VENTURE CAPITAL

Definition
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 .

Origins of VC
Before World War II, venture capital investments were primarily the domain of wealthy individuals and families. The Vanderbilts, Whitneys, Rockefellers and Warburgs were notable investors in private companies in the first half of the century. It was not until after World War II that what is considered today to be true private equity investments began to emerge marked by the founding of the first two venture capital firms in 1946: American Research and Development Corporation. (ARDC) and J.H. Whitney & Company.

Georges F. Doriot

John Hay Whitney

Laurance Rockfellar

Although the titles are not entirely uniform from firm to firm. other positions at venture capital firms include: ‡ Venture partners . Venture capitalists with finance backgrounds tend to have investment banking or other corporate finance experience. Typical career backgrounds vary. the general partners of which serve as the managers of the firm and will serve as investment advisors to the venture capital funds raised.Venture partners are expected to source potential investment opportunities ("bring in deals") and typically are compensated only for those deals with which they are involved. .Structure of Venture Capital Firms Venture capital firms are typically structured as partnerships. 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 served as management consultants.

and often considered a "partner-track" position.EIRs are experts in a particular domain and perform due diligence on potential deals.Structure contd ‡ Entrepreneur-in-residence (EIR) .This is a mid-level investment professional position. ‡ Principal .This is typically the most junior apprentice position within a venture capital firm. Principals are either promoted from a senior associate position or have commensurate experience in fields such as investment banking or consulting. After a few successful years. ‡ Associate . Associates will often have worked for 1-2 years in another field such as investment banking or management consulting. an associate may move up to the "senior associate" position and potentially principal and beyond. EIRs are engaged by venture capital firms temporarily (six to 18 months) and are expected to develop and pitch startup ideas to their host firm. .

years 9-12. That is why investment is done in stages.Characteristics of VC Long Time Horizon Venture financing is a long term illiquid investment. Promising companies are included in the portfolio. 1 out of 400th company is successful.e. . First few years. 1-3 years. Years 7-9th is a harvest period and the focus is on exit strategy and cash management. In the maturity period i. Lack of Liquidity The investments made in the private company are illiquid until the company goes public or is sold. Partners decided which venture to cut out and which to continue to support. Years 4-6th are growth period in which follow on investments are made and a few new investments are added. the sole focus is on the liquidation of the position. it is not repayable on demand. are of intense investment activity. VCFs may have to wait long period (7-12 years) to make substantial profits.

a VC provides his marketing. technology.Characteristics of VC High Risk Few investments will return many times the initial investments. Almost 30% become living dead. planning and management skills to the new firm. Equity Participation The objective is to make capital gains by selling off the investment once the enterprise becomes profitable. And only 2% of all the investments ends up generating returns of 10 times the initial investment. About 20 % return 2 to 5 times the initial investment. Apart from finance. other will fail completely. And around 8% return 8-10 times returns. . Approximately 40% of all investments are losers. Participation in Management This helps VC to protect and enhance the investment by actually involving and supporting the entrepreneur.

fund studies and critically examines the under mentioned variables to make SWOT analysis of the ventures before it takes financing decision. Financial Analysis and Projections 6. Analysis of Management Mental Attributes Behavioral Attributes 2. Analysis of Reference Information . Analysis of Marketing and Sales 5. Analysis of Production Process 4. Analysis of Organization Pattern Management Team Equity Holders Trade Union & Industrial Peace Strengths and Weaknesses 3. 1.Investment Determinants A venture capital.

its findings are still relevant and confirm the findings of researchers globally. long term vision. etc.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. attention to detail.) to be the most important criteria for the VC. enthusiasm and expertise of the entrepreneur are the most important factors considered by the VCs. Mishra found the entrepreneurs' personality (integrity. Past research shows that trustworthiness. 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. Even though the study was conducted six years back. . followed by growth prospects of the business.

P/E ratio is calculated on the maturing date. also known as liquidity date. The various methods used are: CONVENTIONAL VALUATION METHOD Based on the expected increase in the initial investment that could be sold out to a third party or through public offering via exit route. Does not take into account the stream of cash flows from the date of investment to the date of liquidity . The earning level post-tax is multiplied by P/E ratio gives valuation of the investment at a future date.Valuation Methods Valuation is important to take a decision about the share in equity capital of the company.

