What is Venture Capital? Stage, Importance, Types, Mode, History

What is Venture Capital?

Venture capital is money provided by an outside investor to finance a new, growing, or troubled business. The venture capitalist provides the funding knowing that there’s a significant risk associated with the company’s future profits and cash flow.

Capital is invested in exchange for an equity stake in the business rather than given as a loan, and the investor hopes the investment will yield a better-than-average return.

Brief History of Venture Capital

Venture capital funding is first originated in the UK in the late 18th century, when European entrepreneurs and merchant bankers were helping the growth of industry in USA, South Africa and India. This informal method of financing became an industry in the late 1970s and early 1980s when a number of venture capital firms were founded.

There are now over 100 active venture capital firms in the UK, which provide several billion pounds each year to unquoted companies mostly located in the UK.

The venture capital funds are active in UK in the form of

  • Clearing bank captive funds,
  • Funds sponsored by savings and investment institutions and merchant bankers
  • Business expansion scheme funds
  • Corporate, academic and other private sector funds
  • Semi-State bodies (both Central and Local Government)

Venture Capital and Development Capital

Venture capital is advanced for ventures using a new technology or new innovation. The venture capital company remains interested in the overall management of the project due to the high risk involved in the venture.

Funds are made available throughout the project, commencing from commercial production to the successful marketing of products, to ensure continuous revenue earnings, enhanced worth of the investments and finally making available a proper exit route for liquating the investments.

Development capital is generally granted in the form of loans for setting up industrial units, and also for expansion and modernization. The lender takes special care in ensuring the end use of the credit and requires prompt payment of interest and repayment of the loan amount.

Venture Capital in India

In India tradition of the venture capital industry goes back more than 150 years when many of the managing agency houses acted as venture capitalists providing both finance & management skill to risky projects. TISCO & Empress Mills were able to raise equity capital through help of these houses.

In the modern era, venture capital goes various stages 1973. R. S. Bhatt committee recommended the formation of an Rs.100 crore venture capital fund. 7th five year plan emphasis need for it. The venture capital took roots when venture capital guidelines were issued by the comptroller of capital issues in Nov. 1988.


Features of Venture Capital

  • It is in the form of equity capital.
  • Investment made only in high risk but high growth potential projects.
  • There is continuous involvement in business after making an investment.
  • Venture capital is not just injection of money but also an input needed to setup firm.
  • Investment is usually made in small & medium scale enterprises.

Venture Capital Stages

A venture capital fund provides finance to the venture capital undertaking at different stages of its life cycle according to requirements. These stages are broadly classified into two, viz.

  1. Early Stage Financing
  2. Later Stage Financing

Each of them is further sub-divided into a number of stages. We shall deal with them individually

Early Stage Financing

Early Stage Financing includes:

Seed Capital Stage

Seed Capital Stage is the primary stage associated with research and development. The concept, idea, process pertaining to high technology or innovation are tested on a laboratory scale. Generally, the ideas developed by the Research and Development wings of companies or scientific research institutions are tried. Based on a laboratory trial, a prototype product development is carried out.

Subsequently, possibilities of commercial production of the product are explored. The risk perception of investment at this stage if quite high and only a few venture capital funds invest in the seed capital stage of product development. Such financing is provided to the innovator in the form of low interest bearing personal loans.

Start-up Stage

Venture capital finance is made available at the start-up stage of the projects which have been selected for commercial production. A start-up refers to launching or beginning a new activity which may be the one taken out from the Research and Development stage of a company or a laboratory or may be based on a transfer of technology from abroad.

Such product may be an import substitute or a new product/service which is yet to be tried. But the product must have effective demand and command potential market in the country.

The entrepreneurs who lack financial resources for undertaking production, approach the venture capital funds for extending funds through equity. Before making such investments, venture capital fund companies assess the managerial ability, capacity and commitment of entrepreneurs to make the project idea a success.

If necessary, the venture capital funds lend managerial skills, experience, competence and supervise the implementation to achieve successful operation. High degree of risk is involved in start-up financing.

