‘VENTURE CAPITAL’ word consists of two parts one ‘Venture‘ means taking any action or undertaking a decision in which risk, uncertainty involve. Venture also means ‘to proceed especially in the face of danger’ or to undertake risks and dangers of.
A person who is investing on risky projects for sake of gaining high returns is called Venture Capitalist. A venture capitalist generally invests in new and risky projects. A person or a private equity investor that provides capital to companies exhibiting high growth potential in exchange for an equity stake. They are acting as angel for newly start-up companies, which are new and in seek of investment. These new start up companies are generally promoted by new and young entrepreneurs having high potential of earning and greater risk of capital invested.
Thus, Venture Capital can be defined as the long-term Equity Investments in the business which display potential for significant growth and financial return. The nature of financing is long term Equity or Debt Financing in which investor bears the risk of venture but would earn a return commensurate with its success.
The return to investor in these entities are not through dividend or return but is through Capital Appreciation in long term.
FEATURES OF VENTURE CAPITAL FINANCING;
i) In a new and innovative project, the promoters are generally competent, capable and technically/professionally qualified to undertake the venture but lack adequate funds for investment in venture.
ii) The ventures normally have innovation as to technology, process and/or products, which puts the venture in a position of advantage over competitors.
iii) The Venture Capital Investment is potentially high risk and high return investment as products/processes or technology is new and offers advantage over other alternatives available for investment.
iv) The investment is for longer period and is illiquid during take off stage of venture /project. Therefore, investor is prepared to lock investment commercialisation by way pf expansion and increasing sales volume of venture.
v) The investment is long term Equity Financing, where the Venture Capitalist earns his return by Capital Gain.
MODE OF INVESTMENT
I) EQUITY INVESTMENT; We know that Venture Capital Investment carries with it more risk than normal and these are generally made in the form of Equity Investment. The relevance of investment by way of Equity is that the return on investment is directly linked to appreciation or diminution in value of investee undertaking. Since Equity Investment is a long-term investment, on success of project or venture the Venture Capitalist earns appreciation in value of shares of venture and return in way of Capital Gain is more than other alternative investments.
II) DEBTS: Generally, Venture Capital Firms do not invest in the form of conventional debt instruments. The investment instruments are normally conditional loans or income notes. The conditional loans are services by royalty on revenue of venture undertaking and do not have pre-determined repayment schedule and rate of interest or investment may be made through Income Notes carrying repayment schedule in addition to royalty and nominal rate of interest.
SCHEME OF FINANCING
There are three schemes of Venture Capital Financing in India;
i) Equity Financial;
ii) Conditional Loans;
iii) Income Notes.
Though are major cases it is in the form of Equity Financing and very rarely the financing is in the form of Convertible Debts or Preference Capital. The investment in a firm in the form of Equity is restricted to a maximum of 10% of the size of the fund and the participation limited to 49% of the Equity Share Capital of project. In this case the ownership will be in the hand of promoters, who have put their idea, data, technology, time and money in the project.
A conditional loan generally carries a royalty ranging 4 to 15% after the venture is capable of earning profit. There is no interest payment clause in the Conditional Loan.
On the other hand, Income Notes carries interest payment clause with it but on lower rate.
CRITERIA FOR INVESTMENT
The Venture Capital Firms are very selective in making investment in an enterprise as it is considered to be vary risky. Though the firms are eligible for finance, venture capital companies evaluate the enterprises very strictly and rigorously before apprising for finance. They attach paramount importance to enterprise’s growth potential and high financial return.
Below mentioned criteria employed for assessment of capability of a venture /project are;
1. Technically Feasibility and Commercial Profitability;
2. Competence of entrepreneur/management team;
3. Long Term competitive advantage available to the company.
A Venture Capital Firms considers the following before making an investment decision;
a. People
- Entrepreneur;
- Talent (Technical & Business);
- Finance and Accounting Capability;
- Some Trained Venture Capitalist.
b. Business Environment (in the host country)
- A history of good business practices;
- Ease of doing business in host country;
- A regulatory framework appropriate to VC such a functional or legal framework of host country;
- Stock Exchanges working on fair market practices;
- Exit route for small scale industry.