Three scenarios are assumed : SUCCESS. prices of finished good. Problem with this method is that its based on a value judgment rather than empirical considerations. The total of these scenarios gives the present value of the company. marketing factors. SURVIVAL and FAILURE.Valuation Methods PRESENT VALUE BASED METHOD / FIRST CHICAGO METHOD This method takes into account the stream of earnings (or losses) generated during the entire period of the investment from the date of the initial investment to date of maturity at a presumed discounted rate. . Each scenario is assigned a probability figure which depends on many things which affect earnings: prices of raw material. Based on such value the venture capitalist makes his investment.

appropriate discount rate for venture capital investment & risk.Valuation Methods REVENUE MULTIPLIER METHOD Revenue multiplier is an assumed factor used to estimate the value of an enterprise. This method is based on sales income and not on earnings. By multiplying the annual estimated sales by such factor. The multiplier M is obtained by using the following equation: M = (1 + g) n (e) (PE) 1+dn g N e PE d growth rate number of years between initial investment and exit date expected profit margin (post tax) percentage at the exit date expected price earnings ratio at the exit date. . the valuation figure is derived.

minimize taxes. have enough liquidity to operate their business.Deal Structuring Its an important step of the overall process. form and price of the investment. buy-back arrangements. They would like to earn reasonable return. Covenants include the venture capitalist s right to control the company and to change its management. if needed. making initial public offering. Earn-out arrangements specify the entrepreneur s equity share and the objectives to be achieved. Terms are negotiated with respect to amount. etc. . The venture companies like deal to be structured in such a way that their interests are protected. The agreement also includes the protective covenants and earn-out arrangements. acquisition.

The pricing of the deal is done by valuation. . Pricing involves valuation of a company before and after financing based on an analysis of risk and return. In seed capital and early stage investment. Different valuation methods are used in structuring and pricing deals. VC expect a compounded annual return of 50 percent. In second stage investment VC may be satisfied with an annual return of 30-40 percent In later stage financing they would expect something like 25-30 percent.Pricing Pricing is the most sensitive part of the negotiation process.

this is expansion money for a newly profitable company ‡ Fourth-Round: Also called bridge financing. ‡ Seed Money: Low level financing needed to prove a new idea ‡ Start-up: Early stage firms that need funding for expenses associated with marketing and product development ‡ First-Round: Early sales and manufacturing funds ‡ Second-Round: Working capital for early stage companies that are selling product. that roughly correspond to these stages of a company's development. but not yet turning a profit ‡ Third-Round: Also called Mezzanine financing. 4th round is intended to finance the "going public" process .Venture Financing There are typically six stages of financing offered in Venture Capital.

. as it does not put any pressure in the initial teething period. No interest is paid on such loans. Some VCs give a choice to the enterprise of paying a high rate of interest ( well above 20 %) instead on royalty on sales. Equity It is the most desirable form of financing. 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. actual rate depends on various factors such as gestation period. risk and other factors of the enterprise. In India royalty charges are between 2 to 15 %. cost flow patterns.Venture Financing The financing pattern of the deal is the most important element. Ideally the support should be through equity to reflect an approach of sharing risk and rewards.

Once the venture is commercial. before the venture attains operations to a minimum level. The entrepreneur has to pay both interest and royalty on sales. Participating Debenture Such security carries charges in 3 phases. In the start-up phase. A variation could be in terms of paying a certain share of the post-tax profits instead of royalty. no interest is charged.Venture Financing Income Note This method is unique to India. After this. . but at substantially low rates. It s a hybrid security which combines the feature of both conventional and conditional loan. a high rate of interest is required to be paid. low rate of interest is charged up to a particular level of operation.

Cumulative convertible preference shares. i. it motivates the promoter to work harder so as to minimize dilution of their control on the company. Since it is performance related. 3.Venture Financing Quasi Equity Quasi equity instruments are converted into equity at a later date. . The premium automatically rewards the promoter for their initiative and hard work. 2.e. Partially convertible debentures. Fully convertible debentures. The different quasi-equity instruments are as follows: 1. Convertible instruments are normally converted into equity at the book value or at certain multiple of EPS. at a premium to par value at a later date.

Project Monitoring The VC carry out close monitoring through various devices like periodical reports. They make active contribution to strategies and policies of the firm. marketing and general management. carrying out periodical inspections and at times appointing their own management personnel. Three styles of monitoring are in use: 1. Hands-on style Involves supportive and direct involvement of VC in firm through representation on matters of technology. 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. appointing nominee directors on the boards of the assisted companies. .

Hands-off style Also know as passive style and involves occasional assessment of the assisted firms management and their performance with no direct assistance being provided. acquisitions and board appointments. VCs are also entitled to be consulted on key decisions such as major capital expenditure. The VC would receive periodic post-investment information from the entrepreneur. Intermediate style This is intermediate style between hands-off and hands-on. VCs are entitled to obtain on regular basis information about the assisted projects. Indian VC generally follow this practice 3. .Project Monitoring 2.

