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net

MEANING

Venture capital refers to an equity/equity-related investment in a growth oriented small/medium

business to enable the investors to accomplish corporate objectives, in return for monetary
shareholding in the business or the irrevocable rights to acquire it. Venture capital is a typical
‘private equity investment.’

Venture capital is a popular method by which investors support entrepreneurial talent with
finance and business skills to exploit market opportunities with a view to obtaining long-term
capital gains. It involves the provision of risk-bearing capital, usually in the form of equity
participation, to companies with high growth potential, besides providing more value addition in
the form of management advice and contribution to overall strategy.

Long-term investment, generally in high-risk industrial projects with high reward possibilities, is
called ‘venture capital.’ The investment may take place at any stage of implementation of the
project, between the start-up and commencement of commercial production. Venture capital is
also invested in financing the new business and professional activities that carr y a higher degree
of success and failure as well. Venture capital implies a high level of risk implicit in the
investment of funds.

DEFINITION
According to the of 1984, “Venture capital
investment is defined as an activity by which investors support entrepreneurial talent with
finance and business skills to exploit market opportunities and thus obtain long-term capital
gains.”

RATIONALE
The rationale for venture capital arises on account of the fact that there is high
expectation for large gains for an entrepreneur which acts as the motivation behind taking up

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risky investments that carry high return profiles. Venture capital investmen is made with the
objective of obtaining equity ownership in such enterprises initially, and to take part in the
growing prospects in the form of capital appreciation subsequently.

FEATURES

Venture capital investment is generally made in new enterprises that use new
technology to produce new products, in expectation of high gains or sometimes, spectacular
returns.
Venture capitalists continuously involve themselves with the client’s
investments, either by providing loans or managerial skills or any other support.
Venture capital is basically an equity financing method, the investment
being made in relatively new companies when it is too early to go to the capital market to raise
funds. In addition, financing also takes the form of loan finance/convertible debt to ensure a
running yield on the portfolio of the venture capitalists.

The basic objective of a venture capitalist is to make a capital gain on equity

investment at the time of exit, and regular return on debt financing. It is a long-term investment
in growth oriented small/medium firms. It is long-term capital that is injected to enable the
business to grow at a rapid pace, mostly from the start-up stage.
Venture capital institutions take an active part in providing value added
services such as providing business skills, etc. to investee firms. They do not interfere in the
management of the firms nor do they acquire a majority /controlling interest in the investee
firms. The rationale for the extension of hands-on management is that venture capital
investments tend to be highly non-liquid.
Venture capitalists finance high risk-return ventures. Some of the
ventures yield very high return in order to compensate for the heavy risks related to the ventures.
Venture capitalists usually make huge capital gains at the time of exit.
Venture capitalists usually finance small & medium sized firms during the early
stages of their development, until they are established and are able to raise finance from the
conventional industrial finance market. Many of these fir ms are new, high-technology oriented
companies

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Liquidity of venture capital investment depends on the success or otherwise of the

new venture or product. Accordingly there will be higher liquidity where the new ventures are
highly successful.

ORIGIN & GROWTH OF VENTURE CAPITAL IN INDIA

Venture capital that originated in India very late is still in its infancy. It was the Bhatt Committee
(Committee on Development of Small & Medium Entrepreneurs) in the year 1972, which
recommended the creation of venture capital. The committee urged the need for providing such
capital to help new entrepreneurs and technologists in setting up industries.