Second Round Financing

After the product has been launched in the market, further funds are needed because the business has not yet become profitable and hence new investors are difficult to attract. Venture capital funds provide finance at such a stage, which is comparatively less risky than the first two stages. At this stage, finance is provided in the form of debt also, on which they earn a regular income

Later Stage Financing

Even when the business of the entrepreneur is established it requires additional finance, which cannot be secured by offering shares by way of the public issue. Venture capital funds prefer later stage financing as they anticipate income at a shorter duration and capital gains subsequently.

Later stage financing may take the following forms:

Expansion Finance

Expansion finance may be needed by an enterprise for adding production capacity once it has successfully gained market share and expects growth in demand for its product. Expansion of an enterprise may take the form of organic growth or by way of acquisition or takeover.

In the case of organic growth, the entrepreneur retains maximum equity holdings of the entrepreneur and the venture capitalist could be in much higher proportion depending upon factors such as the net worth of the acquired business, its purchase price and the amount already raised by the company from the venture capitalists.

Replacement Finance

In this form of financing, the venture capitalist purchases the shares from the existing shareholders of the company who are willing to exit from the company. Such a course is often adopted with the investors who want to exit from the investee company, and the promoters do not intend to list its shares in the secondary market, the venture capitalist perceives growth of the company over 3 to 5 years and expects to earn capital gain at a much shorter duration.

Turn Around

When a company is operating at a loss after crossing the early stage and entering into commercial production, it may plan to bring about a change in its operations by modernizing or expanding its operations, by adding to its existing products or deletion of the loss-making products, by reorganizing its staff or undertaking aggressive marketing of its products, etc.

For undertaking the above steps for reviving the company, an infusion of additional capital is needed. The funds provided by the venture capitalist for this purpose are called turnaround financing. In most of cases, the venture capitalist which supported the project at an early stage may provide turnaround finance, as a new venture capitalist may not be interested to invest his funds at this stage.

Turn around financing is a more risky proposition. Hence the venture capitalist has to judge in greater depths the prospects of the enterprise to become viable and profitable. Generally, substantial investment is required for this form of financing.

Besides providing finance, the venture capitalist also provides management support to the entrepreneur by nominating its own directors on the Board of the company to effectively monitor the progress of recovery of the company and to ensure timely implementation of the necessary measures.

Buyout Deals

A venture capitalist may also provide finance for buyout deals. A management buyout means that the shares (and management) of one set of shareholders, who are passive shareholders, are purchased by another set of shareholders who are actively involved in the operations of the organization.

The latter group of shareholders buyout the shares from the inactive shareholders so that they derive the full benefit from the efforts made by them towards managing the enterprise. Such shareholders may need funds for buying the shares, venture capitalists provide them with such funds. This form of financing is called buyout financing.


Modes of Venture Capital

The venture capital funds provide finance to venture capital undertakings through different modes/instruments which are traditionally divided into

Investment is also made partly by way of equity and partly as debt. The VCFs select the instrument of finance taking into account the stage of financing, the degree of risk involved and the nature of finance required. These instruments are detailed below:

Equity Instruments

Equity instruments are ownership instruments and bestow the rights of the owner on the investor/VCFs. They are:

Ordinary Shares

Ordinary Shares on which no dividend is assured. Non-voting equity shares may also be issued, which carry a little higher dividend, but no voting rights are enjoyed by the investors. There may be different variants of equity shares also, e.g. deferred equity shares on which the ordinary shares rights are deferred till a certain period or the happening of an event. Moreover, preferred ordinary shares carry an additional fixed income.

Preference Shares

Preference Shares carry an assured dividend at a specified rate. Preference shares may be cumulative/non-cumulative, participating preference shares which provide for an additional dividend, after payment of dividend to equity shareholders.

Convertible preference shares are exchangeable with equity shares after a specified period of time. Thus, the venture capital fund can select the instrument with flexibility.

Debt Instruments

VCFs prefer debt instruments to ensure a return in the earlier years of financing when the equity shares do not give any return. The debt instruments are of various types, as explained below:

Conditional Loans

On conditional loans, no interest rate as lower rate of interest and no payment period is prescribed. The VC funds, recover their funds, along with the return thereon by way of a share in the sales of the undertaking for a specified period of time.

