VENTURE CAPITAL

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Why Venture Capital?

A critical resource for supporting innovation, knowledge based ideas and technology and human capital intensive enterprises High risk / high return finance combined with hand holding Supports first generation entrepreneurs by providing the finance needed for idea based enterprises generally not available from banks and institutions

Terms

Angel investor: a high-net-worth individual who has made money through his own enterprises and reinvests in other entrepreneurs. Usually a source of seed money and other early capital infusions. Private equity: the spectrum of nonquoted equity investment, ranging from seed money and startup capital to cashflow-driven turnarounds and leveraged buyouts.

Venture capital: a segment of private equity; investment focused on emerging, generally risky, businesses whose entrepreneurial founders require early funding to develop prototypes, perform beta-testing and otherwise finance their dreams. Seed capital: the earliest stage of venture capital, often put up by angel investors. An entrepreneur with a business concept--but nothing else--seeks this money to research and develop his idea.

Early-stage capital: the next phase of financing after seed capital, raised when the business is in the startup phase. Most VCs enter the picture at this point. Expansion capital: second-or third-stage funding for growth of a company that is generating revenue.

Exit - Exit is the sale or exchange of a significant amount of company ownership for cash, debt, or equity of another company. Initial public offering: listing shares of the venture on a stock exchange and selling some of them to public investors. At this stage angel investors and venture capital funds will usually recoup some (or all) of the capital they have advanced, shifting some of the risk to the public investors.

What is "venture capital"?

Venture capital is an important source of equity for start-up companies.

Venture capital is capital invested or available for investment in the ownership element of a new enterprise. While there may also exist a preferred return or debt component, the defining characteristic is that the capital investor retains some equity in the venture.

Venture capital firms are pools of capital, that invests in companies that represent the opportunity for a high rate of return within five to seven years. Professionally managed venture capital firms generally are private partnerships or closely-held corporations funded by private and public pension funds, endowment funds, foundations, corporations, wealthy individuals, foreign investors, and the venture capitalists themselves.

Venture capital is money provided by professionals who invest alongside management in young, rapidly growing companies that have the potential to develop into significant economic contributors. Far from being simply passive financiers, venture capitalists foster growth in companies through their involvement in the management, strategic marketing and planning of their investee companies.

They actively work with the company's management by contributing their experience and business savvy gained from helping other companies with similar growth challenges. They are entrepreneurs first and financiers second.

When considering an investment, venture capitalists carefully screen the technical and business merits of the proposed company. Venture capitalists only invest in a small percentage of the businesses they review and have a long-term perspective.

Companies such as Digital Equipment Corporation, Apple, Federal Express, Compaq, Sun Microsystems, Intel and Microsoft are famous examples of companies that received venture capital early in their development.

Venture capitalists generally: Finance new and rapidly growing companies; Purchase equity securities; Assist in the development of new products or services; Add value to the company through active participation; Take higher risks with the expectation of higher rewards; Have a long-term orientation

What Venture Capital Firms Look For

Banks and venture capital firms evaluate a small business seeking funds, differently: Banks look at its immediate future, but are most heavily influenced by its past. Venture capitalists look to its longer run future.

Venture capital firms, like other financial people, want to know the results and ratios of past operations, the amount and intended use of the needed funds, and the earnings and financial condition of future projections. But venture capitalists look much more closely at the features of the product and the size of the market than do commercial banks.

Banks are creditors. They're interested in the product/market position of the company to the extent they look for assurance that this service or product can provide steady sales and generate sufficient cash flow to repay the loan. They look at projections to be certain that owner/managers have done their homework. Venture capital firms are owners. They hold stock in the company, adding their invested capital to its equity base. Therefore, they examine existing or planned products or services and the potential markets for them with extreme care. They invest only in firms they believe can rapidly increase sales and generate substantial profits.

STAGES OF VENTURE FINANCING

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There are several types or stages of venture financing typically referred to as: 1. Seed 2. Start-Up 3. Second Stage 4. Third Stage 5. Mezzanine 6. Initial Public Offering (IPO)

A venture capitalist may invest before there is a real product or company organized (so called "seed investing"), or may provide capital to start up a company in its first or second stages of development known as "early stage investing." Also, the venture capitalist may provide needed financing to help a company grow beyond a critical mass to become more successful ("expansion stage financing").

Seed money, seed capital or seed financing is venture capital used to finance the early development of a new product or service concept. There is no guarantee that the product or service under development will ever make it to the stage of a workable prototype much less a viable commercial enterprise. Start-up capital usually refers to venture funding sufficient to generate initial sales and profits.

Mezzanine financing

Mezzanine Financing is a late-stage venture capital, usually the final round of financing prior to an IPO. Mezzanine Financing is for a company expecting to go public usually within 6 to 12 months, usually so structured to be repaid from proceeds of a public offerings, or to establish floor price for public offer.

