Venture Capital

VENTURE CAPITAL

Ravish Jain, MBA (A)

Definition Venture capital is a type of private equity capital typically provided to early stage, high-potential, growth companies in the interest of generating a return through an eventual realization event such as an IPO or trade sale of the company. Venture capital investments are generally made as cash in exchange for shares in the invested company. The European Venture Capital Association has described it as risk finance for entrepreneurial growth oriented companies, and investment for medium or longterm to maximize returns. It is a partnership with the entrepreneur in which the investor can add value to the company because of his knowledge and experience. The SEBI has defined Venture Capital Fund in its Regulation 1996 as ‘a fund established in the form of a company or trust which raises money through loans, donations, issue of securities or units as the case may be

Origins of VC Before World War II, venture capital investments were primarily the domain of wealthy individuals and families. The Vanderbilts, Whitneys, Rockefellers and Warburgs were notable investors in private companies in the first half of the century. It was not until after World War II that what is considered today to be true private equity investments began to emerge marked by the founding of the first two venture capital firms in 1946: American Research and Development Corporation. (ARDC) and J.H. Whitney &

Georges F. Doriot Laurance Rockfellar

John Hay Whitney

Structure of Venture Capital Firms Venture capital firms are typically structured as partnerships, the general partners of which serve as the managers of the firm and will serve as investment advisors to the venture capital funds raised. Typical career backgrounds vary, but broadly speaking venture capitalists come from either an operational or a finance background. Venture capitalists with an operational background tend to be former founders or executives of companies or will have served as management consultants. Venture capitalists with finance backgrounds tend to have investment banking or other corporate finance experience. Although the titles are not entirely uniform from firm to firm, other positions at venture capital firms include: • Venture partners - Venture partners are expected to source potential investment opportunities ("bring in

Structure contd … • Entrepreneur-in-residence (EIR) - EIRs are experts in a particular domain and perform due diligence on potential deals. EIRs are engaged by venture capital firms temporarily (six to 18 months) and are expected to develop and pitch startup ideas to their host firm. • Principal - This is a mid-level investment professional position, and often considered a "partner-track" position. Principals are either promoted from a senior associate position or have commensurate experience in fields such as investment banking or consulting. • Associate - This is typically the most junior apprentice position within a venture capital firm. After a few successful years, an associate may move up to the "senior associate" position and potentially principal and beyond. Associates will often have

Characteristics of VC Long Time Horizon – Venture financing is a long term illiquid investment; it is not repayable on demand. VCFs may have to wait long period (7-12 years) to make substantial profits. Lack of Liquidity – The investments made in the private company are illiquid until the company goes public or is sold. That is why investment is done in stages. First few years, 1-3 years, are of intense investment activity. Promising companies are included in the portfolio. 1 out of 400th company is successful. Years 4-6th are growth period in which follow on investments are made and a few new investments are added. Partners decided which venture to cut out and which to continue to support.

Characteristics of VC High Risk – Few investments will return many times the initial investments, other will fail completely. Approximately 40% of all investments are losers. Almost 30% become living dead. About 20 % return 2 to 5 times the initial investment. And around 8% return 8-10 times returns. And only 2% of all the investments ends up generating returns of 10 times the initial investment. Equity Participation – The objective is to make capital gains by selling off the investment once the enterprise becomes profitable. Participation in Management – This helps VC to protect and enhance the investment by actually involving and supporting the entrepreneur. Apart from finance, a VC provides his marketing, technology, planning and

Investment Determinants A venture capital; fund studies and critically examines the under mentioned variables to make SWOT analysis of the ventures before it takes financing decision. 1. Analysis of Management – Mental Attributes – Behavioral Attributes 2. Analysis of Organization Pattern – Management Team – Equity Holders – Trade Union & Industrial Peace – Strengths and Weaknesses 3. Analysis of Production Process 4. Analysis of Marketing and Sales 5. Financial Analysis and Projections 6. Analysis of Reference Information

A Study on Investment Criteria Dr A K Mishra of IIM Lucknow, conducted a detailed study in the year 2001 on the investment evaluation criteria used by the Indian venture capitalists. Even though the study was conducted six years back, its findings are still relevant and confirm the findings of researchers globally. Mishra found the entrepreneurs' personality (integrity, attention to detail, long term vision, etc.) to be the most important criteria for the VC, followed by growth prospects of the business. Past research shows that trustworthiness, enthusiasm and expertise of the entrepreneur are the most important factors considered by the VCs. It has also been seen that about 50-60 per cent of the projects which are seriously considered for financing but are ultimately