A brief description of some of the venture capital funds in India is as follows:

1. The Industrial Finance Corporation of India (IFCI) launched the

first venture capital fund in the year 1975. The fund, ‘Risk Capital Foundation’ (RCF) aimed
at supplementing ‘promoter’s equity’ with a view to encouraging technologists and
professionals to promote new industries.
2. This venture capital fund was launched by IDBI in 1976, with the same
objective in mind.
3. Venture capital funding obtained official patronage with the
announcement by the Central Government of the ‘Technology Policy Statement’ in 1983. It
prescribed guidelines for achieving technological self-reliance through commercialization and
exploitation of technologies. The ICICI, an all India financial institution in the private sector
set up a Venture capital scheme in 1986, to encourage new technocrats in the private sector to
enter new fields of high technology with inherent high risk. The scheme aimed at allocating
funds for providing assistance in the form of venture capital to economic activities having
risk, but also high profit potential.
4. The ICICI undertook the administration of Program for Application of Commercial
Technology (PACT), aided by U.S.AID with an initial grant of USD 10 million. The program

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aims at financing specific needs of the corporate sector industrial units along the lines of
venture capital funding.
5. IDBI, as nodal agency, administers the venture capital fund created by
st
the Central Government with effect from 1 April, 1986. The government started imposing a
Research & Development (R & D) levy on all payments made for the purchase of technology
from abroad, including royalty payments, lump sum payments for foreign collaboration and
payment for designs and drawings under the R&D Cess Act, 1986. The levy was used as a
source of funding the venture capital fund.
6. In 1988, an ICICI sponsored company, viz. Technology Development and
Information Company of India ltd. (TDICI) was founded, and venture capital operations of
ICICI were taken over by it with effect from July 1, 1988.
7. The Risk Capital Foundation (RCF) sponsored by IFCI was converted into Risk
Capital and Technology Finance Corporation Ltd. (RCTFC) in the year 1988. It took over the
activities of RCF, in addition to the management of other financing technology development
schemes and venture capital fund.

8. VECAUS-I, the UTI sponsored “Venture Capital Unit Scheme” was launched in
the year 1989. Technology Development and Information Company of India Ltd. (TDICI)
was appointed as its managers. In the year 1990, the corporation was also entrusted with the
responsibility of managing another UTI sponsored venture fund entitled ‘VECAUS-II’. In
1991, UTI launched VECAUS-III and RCTC was appointed as fund manager.

VENTURE CAPITAL & OTHER FUNDS

Venture capital funds are different from other capital funds in man y respects as shown below:
Venture capital is advanced for ventures using new
technology or new innovation. In this type of financing the venture capital company remains
interested in the overall management of the project due to the high risk involved in the venture.
Funds are made available throughout the project, commencing from commercial production to
the successful marketing of products, to ensure continuous revenue earnings, enhanced worth of
the investments, and finally making available a proper exit route for liquidating the investments.

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Development capital, on the other hand, is generally granted in the form of loans for setting
industrial units, and also for expansion and modernization. The lender takes special care in
ensuring the end use of the credit and requires prompt payment of interest and repayment of the
loan amount.

There are no tangible differences between venture

capital, seed capital & risk capital. Both seed capital & risk capital are components of venture
capital. Seed capital and risk capital are provided by all- India financial institutions in the form
of promoter’s contribution to the project, with the emphasis on providing interest free finance to
encourage professionals to become promotees of industrial projects.

The National equity fund,

administered by SIDBI, was established in 1987, with the object of providing seed capital
assistance to small entrepreneurs, in the rural as well as urban areas, with a population below 5
Lakhs.

STAGES OF VENTURE CAPITAL FINANCING

Setting up a new venture

Seed Capital

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Early stage financing

Follow on financing

Expansion financing

Replacement financing

Turnaround financing

Exit

IPO Sale of shares Puts & Calls

This is the early stage of financing. This stage involves primarily R & D financing .The European
venture capital financing defines seed capital as “the financing of the initial product development or
capital provided to an entrepreneur to prove the feasibility of a project for start up capital.

This stage involves serious risk, as there is no guarantee for the success of the concept, idea & process
pertaining to high technology or innovation. This stage requires constant infusion of funds in order to

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sustain the R & D work & establish the process of successful adaptation, going into the
commencement of commercial production & marketing. Venture financing constitutes financing of
ideas developed by R & D wings of companies or at university centers. Chances of success in hi – tech
projects are meager. The venture capital fund considers the following points to safeguard its own
interests.