Mezzanine debts are debts that incorporates equity-based options, such as warrants, with a lower-priority debt. Mezzanine debt is actually closer to equity than debt, in that the debt is usually only of importance in the event of bankruptcy.

"IPO"

IPO is the frequently-used abbreviation for initial public offering. Many venture capital investors think of it as "payday". That's because, if successful, an initial public offering will create a viable market for the company's stock and provide its founders and early-stage investors with a cash return on their investment and, eventually, liquidity for their remaining shares.

Types of Venture Capital Firms

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Who invests in start-ups?

Venture investors include: 1. Institutional venture capital funds typically organized as limited partnerships. 2. Corporations seeking to gain access to new technologies and/or markets. 3. Corporations seeking venture opportunities strictly to enhance return on equity. 4. Wealthy individuals who either specialize or have a percentage of their portfolio in venture capital investments. 5. Entrepreneurial business owners and corporate managers.

Traditional partnerships--which are often established by wealthy families to aggressively manage a portion of their funds by investing in small companies; Professionally managed pools--which are made up of institutional money and which operate like the traditional partnerships; Investment banking firms--which usually trade in more established securities, but occasionally form investor syndicates for venture proposals;

Insurance companies--which often have required a portion of equity as a condition of their loans to smaller companies as protection against inflation; Manufacturing companies--which have sometimes looked upon investing in smaller companies as a means of supplementing their R&D programs (Some "Fortune 500" corporations have venture capital operations to help keep them abreast of technological innovations)

There are several types of venture capital firms, but most mainstream firms invest their capital through funds organized as limited partnerships in which the venture capital firm serves as the general partner. The most common type of venture firm is an independent venture firm that has no affiliations with any other financial institution. These are called "private independent firms".

Venture firms may also be affiliates or subsidiaries of a commercial bank, investment bank or insurance company and make investments on behalf of outside investors or the parent firms clients. Still other firms may be subsidiaries of nonfinancial, industrial corporations making investments on behalf of the parent itself. These latter firms are typically called "direct investors" or "corporate venture investors."

Investment Focus

Venture capitalists may be generalist or specialist investors depending on their investment strategy. Venture capitalists can be generalists, investing in various industry sectors, or various geographic locations, or various stages of a companys life. Alternatively, they may be specialists in one or two industry sectors, or may seek to invest in only a localized geographic area.

Not all venture capitalists invest in "start-ups." While venture firms will invest in companies that are in their initial start-up modes, venture capitalists will also invest in companies at various stages of the business life cycle. A venture capitalist may invest before there is a real product or company organized (so called "seed investing"), or may provide capital to start up a company in its first or second stages of development known as "early stage investing." Also, the venture capitalist may provide needed financing to help a company grow beyond a critical mass to become more successful ("expansion stage financing").

There are venture funds that will be broadly diversified and will invest in companies in various industry sectors as diverse as semiconductors, software, retailing and restaurants and others that may be specialists in only one technology. While the venture industry gets a lot of attention for its high technology investments, venture capitalists also invest in companies such as construction, industrial products, business services, etc.

Length of Investment

Venture capitalists will help companies grow, but they eventually seek to exit the investment in three to seven years. An early stage investment make take seven to ten years to mature, while a later stage investment many only take a few years, so the appetite for the investment life cycle must be congruent with the firms appetite for liquidity. The venture investment is neither a short term nor a liquid investment, but an investment that must be made with careful diligence and expertise.

FUND RAISING
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The venture capital firm will organize its partnership as a pooled fund; that is, a fund made up of the general partner and the investors or limited partners. These funds are typically organized as fixed life partnerships, usually having a life of ten years.

Each fund is capitalized by commitments of capital from the limited partners. Once the partnership has reached its target size, the partnership is closed to further investment from new investors or even existing investors so the fund has a fixed capital pool from which to make its investments. Venture capitalists mitigate the risk of venture investing by developing a portfolio of young companies in a single venture fund. Many times they will co-invest with other professional venture capital firms.

In addition, many venture partnership will manage multiple funds simultaneously. Like a mutual fund company, a venture capital firm may have more than one fund in existence. A venture firm may raise another fund a few years after closing the first fund in order to continue to invest in companies and to provide more opportunities for existing and new investors. It is not uncommon to see a successful firm raise six or seven funds consecutively over the span of ten to fifteen years. Each fund is managed separately and has its own investors or limited partners and its own general partner.

Commitments and Fund Raising

The process that venture firms go through in seeking investment commitments from investors is typically called "fund raising. The commitments of capital are raised from the investors during the formation of the fund. A venture firm will set out prospecting for investors with a target fund size. It will distribute a prospectus to potential investors and may take from several weeks to several months to raise the requisite capital.

