Venture Capital – Concepts

Mohd, A. (2009)

1.1 Introduction: The activity of financing entrepreneurs have actually existed almost as long as entrepreneurs themselves. The two most important and established sources of finance for small firms are the owners themselves (Rosen, 1998) and commercial banks (Meyer, 1998). Funding of business ventures usually poses a dilemma for entrepreneurs because, to begin with, many times entrepreneurs do not have funds to finance ventures from their own funds and then, in general, private banks are also usually unwilling to lend Money to a small and newly established firm (Rangarajan, 1980). Venture capital

Venture capital is a source of finance, which can help an entrepreneur in obtaining funds for the business. Venture capital has some unique characteristics that separate them from traditional sources of funds. Their investments which are in startups firms have firstly; a higher level of uncertainty, secondly; they have substantial asymmetric information, and thirdly; they typically have higher intangible assets and growth prospects.

1.2 Definition of venture capital:

Venture capital as the name suggests is the provision of capital for business ventures. It supports entrepreneurial talent with funds and business skills to exploit market opportunities with an aim to obtain capital gains.

Venture capital is a form of intermediation particularly well suited to support the creation and growth of innovative, entrepreneurial companies (Hellmann & Puri 2000, 2002; Kortum & Lerner, 2000). It specializes in financing and nurturing companies at an early stage of development (start-ups) that operate in high-tech industries. For such companies the expertise of the venture capitalist, its knowledge of markets and of the entrepreneurial process, and its network of contacts are most useful to help unfold their growth potential (Bottazzi, Da Rin & Hellmann, 2004; Gompers, 1995; Hellmann & Puri, 2002; Lerner, 1994, 1995; Lindsey, 2003).

There are various consistent definitions of venture capital; Chris (1990) has defined Venture capital as the provision of risk-bearing capital, usually in the form of participation in equity, to companies with high growth potential. In addition, the venture capital company provides some value-added services in the form of management advice and contribution to the overall strategy. The relatively high risk of the venture capitalist is compensated by the possibility of high return, usually through substantial capital gains in the medium term. In India Pandey (1995) have provided the following definition, Venture capital is an investment in the form of equity, quasi-equity and sometimes debt, straight or conditional (interest and principal payable when the venture starts generating sales), made in a new or untried technology, or high-risk venture, promoted by a technically or professionally qualified entrepreneur, where the venture capitalist

■ Expects the enterprise to have a very high growth rate

■ Provides management and business skills to the enterprise

■ Expects medium to long term gains

■ Does not expect any collateral to cover the capital provided

Another definition of venture capital as per Wright & Robbie (1998), “venture capital is investment by professional investors of long-term, unquoted, risk equity finance in new firms where the primary reward is capital gain supplemented by dividend yield”. Similarly, The United States National Venture Capital Association defines venture capital as “money provided by professionals who invest alongside management in young, rapidly growing companies that have the potential to develop into significant economic contributors” (NVCA, 2002). Gompers & Lerner (1999) define venture capital as the investment activities of professional funds that purchase equity or equity-linked stakes in new, unquoted firms, private equity includes funds devoted to venture capital, leveraged buyouts, consolidations, mezzanine and distressed debt investments, and a variety of hybrids such as venture leasing and venture factoring.

1.3 Process and structure of venture capital:

Process of venture capital consists of a number of steps that are undertaken by venture capitalist while investing in a company. They are as follows (Tyebjee & Bruno, 1986; Sagari & Guidotti 1991).

  1. Deal origination – referral system is an important source of information for VC regarding the potential investors
  2. Screening of proposals – regarding their size of the investment, geographical location and stage of financing is done for those proposals which are of interest to the VC
  3. Evaluation and due diligence – the risk and returns are estimated
  4. Deal structuring – terms of deals are decided. These include details such as the amount of funding, the share the company, the contracts. VC negotiate deals to ensure returns commensurate with the risk, control the organization, minimize taxes, assure liquidity, and the right to replace management in case of poor performance.
  5. Post investment activities and exit – VC involve themselves in major decisions and steer the company towards the exit. Exit can be in four ways, initial public offer, acquisition by another company, and repurchase of the VC’s share by the investee company, purchase of the VC share by the third party

The Venture Capital Processes

Structure of the venture capital market

There are three major players, which dominate the US venture capital industry:

1) The institutional investor (provider of capital)

2) The entrepreneurial firm that receives the fund (use of capital) and

3) The agency or agent who stands between the two and identifies, screens, transacts monitors and raises additional funds.

The venture capital business model is based on the selection of young growth companies with a good risk-return profile, financing them with external equity or similar forms of capital and nurturing them with management support before selling them at a higher valuation. The venture capitalist tries to collect money from investors. He has to convince the investors by clearly communicating his investment approach (Silver, 1985; Schroeder, 1992)
As shown in figure 1-2 financial capital flows from limited partners such as pension funds, individuals, insurance companies, corporations, into the venture capital funds. When sufficient capital is available the fund is closed and the venture capitalist makes his first call of capital, i.e. investors actually pay a first share of the capital they have committed (Smith & Smith, 2000). The venture capitalist usually calls on the committed capital when there are immediate attractive opportunities for investment thereby ensuring the best performance possible of the fund since there are no opportunity costs that need to be earned on capital that has not been called yet.

After that, the venture capitalist starts to make portfolio investments, which typically lasts two or three years (Smith & Smith, 2000). He tries to create deal flow; i.e. he actively seeks to find potential investee on the one hand, and he tries to promote the fund in order to attract entrepreneurs on the other hand (Silver, 1985).

The next step is the analysis of potential portfolio companies. In this staged process, the ventures are first screened to check whether they fit in the strategy of the VC. If so they then are compared to a number of explicit and implicit criteria and finally, a formal and costly due diligence is conducted. If both parties are then still interested in the deal, the conditions of the investment are negotiated and the investment is made.

Also, he monitors the portfolio company to ensure efficient use of the funds provided (Gorman& Sahlman, 1989; Sapienza, 1992; Duffner, 2003).

Finally, Venture capitalists seek to exit portfolio companies within approximately ten years after the first closing of the fund.

Venture Capital FlowsAdapted from Venture capital and innovations, OECD-1996

The VC process involves transactions charges such as: the annual fee, a 2-3 percent management fee, and 15-20 percent interest carried on the capital gain. These are built-in incentives for the agent to carry out his role because it is not easy for institutions to make the connection to the entrepreneurial company directly and effectively conclude deals with them.

This, however, leads to a constant tug of war between the Limited Partners and the General Partners. Limited Partners are always suggesting that General Partners are making too much money or that management fees are too high. The General Partners retort with arguments to the contrary. While these terms have stabilized somewhat, there is constant pressure on both sides.

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