Venture Capital (Firms)
The era of venture capital started during the 20th century. Venture Capital emerged as a new financial method of financing. Venture Capital can be simply referred to as a contemporary source of finance for small or medium size firms or for startups for high potential projects and limited operating history. It is generally equity mode of financing. The venture capitalist selects those projects and companies which have the potential to thrive despite the level of risks. Most of the common investors are not willing to invest in risky business therefore many potential projects are not able to raise funds due to their risk profile. In such a situation, many venture capital investors, assessing the risk factor associated, invest in such projects.
There has been a wrong perception that venture capital firms only invest in startups. Venture Capital funds consider all the small and medium size projects who lack investment but have a huge potential to perform. Most of the startups have great ideas to act on but as they are startups, most of the common investors do not wish to take chances and opt out to invest. In such conditions, startups go for venture capital firms and startups with potential get funded by Venture Capitalists. The selection of projects by Venture Capital Firms is totally their internal decision but it has been observed that Venture Capital Firms generally invest in:
- Ventures promoted or started by professionally and technically qualified but unproven entrepreneurs
- Ventures that harness the unproven technology, service or product
- Venture with higher potential despite the level of risk.
Investment Decision Factors
Venture Capital Firms come across hundreds of potential ideas and funding all of them is not possible. There are some of the common factors, Venture Capitalists consider before making an investment decision. These factors measure the potential and risk factors associated with the projects. Some of such common investment decision factors are:
- Strong Management Team:
Venture Capitalists closely consider the composition of management where they are planning to invest. Management team reflects the true potential of the project while in action i.e. management team actually acts or implements the project. Venture Capitalists are very peculiar in terms of adequacy of level of skills, commitment, motivation, knowledge of the management team. The potential of the management team is the potential of the project. Venture Capitalists also go for the track record of promoters before taking any decision.
- Viable Idea:
Venture Capital Firms invest in ideas. Not all the ideas are worth investing therefore, venture capitalists go for thorough study of the presented ideas. They analyze all the events and odds related to the ideas to understand the viable nature and potential of the ideas. A viable idea will only make a go-through in the market among the customers. Identifying the ideas will let investors know what can be done with that idea and how much will the idea worth of investment.
- Business Plan:
Business Plan is a roadmap of the potential idea. It is a document that includes all the descriptions about the business. Business plan includes the nature of business, the motto and vision of establishing the company, details about the product or service, management team and their qualifications, the marketing plan, operational details, financial performance, funds requirement and projection etc. Venture Capitalists study the proposal and plan presented to evaluate the potential of the business. The business plan should meet the investment objective of the venture capitalist.
- Project Cost and Return:
Venture Capitalists will like to consider the potential of the project from its cost and return analysis. All the investors want to have a decent return on its investment therefore venture capitalists look for projects which have better future cash inflows than current cash outflows. Venture capital firms consider Internal Rate of Return (IRR), time period of project, project cost, other sources of financing, output of the business, projected revenue, cash flow statements to value the firm.Project cost and return factor will help venture capitalists to plan their investment decision on the particular projects.
- Existing Technology:
Technical know-how of the management team, existing technology used by the businesses, viability of technology in the project largely affect the investment decision. A great idea but management are unaware of the technical aspect of ideas is bad investment. Similarly, any idea that involves technical efficiency to solve a problem or to serve the purpose is more viable. Venture Capitalists consider this approach while making investment decisions.
- Miscellaneous Factors:
There are many other factors which affect the investment making decision of Venture Capital. Some of such factors are rules and regulation, governance, market it is serving, location of the project, ethics and organizational culture. All these factors matter while deciding the funding.
Venture Capital Funds
A Venture Capital Fund is an investment fund which is invested in projects, small and medium
businesses and startups with high potential. Such funds are managed by venture capital firms.Venture Capital Fund can be the fund allotted by the Venture Capitalists or associated investors. Such investments are generally characterised by high risk and high return opportunities. One of the major characteristics of Venture Capital Funds is that such funds focus on a vert niche type of early stage investment.
