Venture Capital

Introduction
   

Venture Capitalists (VCs) provide capital and management expertise. They take risk as success is unpredictable as nascent stage of product development. But returns also could be high. Sometimes, the product is developed and tested in small market. VCs fund the expansion of the product which is termed as private equity. VC could be at idea level (seed capital), commercialization stage (growth capital), expansion stage (mezzanine level) or establishment stage (private equity). In recent times, only early stage financing is known as VC financing.

Concept of Venture Capital

 

It is the capital invested in a business where the chances of success are uncertain. It is a term to describe the financing of startup or early stage businesses as well as businesses in turn-around situations. VC investments are generally high-risk investments but offer the potential for aboveaverage returns. VC is subject to more than a normal degree of risk and thus is also called as Risk Capital.

Definitions


 

Venture Capital is the capital provided by outside investors for financing of startup ventures, growth ventures or struggling (turn-around) businesses. VC investments generally are highrisk investments but at the same time offer the possibility of extraordinary high returns. Venture Capitalist is a person who makes such investments. Venture Capital Fund is a partnership or a trust or a company that primarily invests the financial capital of promoters and other investors (venture capitalists) in enterprises that are too risky for the standard capital markets or bank loans. An Angel Investor is an affluent individual who provides capital for a business startup usually in exchange for ownership equity. Unlike venture capitalists, angels typically do not manage the pooled money of others in a professionally-managed fund. However, angel investors often organize themselves into angel networks or angel groups to share research and pool their own investment capital.

Features of Venture Capital



    

VC is generally in the form of equity or a mix of equity and debt. In some rare cases, it could be just long term or convertible loans. Commercial success of funded venture is not tested and thus VC is a risk investment. If successful, VCs can get extraordinary returns. Venture Capitalist is not just a fund provider but also is involved in managing the envisaged growth of the firm. VC investment is usually in tiny, small or non-existent ventures as big established ventures are not funded by VCs. Venture Capitalists are just interested in capital gains and so VCs generally exit the business after achieving the desired growth and thereby booking the capital appreciation. VC firms look for 3X & PE firms look for 5X capital appreciation.

Features of a VC Firm


    

Investment in high-risk and high-return ventures Participation in management Expertise in managing funds Raises funds from various sources Diversification of the portfolio Exit after the specified time

Stages & Scope of VC Financing



 

 

Concept & Idea Development Stage Seed Capital For product development and pilot plant. Commercial possibilities are tested at this stage. Implementation Stage Start-up Finance For commercial plant development and full-fledged operations rollout. Expansion Stage Growth Capital To scale up operations. At this stage, the product is almost a tested success in limited markets. Struggling and Loss making Stage Turn-Around Financing Business Process Reengineering and bail-out package. Stop-Gap or Intermediate Stage Mezzanine Financing Urgent need before completing formalities of public issue, term loans, etc.

Eligibility to seek VC Funding

When VC funds consider entrepreneurs and their enterprises for funding, they look for :Strength and motivation of management teams Clarity on product development strategies Carefully defined target markets with possibility to scale-up in a big way Innovation quotient in the proposed product or idea Features of the proposed product or idea should give significant commercial hedge over the competitors Clear exit routes for the investment such as public listing or a third-party acquisition of the investee company

     

Choosing a VC Fund


 

Following factors may be considered to approach a VC fund :Investment philosophy of a VC should match with the needs of the enterprise seeking funds. Risk-return sharing equation should not have basic difference in strategies. The entrepreneur should consider not just the amount and terms of investment but also the additional value that the venture capitalist can bring to the company. These skills may include industry knowledge, fund raising, financial and strategic planning, recruitment of key personnel, mergers and acquisitions and access to international markets and technology. Should offer possible routes of exit for VCs. Time horizon for required investment should match with the investment duration of the VC.

Steps in seeking Venture Capital

      

Study of VCs details Submission of the Business Plan Scrutiny of the Business Plan Preliminary Meeting Negotiating the investment Approvals Legal and other procedures

Steps in seeking Venture Capital



 

The investment process can take up to 3 months and sometimes even longer. It is important, therefore, not to expect a speedy response. It is advisable to plan the financial needs of the business early on so as to allow appropriate time to secure the required funding. It is estimated that only 6 out of 1000 business plans get funded on an average. Only about 5% of the business plans are read beyond the executive summary and 10% of the proposals pass the initial screening. Only 10% of these screened proposals pass the due diligence and receive the funding.

