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If there is one universal attribute that applies to all investors, it is the undying thirst for higher returns. Venture capital (VC) is founded on this fundamental premise, as it has great potential to provide returns far in excess of conventional methods of investments. What makes VC so important is that it is often the only source of funds to new entrepreneurs, as banks and financial institutions provide finance only against securities or guarantees. VC has grown from a small investment pool in the 60s and 70s to a full-fledged investment tool and a key element in corporate and institutional investment portfolio.
The term 'venture capital' is often used interchangeably with private equity investing, which refers to venture investing and buy out. The astonishing growth and successes of new generation companies such as Apple, Intel, Federal Express, Microsoft, Yahoo and Cisco is a sterling tribute to VC, as these companies had received VC in their early stages of development. The singular difference between VC and other forms of financing is that VC provides money to firms whose success is not guaranteed; in fact, there had been instances when firms had to be funded even for incorporation.
VC investments are characterized by high uncertainty levels in terms of technology risk, product market risk, management risk and liquidity risk. A major distinction is the relationship between investor and investee in a VC transaction. While on a commercial plane, they are bound by the interest in mutual economic benefit, on a legal plane the interests can diverge. For the investor, profits and timely exit from the venture is of paramount importance. The investee would like to retain and ensure her continued role in the company. This requires the investor to respond to the challenges of various exigencies that may arise after the funding process is set in motion. Unlike the conventional lending methods, the only protection for the investor is to ensure that the venture stays on track and succeeds in time, which may prompt the investor to exercise controlling rights when things go wrong. This is perhaps the single biggest challenge that can make or break a venture capital transaction.
A common perception of a venture capitalists are that of a rich financier who is on the look out for start-up ventures to put money with the hope of getting abnormal profits at some point in future. The reality is far different - professional venture capital firms are closely held corporations or private partnerships, funded by public and private pension funds, endowment funds, corporations, wealthy individuals and foreign investors. Not all venture capitalists invest in start-ups; in fact a rational venture capitalist will strive to have a balanced portfolio that will level out risks and ensure a net positive return. VC firms also specialize in other investment alternatives such as initial public offerings, mergers and acquisitions.
Venture capital is a form of equity finance, which took solid roots in the post world war II years, especially in the United States of America. From a relatively small scale in the sixties, the venture capital industry now spans almost all sectors of business and economy. In the last four decades, American venture capitalists have proved time and again that VC can be the prime vehicle for economic growth even in times of recession. Other countries, including the European nations, Canada, Australia and Asian nations seemed to have grasped the significance and potential of VC financing. The philosophy of VC is best described by an old saying, 'the biggest shortage is not the capital, but the people with the right know-how'. As VC markets advance and mature across the world, the challenge facing investors and companies seeking fund is to fully understand the dynamics of VC so that the mutual objectives are realized.
Definition of Venture Capital:
It is the money provided by professional investors, who invest along with management in start-up, young and rapidly growing companies that have the potential to develop into highly profitable ventures. There are many popular perceptions of venture capital and formal definitions are not easy to find. A widely discussed definition is that offered by Dr. Neil Cross, former Chairman of the European Venture Capital Association. According to this definition, venture capital is making facilities for risk bearing capital, which can be by means of a participation in equity, and this would be in relation to companies which have capacities for high growth. The basic characteristic of venture capital is that it is a form of equity finance, participatory in nature with long-term of maturity. Venture capitalists require a high rate of return as a trade-off for the degree of risk and patience for the returns to materialize. The general expected return is approximately 40% per annum compounded. (Bovaird, p.33)
VC financing is provided in several stages based on pre-agreed schedule of achievement of well-defined milestones. A venture capital life cycle has seven stages - seed capital, start-up capital, early stage finance, second round finance, expansion capital, management buy outs and buy ins and mezzanine finance. As the name implies, seed capital is provided for initial product development or the finance provided to the entrepreneur to justify the proposed project feasibility and qualify for start-up capital. The second stage, start-up capital is for the product development, initial marketing and setting up product facilities. Early stage financing is provided to firms that have crossed the product development stage and require funds to commission commercial product and sales.
As the firm expands, it may need more capital, which is provided by second round finance. When the firm reaches breakeven point or has already started making small profits, it will need funding for expansion of the business. This critical requirement in met by expansion capital, which drives the firm to maximize profits. Management buy out is the finance granted to the firm's management and investors to acquire an existing product line or business. As opposed to this is the Management buy-ins where funds are provided to managers outside the firm to buy into the firm with the support of venture capital investors. Finally, mezzanine financing is supplied to the firm to enable it to complete a trade sale or go in for public floatation of the firm's shares. Mezzanine financing is offered either in the form of debt or high ranking equity.
Legal status of VC firms:
VC firms operate in many forms, but most are organized as limited partnerships in which they are general partners. A common type is the private independent firm, which has no affiliation with any financial institution. Apart from limited partnership, which continues to be the major form of VC firms, the government has permitted formation of either Limited Liability Partnerships (LLP) or Limited Liability Companies (LLC). The VC firm can choose the style of organization depending on management responsibility, liability and taxation issues. Typically, the VC firm organizes the partnership as a pooled fund, comprising of the general partner and the investors or limited partners. The funds are fixed life partnerships, with normal life of ten years and each fund is capitalized by investments from the limited partners. Soon after the partnership attains the targeted size, it does not accept further investment, and the fixed capital pool is utilized for investments.
In a different form, VC firms may be affiliates or subsidiaries of commercial banks, investment banks or insurance companies and make investments on behalf of the parent entities, popularly known as 'corporate venture investors' or 'direct investors'. This form of investing was quite popular in the eighties and is now doing back in vogue. In this case, the objective is to identify and invest in opportunities that are synchronous with the parent entities' business strategies. They may also be interested in investing if they can secure access to superior technology they need or achieve cost savings in their business operations. A major feature of corporate venture investing is that the main objective is related to corporate strategy rather than pure financial considerations.
The activities of venture capitalists generally include financing new and growing companies and purchasing equity securities with a long- term perspective. Thus, venture capitalists take higher risks with the expectation of higher rewards, which cannot be provided by other forms of investment. Before investing, venture capitalists make a thorough analysis of the business model of the investee company and estimate future returns. They take active interest and work closely with the management of investee companies, by offering expertise gained from assisting other companies to grow from nascent stage. As part of diversifying risk, venture capital firms invest in a portfolio of young companies under a single fund. It is also common for them to invest as a syndicate with other professional VC firms. Usually, venture partnerships manage multiple funds simultaneously to spread the risk and maximize returns on investments.
Typical venture capitalists would examine many investment opportunities before selecting a clutch of companies to actually put the money. They look for a high rate of return, much higher than most…[continue]
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