venture
Capital for funding as a Company
 The venture capital funding process typically
involves four phases in the company’s development:

• Idea generation
• Start-up
• Ramp up
• Exit
 Step 1: Idea generation and
submission of the Business Plan
• The initial step in approaching a Venture Capital is to submit a
business plan. The plan should include the below points:
• There should be an executive summary of the business proposal
• Description of the opportunity and the market potential and size
• Review on the existing and expected competitive scenario
• Detailed financial projections
• Details of the management of the company
• There is detailed analysis done of the submitted plan, by the Venture
Capital to decide whether to take up the project or no.
 Step 2: Introductory Meeting

• Once the preliminary study is done by the VC and

they find the project as per their preferences, there
is a one-to-one meeting that is called for
discussing the project in detail. After the meeting
the VC finally decides whether or not to move
forward to the due diligence stage of the process.
 Step 3: Due Diligence

• The due diligence phase varies depending upon the nature

of the business proposal. This process involves solving of
queries related to customer references, product and
business strategy evaluations, management interviews, and
other such exchanges of information during this time
period.
Step 4: Term Sheets and Funding

• If the due diligence phase is satisfactory, the VC

offers a term sheet, which is a non-binding
document explaining the basic terms and
conditions of the investment agreement. The term
sheet is generally negotiable and must be agreed
upon by all parties, after which on completion of
legal documents and legal due diligence, funds are
made available.
Types of Venture Capital funding

• The various types of venture capital are

classified as per their applications at various
stages of a business.
The three principal types of venture capital are:
 early stage financing,
 expansion financing and
 acquisition/buyout financing.
 A) Early Stage Financing:

Early stage financing has three sub divisions seed financing, start up
financing and first stage financing.
•Seed financing is defined as a small amount that an entrepreneur
receives for the purpose of being eligible for a start up loan.
•Start up financing is given to companies for the purpose of finishing the
development of products and services.
•First Stage financing: Companies that have spent all their starting
capital and need finance for beginning business activities at the full-scale
are the major beneficiaries of the First Stage Financing.
 B) Expansion Financing:

Expansion financing may be categorized into second-stage financing,

bridge financing and third stage financing or mezzanine financing.
•Second-stage financing is provided to companies for the purpose of
beginning their expansion. It is also known as mezzanine financing. It is
provided for the purpose of assisting a particular company to expand in a
major way.
•Bridge financing may be provided as a short term interest only finance
option as well as a form of monetary assistance to companies that employ
the Initial Public Offers as a major business strategy.
 C) Acquisition or Buyout
Financing:
• Acquisition or buyout financing is categorized
into acquisition finance and management or
leveraged buyout financing.
• Acquisition financing assists a company to acquire
certain parts or an entire company.
• Management or leveraged buyout financing helps
a particular management group to obtain a
particular product of another company.
 Advantages of Venture Capital

• They bring wealth and expertise to the company

• Large sum of equity finance can be provided
• The business does not stand the obligation to
repay the money
• In addition to capital, it provides valuable
information, resources, technical assistance to
make a business successful
Disadvantages of Venture Capital

• As the investors become part owners, the

autonomy and control of the founder is lost
• It is a lengthy and complex process
• It is an uncertain form of financing
• Benefit from such financing can be realized
in long run only
 Exit route

There are various exit options for Venture

Capital to cash out their investment:
•IPO
•Promoter buyback
•Mergers and Acquisitions
•Sale to other strategic investor