1. Successful performance record, entrepreneur’s previous experience in similar products, technology &
market.
2. Qualities of business management & technical innovation in the enterprise, realistic business plan with
the clear future projects for which seed capital is required.

The European venture capital association defines start up financing as “the capital needed to finance the
product development, initial marketing & establishment of product facilities “. This too falls under the

category of early stage financing .the term ‘start up’ refers where a new activity is launched .the activity
may be one emanating from R & DS stage, or arising from transfer of technology from overseas – based
business.

Venture capital finance is provided to the projects, which have been selected for commercial production
.The activity chosen for funding has the potential for fulfilling effective demand. Venture capitalists
provide finance with the view to take advantage of the capital gain arising from equity appreciation on
completion of such projects & marketing of its product. The venture capitalists on their part take into
consideration such factors as the managerial ability, capacity, experience, competence etc of the
entrepreneur before making investments.

The entrepreneur should furnish the following details to the venture capitalists:

1. Brief history of business or project.

2. A synoptic note on career history of entrepreneur & key managers.
3. Description of product / service to be manufactured.

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4. Description of product /service with existing /future state of competition, growth prospects in the share
market etc.
5. Description of technical process involved & technology to be followed in the manufacturing process.
6. Degree of technological obsolesce in technical process.
7. Finance history & forward projections of turnover profits, cash flows & borrowings over at least a two
yr period.
8. Proposed deal structure for the funding being sought.

Venture capitalists appraise projects by taking the following key factors into consideration with the basic
objective of assessing the risk involved in financing, & then judge the realistic expectation of gains.

1. : The track record of the promoter / entrepreneur /management team / skilled staff
resource is analyzed to evaluate the management performance record, ability, capacity of the entrepreneur
to handle the proposed business plan successfully.

2. : the technical performance assumptions about the product/process/service,

the technical strength of the proposed process service with reference to product life cycle are also
analyzed.

3. : Market potential, relating to market size, growth & penetration are analyzed .in
addition, evaluation state of domestic competition & international competition is also carried out.

4. : An analysis in order to evaluate profitability projections on realistic cost assumptions

& competitive price setting is under taken, as part of venture financing.

5. : overall completion time is ascertained by evaluating the time schedule given by client
for completion of the plan on a realistic basis ,& the experience gained by the venture capitalist/merchant
bankers from other projects.

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The European venture capital Association defines early stage finance as “ finance provided to companies
that have completed development stage & require further funds to initiate commercial manufacturing &
sales. They will not be generating profit”. This is the kind of financing required fro completing the project
.It is required immediately after the start up stage of a project. The need for additional funds arises when
the project encounters cost & time over – runs or when the completed projects starts making losses, thus
necessitating the infusion of equity type funding. This type of funding may also be required when the start
up has been successful, & the business is growing.

The European venture capital association defines follow on financing or second round finance as “ the
provision of capital to a firm which has been in receipt of external capital but whose financial needs have
subsequent expanded “. Later stage, in a project at this stage promises to be a attractive in terms of earning
potential, it is considered to be the most attractive stage for venture capital financing. Financing, at this

point in the project, is preferred by venture capitalists around the world, particularly in U.K & U.S.A.

The European Venture capital Association defines expansion capital as “the finance provided to fund the
expansion or growth of a company which is breaking even or trading at small profit “. Expansion or
growth of a company will be used to finance increased production capacity, market or product
development to provide additional working capital. This is one of the later stage financing methods,
whereby finance is provided by the venture capitalists for adding production capacity, once it has
successfully gained a market share, & faces increased demand for the product. Financing is also made
available for acquisition or takeover.

A later stage financing method, also know as ‘money – out deal’, whereby venture capitalists extend
financing for the purchase of the existing shares from an entrepreneur or their associates in order to reduce
their holdings in the unlisted company, is know as ‘replacement financing ‘. This sale of shares may be by

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persons other than entrepreneurs or their associate’s .The venture capitalists may buy ordinary shares from
vendors and may convert them into preference shares bearing a fixed dividend coupon. Such shares may
be converted back into ordinary shares if the company is listed & can thereafter be sold.