In 2018, $254 billion was invested globally into more than 18,000 startups through venture capital financing i.e. 46% more than the investment done in 2017. The U.S. is the biggest hub for venture capital funds with more than $131 billion investment alone in the United States.
Some of the example of Venture Capital Funds are:
- SoftBank Vision Fund owned by SoftBank and money raised worth $ 100 billion.
- Chinese Reforms Holdings Corporation Fund I owned by Chinese Reform Holdings Corporation raised worth $ 15 Billion.
Venture Capital and Private Equity are generally misunderstood and interchangeably used concepts. Private Equity is more concerned with investment in mature firms or businesses i.e. already operating firms. In private equity , investors try to own 100% ownership in the firm one is trying to invest in. Whereas venture capital invest in startups or businesses that are in the beginning or introductory phase and need investment. Venture Capitalists generally invest 50% or less of firms equity.
Characteristics/Features of Venture Capital
- Long time horizon:
Venture Capital funds are long-term investments as investments have potential but are risky. For a new firm with potential, it requires constant financial backup and Venture Capitalists(VC) provide that support. To reap the potential, projects take subsequent time. Therefore, VCs invest in such projects considering long term investment.
- Lack of Liquidity:
Venture Capital Firms are early investors in any business. They invest in startups and other businesses which have short operating history and hold a great deal of potential in future.The venture capital mode of financing is long term and cash inflow for such investment is not defined. All the methods of VCs include the repayment or royalty or dividend once the firm will start to generate profit or cash inflow, which is uncertain. There is regular outflow but uncertain inflows hence there is always shortage of liquidity.
- High Risk:
Venture Capitalists are looking for high potential projects to invest in. Such investments are always risky and the chance of failure is high. Due to this risky nature, venture capital funds are of long-term nature as it requires time to offset risk and strike for return. Some of the risks associated are:
- Management Risk: Inabilities of management team and work-interest conflicts among team members.
- Market Risk: Chances of product failure and service rejection, change in preferences.
- Product Risk: Product may not be viable or may not meet the expectation.
- Operational Risk: Higher operation costs, increasing overheads etc.
- Equity Participation:
Venture Capitalists participate in equity form of investment in the desired projects. Unless the projects invested will reap he returns, VC will ensure and bear the risk associated. VC will only enjoy dividend or royalty or capital gains once the projects start kicking off. VCs are more towards equity-form.
- Participation in management:
As a fund management company and financing firm, venture capitalists, based on the experience , advise the promoters and businesses on project planning, monitoring, financial planning, working capital and other public issues. Venture Capital firms do not interfere in the operations but advise firms regarding various issues. This is important as they are the investor directly or indirectly.
Methods of Venture Capital Financing
Venture Capital firms indulge in equity-form of investment when a potential business (existing or startups) requires huge capital to execute a robust business plan. When a company has potential to grow into a profitable venture, the company enters into equity financing with Venture Capitalists. In equity financing, the company offers the ownership in the business for the investment made by the Venture Capitalists. Equity investment is more of a long-term investment and equity investment is not more than 50% i.e. decision making power always remains with the entrepreneur or the business.
- Conditional Loan
Conditional loans are totally different from bank loans. In venture capital, conditional loans are loans that do not carry any interest but are repayable to the lenders after the firm has started making revenue, in the form of royalty. The royalty rate ranges between 2% and 15% depending upon the revenue generated, cash flow generated, profit percentage, size of business etc. The name includes loan but it is not like debt-financing as it does not require any interest or principal payment.