Exit Route Initial Public Offer The most preferred 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. Acquisition by another company . 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 predetermined price.

DEVELOPMENT OF VENTURE CAPITAL IN INDIA .

‡ The concept of venture capital was formally introduced in India in 1987 by IDBI ‡ The government levied a 5 per cent cess on all know-how import payments to create the venture fund ‡ ICICI started VC activity in the same year ‡ Later on ICICI floated a separate VC company TDICI .

VCFs in India can be categorized into following five groups ‡ Central financial institutions such as IDBI and SIDBI ‡ State level financial institutions such as Punjab Infotech Venture Fund ‡ Banks such as Canbank Venture Capital Fund Limited ‡ Private Sector institutions such as IL&FS Venture Corporation Limited ‡ Overseas such as HSBC Private Equity management Mauritius Limited .

‡ VCFs can play a significant role in developing countries in the service sector including tourism. health care etc. technical institutes etc thus promoting entrepreneurial spirit. publishing. ‡ They can provide financial assistance to people coming out of universities. .Future Prospects of Venture Financing ‡ VC can assist small ancillary units to upgrade their technologies so that they could be in line with the developments taking place in their parent companies.

Elements needed for success of venture capital in any country ‡ ‡ ‡ ‡ ‡ ‡ ‡ ‡ ‡ Entrepreneurial Tradition Unregulated economic environment Disinvestments avenues Fiscal incentives Broad based education Venture capital managers Promotion efforts Institute industry linkage R&D activities .

of Deals ‡ Early Stage 24 ‡ Growth Stage 25 ‡ Late Stage 67 ‡ PIPE 34 ‡ Buyout 6 ‡ Others 6 Source: TSJ Venture Intelligence India Amount (US$M) 154 1082 2162 1714 440 47 ‡ Total number of deals: 162 with total amount invested at ‡ ~ US$5.6B .PE Investments by Stage : 2007 ‡ Stage of Company No.

& Construction Shipping & Logistics Energy Telecom Others 16% 07% 02% 03% 37% 02% 07% 14% 05% 02% 01% 04% .PE/VC Investments by Industry Total US$5.6B (First Half of 2007) ‡ ‡ ‡ ‡ ‡ ‡ ‡ ‡ ‡ ‡ ‡ ‡ IT & ITES Manufacturing Healthcare & Life Sciences Textiles & Garments BFSI* Hotels & Resorts Media & Entertainment Engg.

525 354 492 1.114 .Top Cities attracting PE Investments (2006) ‡ ‡ ‡ ‡ ‡ ‡ ‡ City No.780 395 1. of Deals Mumbai 69 Delhi/NCR* 41 Bangalore 40 Chennai 22 Hyderabad 17 Pune 10 Value(US$M) 1.

. They found that the sales of listed PE-backed companies grew at 22.9% as compared to 10% for non-PE-backed listed firms. Hyderabad. PE backed firms added more jobs to the economy and even the wages at listed PE financed firms grew at around 32% as compared to 6% for non-PE-backed firms. studied the economic impact of PE and VCs on the Indian businesses. Amit Bubna of Indian School of Business. The following are some of the interesting observations of this study: The study shows that the VC backed companies grew faster compared to the non-VC backed peers and even better than the benchmark indices like the NSE Nifty.Venture Intelligence with the guidance of Prof.

while only about 4% felt that they would have developed the same way even without PE funding. ‡ The study also shows that the biggest support of the PE investors were provided in the area of strategic direction followed by the financial advice and then recruitment and the marketing activities .‡ An astonishing finding was that almost 96% of the top executives felt that without the support and the backing of private equity these companies would not have existed or would have grown at a slower rate.

MAIN PROVISIONS OF VCF REGULATIONS (1996) .

it shall be binding on the venture capital fund to abide by the provisions of the SEBI Act. 1) A venture capital fund may be set up by a company or a trust. after a certificate of registration is granted by SEBI on an application made to it.PROVISIONS Cont. The VCF shall not carry on any other activity than that of VCF> . On receipt of the certificate of registration. 1992 .

The VCF shall not issue any document or advertisement inviting offers from the public for subscription of its security or units . Indian. Non-resident Indian or foreign.PROVISIONS Cont. provided the money accepted from any investor is not less than Rs 5 lakh. 2) A VCF may raise money from any investor.