This type of financing provided by the venture capitalists in the event of an enterprise becoming un
profitable after the launch of commercial production. This is provided in the form of a relief package from
the existing the exiting venture capital investors, & the enterprise is provided with specialist skills to
recover. This form of financing is popular in the U.S finance is made available to a unlisted & non
profitable venture in need of equity funds to allow for turn around .The finance may also be provided to
sustain the current operations of the enterprise.

Analyzing venture capital financing proposals – criteria

Fundamental analysis refers to an examination of the aspects of the business without which the investor
cannot even begin to make an informed decision. As part of fundamental analysis the following f actors are
considered

: A brief history of the company, including date in incorporation & summary of progress.

: The quality, experience, strategy & motivations of management, directors & existing
shareholders.

: A complete description of the company’s products or services.

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: The market which the company serves, including size & nature of the industry ,location &
characteristics of customer base ,potential competition & unique selling points.

: Manufacturing & operational aspects of the business, including a description of the

technology used, access to sources of supply, manufacturing capacity & premises owned or occupied .

: An objective analysis of the fundamental risks & management‘s plans to cope with the same.

The purpose of financial analysis is to set out the financial implications of a company’s strategy & to
measure its performance. Following aspects are considered by venture capitalists to determine the
financial viability of the project:

Earnings growth potential.

Sensitivity of earnings to sales & margins.
Likely time – lag between investment & return .
Likely impact on cash flow.
Expected value of the company at the notional time of divestment.
Analysis of the financial risks & managements plans to cope with these.

Portfolio analysis consists in examining the venture capitalist portfolio balance at the time the investment
proposal is being considered. According, the proposed investment must be an acceptable addition to the

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venture capitalists portfolio, in terms of its size of development, its geographic location & its industry
sector.

: the amount of money per investment has a significant impact on the size of the
portfolio. Moreover, if the venture capitalist builds up a large portfolio, hands on management will be
difficult.

: A venture capital portfolio will typically of some companies, which are in the
start up phase, some companies in a development stage & others in the mature phase of its life cycle, such
as MBO investments.

: In order to reach an acceptable level of portfolio diversity & volume, many

funds will go in search of foreign investments .The basic principle of a successful international investment
policy is it join a syndicate with local fund, which will have a superior understanding of the market, &
also the social, investment & tax environment.

: This is the fourth in the portfolio diversification. Venture capitalists attempts to

diversify the portfolio in order t offset problematic or slow growth investments.

Divestment calls for venture capitalists to have a clear idea about the method, the timing & valuation of
the company upon divestment. There are 4 principal means by which venture capitalists realize
investments:

: The process of selling the investment to a compan y in the trade, i.e. a competitor wishing to
buy the investor’s market share or production capacity, a supplier intending to integrate forward, or a
customer trying to integrate backward or tie up source of supply, is referred to as ‘trade sale ‘. A trade sale
is in the form of an unexpected & unsolicited bid.

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: The process of selling the investment to another professional investor, another venture
capitalist, by way of private placement with a major institutional investor such as an insurance company or
pension fund manager, or a management holding company is know as ‘take out’. Under this agreement,
typically, only the venture capital company will sell its shares while the entrepreneur retains his stake.

: I this method, the venture capital investment is realized through the entrepreneur buying back
the venture capitalist shares with the proceeds of the project .For their purpose the entrepreneur is given
the option at the time of investment.

: This is the final exit route for the venture capital investment. Under this method. Issue of
securities is made in the stock market. In order to float, the company must have a good & complete
management team. The methods of floatation may var y as shown below;

a) , where the company‘s shares are placed with prearranged buyers.

b) , where the company invites the public to subscribe to its shares at a fixed price, which is

underwritten.
c) , where the public is invited to name the number of shares & price it will pay, with a minimum
price underwritten.

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