Venture Capital

By: Soumya Mishra Roll: 14MBA021

Introduction

A project or activity that involves risk

The money or fund

needed business

The capital invested in a project

in which there is a substantial

element of risk, typically a new

or expanding business.

Venture Capital

• Venture capital is a type of private equity capital

typically provided by professional, outside investors to

new, growth businesses .

• 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‘.

Venture Capitalist

• A venture capitalist (VC) is a person who makes such investments,

these include wealthy investors, investment banks, other financial

institutions other partnerships.

• Venture Capitalists generally: – Finance new and rapidly growing companies

– Purchase equity securities

– Assist in the development of new products or services

– Add value to the company through active participation.

Features of Venture Capital

1.High Risk:

By definition the Venture capital financing is highly risky and

chances of failure are high as it provides long term start up capital to high

risk-high reward ventures. Venture capital assumes four types of risks, these

are:

• Management risk - Inability of management teams to work together.

• Market risk - Product may fail in the market.

• Product risk - Product may not be commercially viable.

• Operation risk - Operations may not be cost effective

resulting in increased cost decreased

gross margins.

2. Equity Participation & Capital Gains

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.

3. Participation In Management

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.

4.Length of Investment

The process of having significant returns takes

several years and calls on the capacity and talent of venture

capitalist and entrepreneurs to reach fruition.

5.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.

6.High-tech

Venture capital finance caters largely to the needs of first-

generation entrepreneurs who are technocrats, with innovative

technological business ideas that have not so far been

tapped in the industrial field .

Stages of Venture Capital

Financial

Stage

Meaning

Period (Funds

locked in years)

Risk Percep

tion

Activity to be financed

Seed

Money

Low level financing needed to prove a new idea.

7-10

Extreme

For supporting a concept or idea or R&D for product development

Start Up

Early stage firms that need funding for expenses associated with marketing and product development.

5-9

Very High

Initializing operations or developing prototypes

First Stage

Early sales and manufacturing funds.

3-7

High

Start commercials production and marketing

Financial Stage

Meaning Period (Funds locked

in years)

Risk Percepti

on

Activity to be financed

Second Stage

Working capital for early stage companies that are selling product, but not yet turning a profit .

3-5

Sufficien

tly high

Expand market and growing working capital need

Third Stage

Also called Mezzanine financing, this is expansion money for a newly profitable company .

1-3

Medium

Market expansion, acquisition & product development for profit making company

Fourth Stage

Also called bridge financing, it is intended to finance the "going public" process .

1-3 Low Facilitating public issue

Buy – out / Buy – in Financing • It is a recent development and a new form of investment by venture

capitalist. The funds provided to the current operating management to acquire or

purchase a significant share holding in the business they manage are called

management buyout.

• Management Buy-in refers to the funds provided to enable a manager or a group

of managers from outside the company to buy into it.

• It is the most popular form of venture capital amongst later stage financing. It is

less risky as venture capitalist in invests in solid, ongoing and more mature

business. The funds are provided for acquiring and revitalizing an existing product

line or division of a major business. MBO (Management buyout) has low risk as

enterprise to be bought have existed for some time besides having positive cash

flow to provide regular returns to the venture capitalist, who structure their

investment by judicious combination of debt and equity. Of late there

has been a gradual shift away from start up and early finance

towards MBO opportunities. This shift is because of lower

risk than start up investments.

Turnaround Finance

It is rare form later stage finance which most of the venture capitalist avoid

because of higher degree of risk. When an established enterprise becomes sick, it

needs finance as well as management assistance foe a major restructuring to

revitalize growth of profits. Unquoted company at an early stage of development

often has higher debt than equity; its cash flows are slowing down due to lack of

managerial skill and inability to exploit the market potential. The sick companies

at the later stages of development do not normally have high debt burden but

lack competent staff at various levels. Such enterprises are compelled to

relinquish control to new management. The venture capitalist has to carry out the

recovery process using hands on management in 2 to 5 years. The risk profile and

anticipated rewards are akin to early stage investment.

Methods of Venture Financing

• A pre-requisite for the development of an active venture capital industry

is the availability of a variety of financial instruments which cater to the

different risk-return needs of investors. They should be acceptable to

entrepreneurs as well.

• Venture capital financing took in forms of

– Equity and quasi equity

– Conditional Loan

– Income notes

– Convertible Debentures

– Cumulative Convertible Preference Share

• 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.

• Quasi Equity: A form of finance that combines some of the benefits of equity and debt

• Conditional 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.

• 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.

• 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.

Process of Venture Financing

Deal origination

Screening

Due diligence (Evaluation)

Deal structuring

Post investment activity

Exit plan

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.

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. Due Diligence

Most venture capitalists ask for a business plan to make an assessment of the possible

risk and return on the venture. Business plan contains detailed information about the

proposed venture. The evaluation of ventures by VCFs in India includes;

– Preliminary evaluation: The applicant required to provide a brief profile of the

proposed venture to establish prima facie eligibility.

– Detailed evaluation: Once the preliminary evaluation is over, the proposal is

evaluated in greater detail. VCFs in India expect the entrepreneur to have:-

Integrity, long-term vision, urge to grow, managerial skills, commercial

orientation.