Valuation Methods Valuation is important to take a decision about the share in equity capital of the company. The various methods used are: CONVENTIONAL VALUATION METHOD Based on the expected increase in the initial investment that could be sold out to a third party or through public offering via exit route. P/E ratio is calculated on the maturing date, also known as liquidity date. The earning level post-tax is multiplied by P/E ratio gives valuation of the investment at a future date. Does not take into account the stream of cash flows from

Valuation Methods PRESENT VALUE BASED METHOD / FIRST CHICAGO METHOD This method takes into account the stream of earnings (or losses) generated during the entire period of the investment from the date of the initial investment to date of maturity at a presumed discounted rate. Three scenarios are assumed : SUCCESS, SURVIVAL and FAILURE. Each scenario is assigned a probability figure which depends on many things which affect earnings: prices of raw material; prices of finished good; marketing factors. The total of these scenarios gives the present value of the company. Based on such value the venture capitalist

Valuation Methods REVENUE MULTIPLIER METHOD Revenue multiplier is an assumed factor used to estimate the value of an enterprise. By multiplying the annual estimated sales by such factor, the valuation figure is derived. This method is based on sales income and not on earnings. The multiplier M is obtained by using the following equation:

M = (1 + g) n (e) (PE) 1+dn g – growth rate N – number of years between initial investment and exit date e – expected profit margin (post tax) percentage at the

Deal Structuring Its an important step of the overall process. Terms are negotiated with respect to amount, form and price of the investment. The agreement also includes the protective covenants and earn-out arrangements. Covenants include the venture capitalist’s right to control the company and to change its management, if needed, buy-back arrangements, acquisition, making initial public offering, etc. Earn-out arrangements specify the entrepreneur’s equity share and the objectives to be achieved. The venture companies like deal to be structured in such a way that their interests are protected. They would like to earn reasonable return, minimize taxes, have enough liquidity to operate their business.

Pricing Pricing is the most sensitive part of the negotiation process. Pricing involves valuation of a company before and after financing based on an analysis of risk and return. In seed capital and early stage investment, VC expect a compounded annual return of 50 percent. In second stage investment VC may be satisfied with an annual return of 30-40 percent In later stage financing they would expect something like 25-30 percent. The pricing of the deal is done by valuation. Different valuation methods are used in structuring and pricing

Venture Financing There are typically six stages of financing offered in Venture Capital, that roughly correspond to these stages of a company's development. • Seed Money: Low level financing needed to prove a new idea • Start-up: Early stage firms that need funding for expenses associated with marketing and product development • First-Round: Early sales and manufacturing funds • Second-Round: Working capital for early stage companies that are selling product, but not yet turning a profit • Third-Round: Also called Mezzanine financing, this is expansion money for a newly profitable company

Venture Financing The financing pattern of the deal is the most important element. •

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Equity

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It is the most desirable form of financing, as it does not put any pressure in the initial teething period. Ideally the support should be through equity to reflect an approach of sharing risk and rewards. The normal limit of assistance by way of equity is to be at a level slightly lower than of the promoter’s equity. •

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Conditional Loan

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It is repayable in the from of royalty after the venture is able to generate sales. No interest is paid on such loans. In India royalty charges are between 2 to 15 %; actual rate depends on various factors such as gestation period, cost flow patterns, risk and other factors of the •

Venture Financing Income Note

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This method is unique to India. It’s a hybrid security which combines the feature of both conventional and conditional loan. The entrepreneur has to pay both interest and royalty on sales, but at substantially low rates. •

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Participating Debenture

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Such security carries charges in 3 phases. In the start-up phase, before the venture attains operations to a minimum level, no interest is charged, After this, low rate of interest is charged up to a particular level of operation. Once the venture is commercial, a high rate of interest is required to be paid. •

A variation could be in terms of paying a certain share of

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Venture Financing Quasi Equity

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Quasi equity instruments are converted into equity at a later date. Convertible instruments are normally converted into equity at the book value or at certain multiple of EPS, i.e. at a premium to par value at a later date. The premium automatically rewards the promoter for their initiative and hard work. Since it is performance related, it motivates the promoter to work harder so as to minimize dilution of their control on the company. •

The different quasi-equity instruments are as follows: 1. Cumulative convertible preference shares. 2. Partially convertible debentures. 3. Fully convertible debentures.

