3 Venture Capital

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Venture Capital


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Introduction

Venture Capitalists (VCs) provide capital andmanagement expertise.

They take risk as success is unpredictable asnascent 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), expansionstage (mezzanine level) or establishment stage(private equity).

In recent times, only early stage financing is knownas VC financing.


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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 asbusinesses in turn-around situations.

VC investments are generally high-riskinvestments but offer the potential for above-average returns.

VC is subject to more than a normal degree

of risk and thus is also called as Risk Capital.


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Definitions

Venture Capital is the capital provided by outside investors forfinancing of startup ventures, growth ventures or struggling

(turn-around) businesses. VC investments generally are high-risk investments but at the same time offer the possibility ofextraordinary 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 andother investors (venture capitalists) in enterprises that are toorisky for the standard capital markets or bank loans.

An Angel Investor is an affluent individual who provides capitalfor a business startup usually in exchange for ownership equity.Unlike venture capitalists, angels typically do not manage thepooled 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 owninvestment capital.


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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 soVCs generally exit the business after achieving the desiredgrowth and thereby booking the capital appreciation.

VC firms look for 3X & PE firms look for 5X capital appreciation.


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Features ofa VCFirm

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


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Stages & Scope of VCFinancing

Concept & Idea Development Stage Seed Capital Forproduct 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. Atthis stage, the product is almost a tested success in limitedmarkets.

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, termloans, etc.


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Eligibility to seek VCFunding

When VC funds consider entrepreneurs and theirenterprises for funding, they look for :-

Strength and motivation of management teams

Clarity on product development strategies

Carefully defined target markets with possibility toscale-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 publiclisting or a third-party acquisition of the investeecompany


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Choosinga VCFund

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 equationshould not have basic difference in strategies.

The entrepreneur should consider not just the amount andterms of investment but also the additional value that theventure capitalist can bring to the company. These skills mayinclude industry knowledge, fund raising, financial and strategic

planning, recruitment of key personnel, mergers andacquisitions and access to international markets andtechnology.

Should offer possible routes of exit for VCs.

Time horizon for required investment should match with the

investment duration of the VC.


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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


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Steps in seeking Venture Capital

The investment process can take up to 3 monthsand 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 tosecure 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 theproposals pass the initial screening.

Only 10% of these screened proposals pass the due

diligence and receive the funding.


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Steps from the VCFunds Perspective

Deal Origination

Screening

Due Diligence

Deal Structuring

Post Investment Activities


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Exit Routes in Venture Capital

Promoters Buyback

Public Issue

Sale to other PE Funds

Management Buyouts

Sell in OTC market


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Origin of Venture CapitalConcept

In 1946, 2 venture capital firms were started - American Research andDevelopment Corporation (ARDC) and J.H. Whitney & Company.

ARDC was founded by Georges Doriot, the "father of venturecapitalism with capital raised from institutional investors, to encourageprivate sector investments in businesses run by soldiers who werereturning fromWorldWar II.

ARDC is credited with the first major venture capital success storywhen its 1957 investment of $70,000 in Digital Equipment Corporation(DEC) would be valued at over $355 million after the company's initialpublic 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 CharlieWaite and Bill Elfers) and Morgan, Holland Ventures, the predecessorof Flagship Ventures (founded in 1982 by James Morgan).

ARDC continued investing until 1971 with the retirement of Doriot. In1972, Doriot merged ARDC with Textron after having invested in over

150 companies.


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Origin of Venture CapitalConcept

J.H.Whitney & Company was founded by John HayWhitneyand his partner Benno Schmidt.

Whitney had been investing since the 1930s, founding PioneerPictures in 1933 and acquiring a 15% interest in TechnicolorCorporation with his cousin Cornelius VanderbiltWhitney.

By far,Whitney's most famous investment was in Florida FoodsCorporation. The company, having developed an innovativemethod for delivering nutrition to American soldiers, later came

to be known as Minute Maid orange juice and was sold to TheCoca-Cola Company in 1960.

J.H.Whitney & Company continues to make investments inleveraged buyout transactions and raised $750 million for itssixth institutional private equity fund in 2005.


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Development of Venture Capital

Concept

BeforeWorldWar II, venture capital investments (originally known as"development capital") were primarily the domain of wealthyindividuals and families.

One of the first steps towards a professionally-managed venturecapital industry was the passage of the Small Business Investment Actof 1958. The 1958 Act officially allowed the U.S. Small BusinessAdministration (SBA) to license private "Small Business InvestmentCompanies" (SBICs) to help the financing and management of thesmall 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 inthe capital markets for long-term funding for growth-oriented smallbusinesses.

Additionally, it was thought that fostering entrepreneurial companieswould spur technological advances to compete against the SovietUnion. Facilitating the flow of capital through the economy up to thepioneering small concerns in order to stimulate the U.S. economy was

and still is the main goal of the SBIC program today.