Steps from the VC Funds Perspective Deal Origination  Screening  Due Diligence  Deal Structuring  Post Investment Activities


Exit Routes in Venture Capital

Promoters Buyback  Public Issue  Sale to other PE Funds  Management Buyouts  Sell in OTC market


Origin of Venture Capital Concept

 

In 1946, 2 venture capital firms were started - American Research and Development Corporation (ARDC) and J.H. Whitney & Company. ARDC was founded by Georges Doriot, the "father of venture capitalism with capital raised from institutional investors, to encourage private sector investments in businesses run by soldiers who were returning from World War II. ARDC is credited with the first major venture capital success story when its 1957 investment of $70,000 in Digital Equipment Corporation (DEC) would be valued at over $355 million after the company's initial public offering in 1968 (representing a return of over 500 times on its investment and an annualized rate of return of 101%. Former employees of ARDC went on to find several prominent venture capital firms including Greylock Partners (founded in 1965 by Charlie Waite and Bill Elfers) and Morgan, Holland Ventures, the predecessor of Flagship Ventures (founded in 1982 by James Morgan). ARDC continued investing until 1971 with the retirement of Doriot. In 1972, Doriot merged ARDC with Textron after having invested in over 150 companies.

Origin of Venture Capital Concept

 

J.H. Whitney & Company was founded by John Hay Whitney and his partner Benno Schmidt. Whitney had been investing since the 1930s, founding Pioneer Pictures in 1933 and acquiring a 15% interest in Technicolor Corporation with his cousin Cornelius Vanderbilt Whitney. By far, Whitney's most famous investment was in Florida Foods Corporation. The company, having developed an innovative method for delivering nutrition to American soldiers, later came to be known as Minute Maid orange juice and was sold to The Coca-Cola Company in 1960. J.H. Whitney & Company continues to make investments in leveraged buyout transactions and raised $750 million for its sixth institutional private equity fund in 2005.

Development of Venture Capital Concept



Before World War II, venture capital investments (originally known as "development capital") were primarily the domain of wealthy individuals and families. One of the first steps towards a professionally-managed venture capital industry was the passage of the Small Business Investment Act of 1958. The 1958 Act officially allowed the U.S. Small Business Administration (SBA) to license private "Small Business Investment Companies" (SBICs) to help the financing and management of the small entrepreneurial businesses in the United States. Passage of the Act addressed concerns raised in a Federal Reserve Board report to Congress that concluded that a major gap existed in the capital markets for long-term funding for growth-oriented small businesses. Additionally, it was thought that fostering entrepreneurial companies would spur technological advances to compete against the Soviet Union. Facilitating the flow of capital through the economy up to the pioneering small concerns in order to stimulate the U.S. economy was and still is the main goal of the SBIC program today.

Development of Venture Capital Concept



The 1958 Act provided venture capital firms structured either as SBICs or Minority Enterprise Small Business Investment Companies (MESBICs) access to federal funds which could be leveraged at a ratio of up to 4:1 against privately raised investment funds. The success of the Small Business Administration's efforts are viewed primarily in terms of the pool of professional private equity investors that the program developed as the rigid regulatory limitations imposed by the program minimized the role of SBICs. In 2005, the SBA significantly reduced its SBIC program, though SBICs continue to make private equity investments.

Development of Venture Capital Concept



 

During the 1960s and 1970s, venture capital firms focused their investment activity primarily on starting and expanding companies. More often than not, these companies were exploiting breakthroughs in electronic, medical or data-processing technology. As a result, venture capital came to be almost synonymous with technology finance. It is commonly noted that the first venture-backed startup was Fairchild Semiconductor (which produced the first commercially practicable integrated circuit), funded in 1959 by what would later become Venrock Associates. The growth of the venture capital industry was fueled by the emergence of the independent investment firms on Sand Hill Road, Menlo Park, CA in Silicon Valley beginning with Kleiner Perkins Caufield & Byers (KPCB) and Sequoia Capital in 1972.

A Brief note on KPCB

 

 

  

The firm (formed in 1972) was named after its four founding partners: Eugene Kleiner, Tom Perkins, Frank Caufield and Brook Byers. It is a world leading venture capital firm located on Sand Hill Road in Menlo Park in Silicon Valley and also has its offices in Shanghai and Beijing in China. The Wall Street Journal has called it one of the "largest and most established" venture capital firms in the world. The New York Times has called it "one of Silicon Valleys top venture capital providers" and said that it is "one of Silicon Valley's most prominent venture capital firms. Reuters news service has called KPCB "one of the most successful venture capital firms in the world. As such, an investment by KPCB is considered a sign that a company has great potential. KPCB specializes in investments in incubation and early stage companies. Since 1972 and till date, KPCB has supported hundreds of entrepreneurs in building over 475 companies, including major names as Amazon.com, Sun Microsystems, Electronic Arts, American Online (AOL), Compaq, Verisign, Macromedia, Netscape and Google. More than 150 of the firm's portfolio companies have gone public.