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Project Monitoring The VC carry out close monitoring through various devices like periodical reports, appointing nominee directors on the boards of the assisted companies, carrying out periodical inspections and at times appointing their own management personnel. Three styles of monitoring are in use: •

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Hands-on style

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Involves supportive and direct involvement of VC in firm through •

representation on matters of technology, marketing and general management. They make active contribution to strategies and policies of the firm, rather than only acting as financial watchdogs. In India VC do not involve themselves on the hands-on basis and do not interfere •

Project Monitoring 2. Hands-off style

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Also know as passive style and involves occasional assessment of the assisted firms management and their performance with no direct assistance being provided. •

The VC would receive periodic post-investment information from the entrepreneur. Indian VC generally follow this practice •

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3. Intermediate style

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This is intermediate style between hands-off and handson. VCs are entitled to obtain on regular basis information about the assisted projects. VCs are also entitled to be consulted on key decisions such as major capital expenditure, acquisitions and board •

Exit Route Initial Public Offer

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The most preferred exit route for a venture capitalist is the Initial Public Offer. •

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Trade Sale

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In a trade sale the venture capitalist sells his stake to a strategic buyer that already owns a business similar or complementary or plans to enter into the target industry. This helps the strategic buyer to produce a synergistic increase in value. •

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Promoter Buy Back

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In this the promoter buy back the venture capitalist stake at a predetermined price. •

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Acquisition by another company

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DEVELOPMENT OF VENTURE CAPITAL IN INDIA

• The concept of venture capital was formally introduced in India in 1987 by IDBI • The government levied a 5 per cent cess on all know-how import payments to create the venture fund • ICICI started VC activity in the same year • Later on ICICI floated a separate VC

VCFs in India can be categorized into following five • Central financial institutions such as IDBI and SIDBI • State level financial institutions such as Punjab Infotech Venture Fund • Banks such as Canbank Venture Capital Fund Limited • Private Sector institutions such as IL&FS Venture Corporation Limited • Overseas such as HSBC Private Equity management Mauritius Limited

Future Prospects of Venture Financing • VC can assist small ancillary units to upgrade their technologies so that they could be in line with the developments taking place in their parent companies. • VCFs can play a significant role in developing countries in the service sector including tourism, publishing, health care etc. • They can provide financial assistance to people coming out of universities, technical institutes etc thus promoting

Elements needed for success of venture capital in any • • • • • • • • •

Entrepreneurial Tradition Unregulated economic environment Disinvestments avenues Fiscal incentives Broad based education Venture capital managers Promotion efforts Institute industry linkage R&D activities

PE Investments by Stage : 2007 • Stage of Company Amount (US$M) • Early Stage 154 • Growth Stage 1082 • Late Stage 2162 • PIPE 1714 • Buyout 440 • Others

No. of Deals 24 25 67 34 6 6

PE/VC Investments by Industry • • • • • • • • • • • •

IT & ITES Manufacturing Healthcare & Life Sciences Textiles & Garments BFSI* Hotels & Resorts Media & Entertainment Engg. & Construction Shipping & Logistics Energy Telecom Others

16% 07% 02% 03% 37% 02% 07% 14% 05% 02% 01% 04%

Top Cities attracting PE Investments • City Value(US$M) • Mumbai 1,780 • Delhi/NCR* 395 • Bangalore 1,525 • Chennai

No. of Deals 69 41 40 22

Venture Intelligence with the guidance of Prof. Amit Bubna of Indian School of Business, Hyderabad, studied the economic impact of PE and VCs on the Indian businesses. The following are some observations of this study:

of

the

interesting

The study shows that the VC backed companies grew faster compared to the non-VC backed peers and even better than the benchmark indices like the NSE Nifty. They found that the sales of listed PEbacked companies grew at 22.9% as compared to 10% for non-PE-backed listed firms. PE backed firms added more jobs to the economy and even the wages at listed PE financed firms grew

• An astonishing finding was that almost 96% of the top executives felt that without the support and the backing of private equity these companies would not have existed or would have grown at a slower rate, while only about 4% felt that they would have developed the same way even without PE funding. • The study also shows that the biggest support of the PE investors were provided in the area of strategic direction followed by the financial advice and then recruitment and the marketing activities

MAIN PROVISIONS OF VCF REGULATIONS (1996)

PROVISIONS Cont. 1) A venture capital fund may be set up by a company or a trust, after a certificate of registration is granted by SEBI on an application made to it. On receipt of the certificate of registration, it shall be binding on the venture capital fund to abide by the provisions of the SEBI Act, 1992 . The VCF shall not carry on any other activity than that of VCF>

PROVISIONS Cont. 2) A VCF may raise money from any investor, Indian, Non-resident Indian or foreign, provided the money accepted from any investor is not less than Rs 5 lakh. The VCF shall not issue any document or advertisement inviting offers from the public for subscription of its security or units

PROVISIONS Cont. 3) A VCF is not permitted to invest in the equity shares of any company or institutions providing financial services.