- Participating Debentures
Debenture is another financing instrument where any startup company or any company who is looking for funds for operation raises funds by issuing a debt paper for a defined period of time with a promise to pay interest. The special characteristics of this type of debenture is that there are three different rates as per the phase of operation;
- Introductory Phase: No Interest
- Commencement of Operation: Low rate of interest
- Reaching a particular level of sales or profit: High rate of interest
- Quasi Equity or Income note
Quasi Equity or Income note is a hybrid instrument which features the characteristics of both traditional loan and conditional loan. In quasi equity;
- Entrepreneurs(businesses) need to repay both principal and interest for a defined period.
- Entrepreneurs(businesses) need to pay a royalty on profit and sales.
Venture Capital in India
The venture capital in India is still an emerging concept and is still at an introductory state. For Venture Capital firms to flourish in India, there should be proper promotion of innovation, enterprise, commercial execution of innovative ideas, entrepreneurial culture etc. India has already entered in the era of Information technology and this sector has seen tremendous growth over the years. The “Make in India” campaign has attracted many individuals and companies from all over to invest and build in India.
A development in the Venture Capital environment will fill the gap between the capital requirement of tech-based and knowledge based startups and traditional financing systems. The traditional Indian Venture Capital environment can be dated back to 150 years when agencies provided both finance and skills to projects.
Phases of Venture Capital
The growth and development of venture capital in India has taken in different phases. The need for the venture capital was first noticed by the Bhatt Committee in 1972 under the chairmanship of R.S. Bhatt. This committee identified the problems of new entrepreneurs and technologists in setting up industries.
- In 1975, venture capital financing was introduced in India by all-india financial institutions with the establishment of Risk Capital Foundation (RCF) supported by Industrial Finance Corporation (IFCI).
- In 1976, seed capital scheme was introduced by Industrial Development Bank of India (IDBI).
- In 1984, Industrial Credit and Investment Corporation of India (ICICI) decided to allocate funds for providing assistance to venture capital firms.
- In 1985, the government announced the creation of a Venture Capital Fund and presented it in parliament. The fund created equity capital for pilot projects with potential businesses.
The First Phase 1986-1995
- April 1, 1986, Venture Capital Fund established by the government was operational and administered by IDBI Bank.
- In 1986, ICICI launched a venture capital scheme to encourage new technocrats in the private sector in the emerging field of high-risk technology.
- In August, 1986, ICICI Bank undertook administration of Programme for Advancement of Commercial Technology (PACT)
- In 1987, IDBI started a venture capital fund scheme
- In 1987-1988, Technology Development Fund (TDF) changed the course of Venture Capital in India.Government of India and World Bank joined together for economic liberalisation in India. November 25, 1988, government announced guidelines for the establishment and functioning of venture capital activities.
- In 1993, Indian Venture Capital Association (IVCA) was established headquartered in Bangalore.
- First phase of Venture Capital in india was a developing experience and policy making with some regulatory framework
The Second Phase 1995-1999
Capital Under Management in India increased after 1995. Non-resident Indians (NRIs) invested in Venture Capital Funds. Suggestion from Shri Vishnu Varshney in 1998, resulted in tax privileges , progressive liberalisation in IPO guidelines and institutions.
In 1999, 80% of total venture capital investment were derived overseas firms.Such overseas firms were registered in Mauritius and operated in India to avoid the regulation by Indian government. IVCA refined its terms and framework to facilitate the Venture Capital ecosystem
The Third Phase 2000 and above
- In 1999, various regulations were adjusted and the horizon of investment in venture capital for other financial institutions was broadened. All the banks with permission were allowed to invest 5% of their new fund in venture capital annually.
- Venture capital industry faced liquidity, legal, political, economical and operational problems during the course of action. K.B. Chandrasekhar committee addressed all these issues and submitted a report to SEBI.
- In 2012 A.D., $3.1 B capital was deployed in India and by the end of 2018, this capital investment amounted to $6.4 billion. By the end of 2019, this amount will reach $ 10 billion.
- Similarly, In 2012, the number of Venture Capitalists investment was 458 and by the end of 2019, the number of investments was more than 750.