Development of Venture Capital Concept



In 1973, with the number of new venture capital firms increasing, leading venture capitalists formed the National Venture Capital Association (NVCA). The NVCA was to serve as the industry trade group for the venture capital industry. Venture capital firms suffered a temporary downturn in 1974, when the stock market crashed and investors were naturally wary of this new kind of investment fund. It was not until 1978 that venture capital experienced its first major fundraising year, as the industry raised approximately $750 million. During this period, the number of venture firms also increased. Among the firms founded in this period, in addition to KPCB and Sequoia, that continue to invest actively are AEA Investors, TA Associates, Mayfield Fund, Apax Partners, New Enterprise Associates, Oak Investment Partners and Sevin Rosen Funds.

Origin of VC Concept in India



      

In 1973, a committee on Development of Small and Medium Enterprises highlighted the need to foster venture capital as a source of funding new entrepreneurs and technology. Thereafter, some public sector funds were set up but the activity of venture capital did not gather momentum. Till almost 1988, individual investors and development financial institutions played the role of VCs in India. Later, a study was undertaken by the World Bank to examine the possibility of developing Venture Capital in the private sector. Based on this study, a policy initiative was taken by the GOI and guidelines for VCFs were formulated in 1988. However, these guidelines restricted setting up of VCFs by the banks or FIs only. So, the GOI issued guidelines in September 1995 for overseas investment in VC in India. For tax exemption purposes, guidelines were also issued by the CBDT and the investments and the flow of foreign currency into and out of India is governed by the RBI.

Origin of VC Concept in India



Also, SEBI framed the SEBI (Venture Capital Funds) Regulations, 1996 which has been further amended in April 2000 with the objective of boosting the VC activities in India. Meanwhile, in 1993, the Indian Private Equity and Venture Capital Association (IVCA) was established which is based in New Delhi. IVCA is a member based national organization that represents Venture Capital and Private Equity firms, promotes the industry within India and throughout the world and encourages investment in high growth companies. It enables the development of VC and PE industry in India and to support entrepreneurial activity and innovation. The IVCA also serves as a powerful platform for investment funds to interact with each other.

VC Regulations in India


   

Any company or trust or a body corporate or a foreign VC Fund (subject to RBI clearance) to carry on any activity as a VC Fund should apply to SEBI. The VC Fund shall not carry on any other activity other than that of a VC Fund. A VC Fund may raise monies from any investor whether Indian, foreign or NRIs by way of issue of units. Minimum sum acceptable by a VC Fund from any investor is INR 5 lakhs. Each scheme launched or fund set up by a VC Fund shall have firm commitment from the investors for contribution of an amount of at least INR 5 crores before the start of operations by the VC Fund. The VC Fund is not permitted to get its units listed on any recognized stock exchange for first 3 years from the date of issuance of units by it.

VC Regulations in India


      

The VC Fund is not permitted to issue any document or advertisement inviting offers from the public for the subscription or purchase of any of its units. It may receive monies for investment only through private placement. The VC Fund should maintain proper books of accounts as per the law. On Investments:The VC Fund should disclose the investment strategy at the time of application for registration. The VC Fund should not invest more than 25% corpus of the fund in one venture. The VC Fund should not invest in the associated companies. At least 75% of the investible funds should be invested in unlisted equity shares or equity linked instruments. Not more than 25% of the investible funds may be invested by way of subscription to an IPO of a VC undertaking whose shares are proposed to be listed subject to a lock-in period of one year or by way of debt or debt instrument of a VC undertaking in which the VC Fund has already made an investment by way of equity.

Methods of Venture Financing

   

Equity Conditional Loan Income Note Other Financing Methods

Advantages of VC to VC Fund Investors



The VC Fund as an institution provides mechanism to evaluate proposals professionally. Risk return equation as a whole assessment process is systematic and convincing. This is not possible for individual investors. The VC Funds provide investment opportunities in high risk new ventures which are not available through any other mechanism. This is the only way to see mega investment for the wealthy. Established businesses have limited demand for funds. New ideas are virtually unlimited.

Advantages of VC to Enterprises seeking VC Funding



At the nascent stage of business, no other way of funding is available. Bankers are unwilling to extend loans. In absence of VC funding, crazy ideas would never take off for lack of funds. The VC Funds contribute not only funds but also management expertise which the promoters may not be having adequately. The Foreign VC Funds also bring their network support for brand establishment and market reach. The venture becomes big very fast because of the VC funding.

Advantages of VC to the Economy



The inorganic and phenomenal growth is not achievable by cautious approach of investment. Ideas worth experimenting are funded by VCs and sometimes these convert to become a trigger of major change in life. VCs in a way achieve social goal of rapid progress. Social talent is utilized properly for its ideas and efforts. More individuals are motivated to experiment as they get motivation from VC funded success stories.

Alternative Forms of Venture Capital

   

Leveraged Buy-Out Management Buy-In Mezzanine Financing Series of Preferred Stock