Generally, Venture Capitalists prefers investment in agribusiness, engineering, healthcare, information technology-software, media and FMCG enterprises.
EVALUATION OF THE PROPOSAL FOR INVESTMENT; A Venture Capitalist invests in a new and risky project after a thorough evaluation of projects in all respects and this process of called “DUE DILIGENCE”.
The parameters like investment security, fixed assets coverage for investment and indicators such as Earning Per Share, Profitability, return on investment are main concern for a VC before investing.
As Due Diligence process involves evaluating ventures for factors beyond these primary concerns, as if, it is own venture and if at all it would viable to promote venture. The perception of a Venture Capital Firm in a venture or project will be same as promoters of the project or venture. The put themselves in the shoes of promoters and access pros -cons of projects that whether it is going to succeed in future or not. A Venture Capitalist access all aspects of a venture or project through Due Diligence Process.
The Venture Capitalist take interest in novel ideas and sunrise industries. Presently industries of interest are Information Technology, Media, Entertainment, Bio-technology, Pharma & Health, Retail and even ethnic foods.
STEPS FOR VENTURE CAPITAL FINANCING;
1. Prepare a Sound Business Plan; a proper business plan or clear growth strategy should be prepared. It should be drawn in such manner so that it should presents their business proposal effectively and clearly. The business plan should address four main areas like Management Team, Products/Services, Market and Finance. The business plan should have potential to address the global marketplace. It should be informative and should address competitive aspects of project also.
2. Shortlist Venture Capital Funds; After Preparation of Sound Business Plan, we have to search an appropriate VC Firm. A VC Firm not only provide appropriate capital but also apprise the project and infuse professional knowledge so that project /venture will succeed. Since their concern in success of venture/project is same as of the promoters of venture. A good VC Firm can be acted as a good coach to new promoters and a venture or project will succeed with the help of a good VC Firm.
3. Negotiate Terms and Conditions of Financing; after shortlisting a VC Firm, we have to negotiate regarding valuation of venture and various terms and conditions of subscription and Shareholder’s Agreement. Valuation of a venture is the most important task to provide proper and actual value of efforts of the promoters. The proper valuation of a venture will decide, what an entrepreneur will get in the venture started by his team. While framing terms and conditions, legal and regulatory frameworks must be adhering to. There are various terms and conditions in term sheets and Shareholder’s Agreement, such as Capital Structuring, Employees Stock Options, Non-Compete Agreements, Restrictions of Transfer of Shares, Creation of Subsidiaries, Appointment of Key People, Exit Option of Investor from the venture and Dead Lock Issue Resolution and many other on mutual agreement of both parties.
Note: The normal process for VC funding is that after the fund has decided in principle to “Invest” in the Company, a Term Sheet is signed. The Term Sheet contains the major terms and conditions, which have been agreed upon by the fund and the entrepreneur. The investment is subject to Due Diligence and on compliance of certain pre-conditions, which are spelt out in the Term Sheet.
4. Capital Structuring: The Capital Structuring needs most attention so that matters relating to Exit Options, ESOPs and IPO are addressed in advance.
5. Building up Team; after funding it is important to have a well educated and experienced team of management and employees to execute venture or project, without loss of time.
6. Defining Exit Options; VC Firms invest in a venture to make multiple gains. VC Firms insist on clearly defined time frame and mode of exit from the venture. The most preferred route of exit is Public Offering or there may be buy back of stakes of VC Firm by existing promoters or merger with more efficient companies.
CONCLUSION: Venture Capital funding fuels the growth of industry sectors that require appreciation of technology and knowledge-based funding. Start-ups ventures normally are technology savvy entrepreneur who have good idea but lack of overall business perspective. These entrepreneurs are having very good and innovative ideas but they lack appropriate amount of capital to rung their venture. A Venture Capitalist is a person (generally high Wealth Individuals or Firms) which are investing in risky and more profitable ventures. The risk involves are high but returns from these ventures and commensurate with the risk. A Venture Capitalist gets return on his investment not through interest or dividend but through Capital Gain, while selling its shares in the venture.
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