PROVISIONS Cont. 3) A VCF is not permitted to invest in the equity shares of any company or institutions providing financial services. .

. Such investment may be made through private placement prior to the listing of such securities is permitted. b) the equity shares and securities of a financially weak company whose securities may or may not be listed on an organized stock exchange. 4) At least 80% of the funds raised by a venture capital funds shall be invested in a) the equity shares or securities by an unlisted company.PROVISIONS Cont.

PROVISIONS Cont. 5) The societies or units issued by a venture capital fund shall not be listed on any recognized stock exchange till the expiry of 4 years from the date of issuance . .

6) A VCF may receive monies for investment in the venture capital fund through private placement of its securities units.PROVISIONS Cont. .

PROVISIONS Cont. . is over b) If the trustee are of the opinion that the winding up shall be in the interest of the investors c) 75 % of the investors in the scheme pass a resolution for winding up or. d) If SEBI so directs in the interest of the investors. 7) A Scheme of VCF set up as a trust shall be wound up a) when the period of the scheme if any.

ASSISTANCE a) Size b) Technology c) Promoters/Entrepreneurs 4. MANAGEMENT 3. Size . ESTABLISHMENT 2.VENTURE CAPITAL GUIDELINES 1.

b) Foreign equity up to 25% in multilateral/ international financial organizations. reputed mutual funds etc. 5. Investment Division with a copy to Chairman. development finance institutes. SEBI. d) Application should be addressed to Ministry of Finance. Capital Issues: a) Funds be raised through public issues and/ or private placement to finance VCC/VCFs. foreign NRI participation in Capital issues. . c) NRI investment would be permitted up to 74% on a non repayable bases.VENTURE CAPITAL GUIDELINES Cont.

Debt-equity ratio 7. Exit 9. Underwriting Listing 8. . Eligibility for Tax Concession.VENTURE CAPITAL GUIDELINES Cont. 6.

4) VCFs can not invest in more than 40% of equity of a venture. 3) VCFs can not invest more than 20% of total money raised in a venture. .VCF REGULATION AS PER PROVISION OF INCOME-TAX RULES 1) 80% of money raised under the fund should be invested in equity shares of unlisted company. with in a period of three years. 2) VCFs are required to hold investment for a minimum period of 3 years.

III. V. Sale of share on stock Exchange after Listing IPO/Offer for sale Strategic Sales Buy Back of Equity by Company Promoters Buy Back .DISINVESTMENT AND EXIT ROUTES IN VC BUSINESS I. IV. II.

III. V.ISSUES IN EXERCISING EXIT OPTION I. Threshold Limit for Listing Formalities Involved in Sale of Venture Stock Market Support Weak Legal Framework Underdeveloped Market for Mergers and Acquisition . II. IV.

Efficient Stock Market II.PRE-REQUISITE FOR THE EFFICIENT EXIT MECHANISM I. Legal Framework IV. Mechanism for listing of Equity by Companies with Low Equity Base III. Facilitate Smooth Transfer/Sale of Ventures .

can invest in approve venture capital funds or VCCs.GUIDELINES FOR FOREIGN VENTURE CAPITAL 1. 2. Off-shore VCC can contribute 100% capital as well as set up a domestic asset management company. with the permission of Foreign Investment Promotion Board. 3. Subsequent investment does not require FIPB s permission. and will be subject to the general restriction applicable to VCCs to invest only in unlisted companies but not exceeding 40% of a company s paid up capital . Off-shore investors.

Offshore investors income from Indian VCFs/VCCs would be subject to existing rates for foreign investors. are available to foreign VCCs. . they are free to invest in any sector. 4.GUIDELINES FOR FOREIGN VENTURE CAPITAL Cont. If they want to avail tax exemptions. 5. subject to the existing guidelines. Tax exemption similar to the domestic VCFs/VCCs.

71-93 WEBSITES ‡ Website of Indian Venture Capital Association. Financial Management.com ‡ www. pp. Pg 455 486 PAPERS Mishra A K. ICFAI Journal of Applied Finance.rediff. 1999 ‡ Pandey I M. Macmillian. 10.gov. Vol. Chapter 23.wiekepedia. Venture Capital: The Indian Experience. 9e.com .References BOOKS ‡ Chary T Satyanarayana. No. Prentice Hall.in www. 2005 ‡ Pandey I M. 2004.org ‡ http://www. www.com/money www. 7.ivca. Indian Venture Capitalists (VCs): Investment Evaluation Criteria . Venture Capital: Concepts and Application.sebi.ficci. Vikas Publication.

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