PROVISIONS Cont. 4) At least 80% of the funds raised by a venture capital funds shall be invested in b) the equity shares or securities by an unlisted company. Such investment may be made through private placement prior to the listing of such securities is permitted. c) the equity shares and securities of a financially weak company whose

PROVISIONS Cont. 5) The societies or units issued by a venture capital fund shall not be listed on any recognized stock exchange till the expiry of 4 years from the date of issuance .

PROVISIONS Cont. 6) A VCF may receive monies for investment in the venture capital fund through private placement of its securities units.

PROVISIONS Cont. 7) A Scheme of VCF set up as a trust shall be wound up b) when the period of the scheme if any, is over c) If the trustee are of the opinion that the winding up shall be in the interest of the investors d) 75 % of the investors in the scheme pass a resolution for winding up or, e) If SEBI so directs in the interest of the

VENTURE CAPITAL GUIDELINES 1. ESTABLISHMENT 2. MANAGEMENT 3. ASSISTANCE d) Size e) Technology f) Promoters/Entrepreneurs 4. Size

VENTURE CAPITAL GUIDELINES Cont. 5. Capital Issues: b) Funds be raised through public issues and/ or private placement to finance VCC/VCFs. c) Foreign equity up to 25% in multilateral/ international financial organizations, development finance institutes, reputed mutual funds etc. d) NRI investment would be permitted up to 74% on a non repayable bases. e) Application should be addressed to Ministry of Finance, Investment Division with a copy to Chairman, SEBI, foreign NRI participation

VENTURE CAPITAL GUIDELINES Cont. 6. 7. 8. 9.

Debt-equity ratio Underwriting Listing Exit Eligibility for Tax Concession.

VCF REGULATION AS PER PROVISION OF INCOME-TAX 1) 80% of money raised under the fund should be invested in equity shares of unlisted company, with in a period of three years. 2) VCFs are required to hold investment for a minimum period of 3 years. 3) VCFs can not invest more than 20% of total money raised in a venture. 4) VCFs can not invest in more than

DISINVESTMENT AND EXIT ROUTES IN VC BUSINESS I. Sale of share on stock Exchange after Listing II. IPO/Offer for sale III. Strategic Sales IV. Buy Back of Equity by Company V. Promoters Buy Back

ISSUES IN EXERCISING EXIT OPTION I. Threshold Limit for Listing II. Formalities Involved in Sale of Venture III. Stock Market Support IV. Weak Legal Framework V. Underdeveloped Market for Mergers and Acquisition

PRE-REQUISITE FOR THE EFFICIENT EXIT MECHANISM I. Efficient Stock Market II. Mechanism for listing of Equity by Companies with Low Equity Base III. Legal Framework IV. Facilitate Smooth Transfer/Sale of Ventures

GUIDELINES FOR FOREIGN VENTURE CAPITAL 1. Off-shore investors, with the permission of Foreign Investment Promotion Board, can invest in approve venture capital funds or VCCs. 2. Off-shore VCC can contribute 100% capital as well as set up a domestic asset management company. 3. Subsequent investment does not require FIPB’s permission, and will be subject to the general restriction applicable to VCCs to invest only in unlisted companies but not exceeding

GUIDELINES FOR FOREIGN VENTURE CAPITAL Cont. 4. Tax exemption similar to the domestic VCFs/VCCs, are available to foreign VCCs, subject to the existing guidelines. If they want to avail tax exemptions, they are free to invest in any sector. 5. Offshore investors’ income from Indian VCFs/VCCs would be subject to existing rates for foreign investors.

References BOOKS • Chary T Satyanarayana, Venture Capital: Concepts and Application, Macmillian, 2005 • Pandey I M, Venture Capital: The Indian Experience, Prentice Hall, 1999 • Pandey I M, Financial Management, 9e, Vikas Publication, Chapter 23, Pg 455 – 486 PAPERS Mishra A K, 2004, Indian Venture Capitalists (VCs): Investment Evaluation Criteria , ICFAI Journal of Applied Finance, Vol. 10, No. 7, pp. 71-93 WEBSITES • Website of Indian Venture Capital Association, www.ivca.org • http://www.rediff.com/money www.wiekepedia.com