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Venture World: An Introduction to Venture Capital

CA.Mathew Jacob 
on 03 October 2012

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As we know Venture Capital is a financial capital provided to early-stage, high-potential and risk companies. In other words, it’s the capital that is invested in a project where there is a substantial element of risk relating to the future creation of profits and cash flows. Risk capital is invested as shares (equity) rather than as a loan and the investor requires a higher "rate of return" to compensate him for his risk. Venture capital being involved in new firms has a high risk for investors but a potential of providing a return of ten times more in less than five years.

The main sources of venture capital are venture capital firms and "business angels" - private investors. However, it should be pointed out the attributes that both venture capital firms and business angels look for in potential investments are often very similar.

1.  Venture capital : In detail   -

Venture capital provides long-term, committed share capital, to help unquoted companies grow and succeed. If an entrepreneur is looking to start-up, expand, buy-into a business, buy-out a business in which he works, turnaround or revitalize a company, venture capital could help do this. Obtaining venture capital is substantially different from raising debt or a loan from a lender. Lenders have a legal right to interest on a loan and repayment of the capital, irrespective of the success or failure of a business. Venture capital is invested in exchange for an equity stake in the business. As a shareholder, the venture capitalists return is dependent on the growth and profitability of the business. This return is generally earned when the venture capitalist "exits" by selling its shareholding when the business is sold to another owner.

2.  Venturing of VCs in India:

The first formal venture capital organization in India was set up in the public sector. Later the role of developmental finance was an extension of the development financial institutions like IDBI, ICICI, SIDBI and SFCs. The origin of venture capital in Indian can be traced to the setting up of Technology Development Fund (TDF) in the year 1987-88 to provide financial assistance for innovative and high risk technological programs through Industrial Development Bank of India.

Indian Venture Capital Association was set –up in 1993 based in New Delhi and has become the nodal centre for all venture fund activity in the country. 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.

What kinds of businesses are attractive to venture capitalists?

Venture capitalist prefers to invest in "entrepreneurial businesses". This does not necessarily mean small or new businesses. Rather, it is more about the investment's aspirations and potential for growth, rather than by current size. Such businesses are aiming to grow rapidly to a significant size. As a rule of thumb, unless a business can offer the prospect of significant turnover growth within five years, it is unlikely to be of interest to a venture capital firm. So, Venture capitalists are only interested in companies with high growth prospects, which are managed by experienced and ambitious teams who are capable of turning their business plan into reality.

For how long do venture capitalists invest in a business?

Venture capital firms usually look to retain their investment for between three and seven years or more. The term of the investment is often linked to the growth profile of the business. Investments in more mature businesses, where the business performance can be improved quicker and easier, are often sold sooner than investments in early-stage or technology companies where it takes time to develop the business model.

Angel investor: An overview

An angel investor (business angel or informal investor) is an affluent individual who provides financial backing for a business start-up or entrepreneurs, usually in exchange for convertible debt or ownership equity. A small but increasing number of angel investors organize themselves into angel groups or angel networks to share research and pool their investment capital.

Angels typically invest their own funds, unlike venture capitalists, who manage the pooled money of others in a professionally-managed fund. Angel capital fills the gap in start-up financing between "friends and family" who provide seed funding.

Investment process

The investment process, from reviewing the business plan to actually investing in a proposition, can take a venture capitalist anything from one month to one year but typically it takes between 3 and 6 months. There are always exceptions to the rule and deals can be done in extremely short time frames. Much depends on the quality of information provided and made available.

There are five stages in the investment process :

1. The Seed stage :

2. The Start-up stage : Funding for expenses associated with marketing and product development

3. Growth stage : Includes  early sales and manufacturing funds

4. Second-Round : Form of working capital

5. Expansion : This is expansion money for a newly profitable company

6. The Bridge/Pre-public stage exit of venture capitalist

The key stage of the investment process is the initial evaluation of a business plan. Most approaches to venture capitalists are rejected at this stage. In considering the business plan, the venture capitalist will consider several principal aspects:

· Is the product or service commercially viable?

· Does the company have potential for sustained growth?

· Does management have the ability to exploit this potential and control the company through the growth phases?

· Does the possible reward justify the risk?

· Does the potential financial return on the investment meet their investment criteria?

Venture capital investments are often accompanied by additional financing at the point of investment. This is nearly always the case where the business in which the investment is being made is relatively mature or well-established. In this case, it is appropriate for a business to have a financing structure that includes both equity and debt.

Making the Investment - Due Diligence

To support an initial positive assessment of your business proposition, the venture capitalist will want to assess the technical and financial feasibility in detail. External consultants are often used to assess market prospects and the technical feasibility of the proposition, unless the venture capital firm has the appropriately qualified people in-house.

Chartered accountants have a major role in the due diligence process, such as to report on the financial projections and other financial aspects of the plan. These reports often follow a detailed study, or a one or two day overview may be all that is required by the venture capital firm.

They will assess and review the following points concerning the company and its management :

1.  Management information systems

2.  Forecasting techniques and accuracy of past forecasting

3.  Assumptions on which financial assumptions are based

4.  The latest available management accounts, including the company's cash/debtor positions

5.  Bank facilities and leasing agreements

6.  Pensions funding

7.  Employee contracts, etc.

The due diligence review aims to support or contradict the venture capital firm's own initial impressions of the business plan formed during the initial stage. References are also be taken up on the company from suppliers, customers, bankers etc.

India certainly needs a large pool of risk capital both from home and abroad. All this can happen provided there is the right regulatory, legal, tax and institutional environment; there are risk-taking capacities among the budding entrepreneurs; start-ups have access to R&D flowing out of national and state level laboratories; and universities and infrastructure support, such as telecom, technology parks, etc. keep pace.

Please mail your valuable suggestions to thurumathilmathew@gmail.com.




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