– VCFs in India also make the risk analysis of the proposed projects which

includes: Product risk, Market risk, Technological risk and Entrepreneurial

risk. The final decision is taken in terms of the expected

risk-return trade-off.

4. Deal Structuring

In this process, the venture capitalist and the venture company negotiate the

terms of the deals, that is, the amount, form and price of the investment. This process is

termed as deal structuring. The agreement also include the venture capitalist‘s right to

control the venture company and to change its management if needed, buyback

arrangements, acquisition, making initial public offerings (IPOs), etc. Earned out

arrangements specify the entrepreneur‘s equity share and the objectives to be achieved.

5. Post Investment Activities

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. The degree of the venture capitalist‘s

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.

If a financial or managerial crisis occurs, the venture capitalist may

intervene, and even install a new management team.

6.Exit

• Venture capitalists 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 may exit in one of

the following ways:

• There are four ways for a venture capitalist to exit its investment:

– Initial Public Offer (IPO)

– Acquisition by another company

– Re-purchase of venture capitalist‘s share by the investee company

– Purchase of venture capitalist‘s share by a third party

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.

Venture capital funds in India

VCFs in India can be categorized into following five groups:

1) Those promoted by the Central Government controlled development finance

institutions. E.g.: - ICICI Venture Funds Ltd.

- IFCI Venture Capital Funds Ltd (IVCF)

- SIDBI Venture Capital Ltd (SVCL)

2) Those promoted by State Government controlled development finance

institutions.

e.g. : - Punjab Infotech Venture Fund

- Gujarat Venture Finance Ltd (GVFL)

- Kerala Venture Capital Fund Pvt Ltd.

- Orissa Venture Capital Fund

3) Those promoted by public banks.

e.g. : - Canbank Venture Capital Fund

- SBI Capital Market Ltd

4)Those promoted by private sector

companies.

e.g.: - IL&FS Trust Company Ltd

- Infinity Venture India Fund

5)Those established as an overseas venture capital fund.

e.g.: - Walden International Investment Group

- HSBC Private Equity management Mauritius Ltd

SEBI (Venture Capital Fund) Regulations, 1996

• VCF – ―Venture Capital Fund‖ means a fund established in the form of a trust or a

company including a body corporate and registered under these regulation which—

(i) has a dedicated pool of capital;

(ii) raised in a manner specified in the regulations; and

(iii) invests in accordance with the regulations;

• VCU -―Venture Capital Undertaking‖ means a domestic company—

i. whose shares are not listed on a recognized stock exchange in India;

ii. which is engaged in the business for providing services, production or

manufacture of article or things or does not include such activities or

sectors which are specified in the negative list by the Board with the

approval of the Central Government by notification in the

Official Gazette in this behalf.

Obligations of Venture Capital fund:

• Venture Capital fund shall not carry out any other activity than that of

venture capital fund .

• Venture capital shall disclose investment strategy at the time of making

investments

• VCF shall disclose the duration of the life cycle of the fund

• VCF shall not get its units listed on any recognized stock exchange till the

expiry of three years from the date of issuance of units by VCF

• VCF cannot invite offers from the public for subscribing for its units and shall

only receive monies by the way of private placement of the units

• VCF shall enter into the placement memorandum and subscription

agreement which contains terms and conditions subject to which

money is proposed to be raised from the investors. A copy of the

placement memorandum and subscription agreement will be placed

with the Board along with the actual money collected

• VCF shall maintain its books of accounts, records and

documents for a period of 8 years

Minimum Investment in Venture Capital:

• Venture Capital Fund may raise money from Indian, foreign, non-

resident Indian, by way of issue of units

• Investments below Rs.5 lakhs from any investor shall not be accepted

other than employees, principal officer, directors of venture capital fund

or employees of fund manager or asset management company

• Venture capital fund shall invest minimum of Rs.5 crores in each of the

schemes launched or fund set up

Scheme of VCF can be wound up in the following circumstances:

• In case of trust

Period of scheme mentioned in the placement memorandum is

over

In the opinion of the trustees and in the interest of the investors

scheme should be wound up

75% of the investors in the scheme pass a resolution that the

scheme should be wound up

If SEBI so directs in the interest of the investors.

• In case of company: wound up in accordance with the provisions of the

Companies Act, 1956

• In case of a body corporate: wound up as per the

statute under which it is incorporated

SEBI (Foreign Venture Capital Investor) Regulations, 2000 • Registration: Application to be made to the Board in Form A with the

application fee. The applicant should be granted the necessary permission

by RBI to make investments in India. The certificate of registration is granted

in Form B by the Board

• Investment criteria:

Investor shall disclose his investment strategy

Can invest all his funds in one venture capital

• Obligations:

Maintain books of account and records for a period of 8 years

The foreign investor shall appoint a custodian for custody of the securities ƒ

Custodian shall monitor the investment ƒ Furnish periodic reports to the Board ƒ

Furnish information as required/ called for by the Board

enter into an agreement with a designated bank for

operating the foreign currency account

Future scopes of VC in India

• VC can help in the rehabilitation of sick units.

• VC can assist small ancillary units to upgrade their

technologies

• VCFs can play a significant role in developing countries

in the service sector including tourism, publishing, health

care etc.

• They can provide financial assistance to people coming

out of universities, technical institutes, etc. thus

promoting entrepreneurial spirits.