The fund will seek commitments of capital from institutional investors, endowments, foundations and individuals who seek to invest part of their portfolio in opportunities with a higher risk factor and commensurate opportunity for higher returns. Because of the risk, length of investment and illiquidity involved in venture investing, and because the minimum commitment requirements are so high, venture capital fund investing is generally out of reach for the average individual. The venture fund will have from a few to almost 100 limited partners depending on the target size of the fund. Once the firm has raised enough commitments, it will start making investments in portfolio companies.

Capital Calls

Making investments in portfolio companies requires the venture firm to start "calling" its limited partners commitments. The firm will collect or "call" the needed investment capital from the limited partner in a series of tranches commonly known as "capital calls". These capital calls from the limited partners to the venture fund are sometimes called "takedowns" or "paid-in capital." Some years ago, the venture firm would "call" this capital down in three equal installments over a three year period. More recently, venture firms have synchronized their funding cycles and call their capital on an as-needed basis for investment.

Illiquidity

Limited partners make these investments in venture funds knowing that the investment will be long-term. It may take several years before the first investments starts to return proceeds; in many cases the invested capital may be tied up in an investment for seven to ten years. Limited partners understand that this illiquidity must be factored into their investment decision.

Disbursements

The investment by venture funds into investee portfolio companies is called "disbursements". A company will receive capital in one or more rounds of financing. A venture firm may make these disbursements by itself or in many cases will co-invest in a company with other venture firms ("co-investment" or "syndication"). This syndication provides more capital resources for the investee company. Firms co-invest because the company investment is congruent with the investment strategies of various venture firms and each firm will bring some competitive advantage to the investment.

The venture firm will provide capital and management expertise and will usually also take a seat on the board of the company to ensure that the investment has the best chance of being successful. A portfolio company may receive one round, or in many cases, several rounds of venture financing in its life as needed.

Exit

Depending on the investment focus and strategy of the venture firm, it will seek to exit the investment in the portfolio company within three to five years of the initial investment. While the initial public offering may be the most glamourous and heralded type of exit for the venture capitalist and owners of the company, most successful exits of venture investments occur through a merger or acquisition of the company by either the original founders or another company.

The expertise of the venture firm in successfully exiting its investment will dictate the success of the exit for themselves and the owner of the company.

IPO

The initial public offering is the most glamourous and visible type of exit for a venture investment. In recent years technology IPOs have been in the limelight. At public offering, the venture firm is considered an insider and will receive stock in the company, but the firm is regulated and restricted in how that stock can be sold or liquidated for several years.

Once this stock is freely tradable, usually after about two years, the venture fund will distribute this stock or cash to its limited partner investor who may then manage the public stock as a regular stock holding or may liquidate it upon receipt.

Mergers and Acquisitions

Mergers and acquisitions represent the most common type of successful exit for venture investments. In the case of a merger or acquisition, the venture firm will receive stock or cash from the acquiring company and the venture investor will distribute the proceeds from the sale to its limited partners.

Indian Context
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Government of India took a policy initiative and announced guidelines for Venture Capital Funds (VCFs) in India in 1988. However, these guidelines restricted setting up of VCFs by the banks or the financial institutions only. Thereafter, the Government of India issued guidelines in September 1995 for overseas investment in Venture Capital in India. For tax-exemption purposes, guidelines were also issued by the Central Board of Direct Taxes (CBDT) and the investments and flow of foreign currency into and out of India have been governed by the Reserve Bank of India's (RBI) requirements.

Further, as a part of its mandate to regulate and to develop the Indian capital markets, the Securities and Exchange Board of India (SEBI) framed the SEBI (Venture Capital Funds) Regulations, 1996. These guidelines were further amended in Apr 2000 with the objective of fuelling the growth of Venture Capital activities in India. Some domestic VCFs were registered with SEBI. Some overseas investment has also come through the Mauritius route. However, the venture capital industry, understood globally as "independently managed, dedicated pools of capital that focus on equity or equity-linked investments in privately held, high-growth companies", is relatively in a nascent stage in India.

Where are VCs Investing In India?

IT and IT-enabled services Software Products (Mainly Enterprise-focused) Wireless/Telecom/Semiconductor Banking PSU Disinvestments Media/Entertainment Bio Technology/Bio Informatics Pharmaceuticals Electronic Manufacturing Retail

Stages of Venture Financing

1.

Small amount of money to prove a concept or develop a product. Funds are likely to pay for marketing and product refinement. Additional money to begin sales and manufacturing. Funds earmarked for working capital for a firm that is currently selling its product but still losing money. Financing for a firm that is at least breaking even and contemplating expansion; a.k.a. mezzanine financing. Financing for a firm that is likely to go public within 6 months; a.k.a. bridge financing.

Seed-Money Stage: Start-Up

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First-Round Financing

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Second-Round Financing Third-Round Financing

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Fourth-Round Financing