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Concept

The 1958 Act provided venture capital firms structured either asSBICs or Minority Enterprise Small Business Investment

Companies (MESBICs) access to federal funds which could beleveraged at a ratio of up to 4:1 against privately raisedinvestment funds.

The success of the Small Business Administration's efforts areviewed primarily in terms of the pool of professional privateequity investors that the program developed as the rigid

regulatory limitations imposed by the program minimized therole of SBICs.

In 2005, the SBA significantly reduced its SBIC program,though SBICs continue to make private equity investments.


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Development of Venture CapitalConcept

During the 1960s and 1970s, venture capital firms focused theirinvestment activity primarily on starting and expanding

companies. More often than not, these companies were exploiting

breakthroughs in electronic, medical or data-processingtechnology.

As a result, venture capital came to be almost synonymous withtechnology finance.

It is commonly noted that the first venture-backed startup wasFairchild Semiconductor (which produced the first commerciallypracticable integrated circuit), funded in 1959 by what wouldlater become Venrock Associates.

The growth of the venture capital industry was fueled by theemergence of the independent investment firms on Sand HillRoad, Menlo Park, CA in Silicon Valley beginning with Kleiner

Perkins Caufield & Byers (KPCB) and Sequoia Capital in 1972.


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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 andBeijing in China. TheWall 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 prominentventure capital firms.

Reuters news service has called KPCB "one of the most successfulventure 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 entrepreneursin 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.


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Concept

In 1973, with the number of new venture capital firmsincreasing, leading venture capitalists formed the National

Venture Capital Association (NVCA). The NVCA was to serveas 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 naturallywary 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 firmsalso increased.

Among the firms founded in this period, in addition to KPCBand 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.


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Origin of VCConcept in India

In 1973, a committee on Development of Small and MediumEnterprises highlighted the need to foster venture capital as a sourceof funding new entrepreneurs and technology.

Thereafter, some public sector funds were set up but the activity ofventure capital did not gather momentum.

Till almost 1988, individual investors and development financialinstitutions played the role of VCs in India.

Later, a study was undertaken by the World Bank to examine thepossibility 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 ofIndia is governed by the RBI.


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Origin of VCConcept in India

Also, SEBI framed the SEBI (Venture Capital Funds)Regulations, 1996 which has been further amended in April2000 with the objective of boosting the VC activities in India.

Meanwhile, in 1993, the Indian Private Equity and VentureCapital Association (IVCA) was established which is based inNew Delhi.

IVCA is a member based national organization that representsVenture Capital and Private Equity firms, promotes the industrywithin 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 IVCAalso serves as a powerful platform for investment funds tointeract with each other.


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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 Fundshould apply to SEBI.

The VC Fund shall not carry on any other activity other thanthat 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 isINR 5 lakhs.

Each scheme launched or fund set up by a VC Fund shall havefirm commitment from the investors for contribution of anamount of at least INR 5 crores before the start of operations bythe VC Fund.

The VC Fund is not permitted to get its units listed on anyrecognized stock exchange for first 3 years from the date of

issuance of units by it.


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VC Regulations in India

The VC Fund is not permitted to issue any document or advertisementinviting offers from the public for the subscription or purchase of any of itsunits. 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 tobe listed subject to a lock-in period of one year or by way of debt or debtinstrument of a VC undertaking in which the VC Fund has already madean investment by way of equity.


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Methods of Venture Financing

Equity

Conditional Loan Income Note

Other Financing Methods


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Advantages of VC to VCFund

Investors

The VC Fund as an institution provides mechanismto evaluate proposals professionally. Risk returnequation as a whole assessment process issystematic and convincing. This is not possible forindividual investors.

The VC Funds provide investment opportunities in

high risk new ventures which are not availablethrough any other mechanism.

This is the only way to see mega investment for thewealthy. Established businesses have limited

demand for funds. New ideas are virtually unlimited.


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Advantages of VC to Enterprises

seeking VCFunding

At the nascent stage of business, no other way offunding is available. Bankers are unwilling to extendloans. In absence of VC funding, crazy ideas wouldnever take off for lack of funds.

The VC Funds contribute not only funds but alsomanagement 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.


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Advantages of VC to the Economy

The inorganic and phenomenal growth is notachievable by cautious approach of investment.Ideas worth experimenting are funded by VCs andsometimes these convert to become a trigger ofmajor change in life. VCs in a way achieve socialgoal of rapid progress.

Social talent is utilized properly for its ideas andefforts.

More individuals are motivated to experiment as theyget motivation from VC funded success stories.


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Alternative Forms of Venture Capital

Leveraged Buy-Out

Management Buy-In Mezzanine Financing

Series of Preferred Stock

Documents

3 Venture Capital