This percentage is pre-determined by VCFs. The recovery by the VCFs depends upon the success of the business enterprise. Hence, such loans are termed as ‘conditional loans’.

Convertible Loans

Sometimes loans are provided with the stipulation that they may be converted into equity at a later stage at the option of the lender or as agreed upon between the two parties.

Conventional Loans

These loans are the usual term loans carrying a specified rate of interest and are repayable in instalments over a number of years.


Importance of Venture Capital

The importance of venture capital is to all. But it is advantageous to three viz:

Investing Public

  • By venture capitalist, investors will be able to reduce risk significantly against unscrupulous management.
  • The venture fund having a representative on the Board of Director of the company help to conduct affairs of business prudently.

Promoter

  • Promoter only required to sell their idea to justify the official of the venture fund which is much more easy than to convince tens of underwriters, brokers for public issue.

General

  • A well developed V.C. institution reduces the time lag between technological & its commercial expansion.
  • Acts as a cushion to support business borrowings.
  • The V.C. firms serves as an intermediary between investor looking for high return & entrepreneurs in search of needed capital for their start ups.

Types of Venture Capitalists

  1. Incubators
  2. Angel Investors
  3. Venture Capitalist
  4. Private Equity players

Incubators

Incubator is a company or facility designed to foster entrepreneurship and help startup companies usually technology-related, to grow through the use of shared resources, management expertise and intellectual capital.

Kanwal Rekhi School of Information Technology (KReSIT) is a business incubators at IIT Mumbai, N.S.Raghavan Centre for Entrepreneurial Learning (NSRCEL) at IIM Bangalore are the best example of business incubators in India.

Angel Investors

An angel investor (known as a “business angel” in Europe, or simply an “angel”) is an affluent individual who provides capital for a business start-up, usually in exchange for ownership equity. Angels typically invest their own funds, unlike venture capitalists, who manage the pooled money of others in a professionally managed fund.

However, a small but increasing number of angel investors are organizing themselves into angel networks or angel groups to share research and pool their investment capital. Angel investments bear extremely high risk, and thus require a very high return on investment.

Angel investors are often retired entrepreneurs or executives, who may be interested in angel investing for other reasons in addition to pure monetary return.

Venture Capitalist

Venture capitalists are organizations which pooled in money from various investors in a professionally managed fund. Venture Capitalists are inclined toward turnaround ventures that entail some investment risk but offer the potential for above average future profits.

Sources of venture capital include wealthy individual investors; subsidiaries of banks and other corporations organized as small business investment companies (SBlCs); groups of investment banks and other financing sources who pool investments in venture capital funds or Venture Capital Limited Partnerships.

Private Equity players

Equity capital that is made available to companies or investors but not quoted on a stock market. The funds raised through private equity can be used to develop new products and technologies, to expand working capital, to make acquisitions, or to strengthen a company’s balance sheet.

KKR (Kohlberg Kravis Roberts), Blackstone and Vestar Capital Venture and ICICI venture are examples of private equity players. Private equity funds typically control management of the companies in which they invest, and often bring in new management teams that focus on making the company more valuable.


Types of Venture Capital Firms

There is quite a variety of types of venture capital firms. They include:

  • Traditional partnerships: which are often established by wealthy families to aggressively manage a portion of their funds by investing in small companies. These funds are typically established as partnerships that invest the money of their institutional limited partners.

    The partners typically include corporate pension funds, government pension funds, private individuals, foreign investors, corporations and insurance companies. These include venture capital funds that are focused on investing in minority businesses or minority markets.

  • Investment banking firms: which usually trade in more established securities, but occasionally form investor syndicates for venture proposals.

  • 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).

  • Small Business Investment Corporations (SBICs): which are licensed by the Small Business Administration (SBA) and which may provide management assistance as well as venture capital.

Venture Capital Providers in India

After seeing methods of venture capital financing let’s look at the main providers of venture capital in India. Normally they are classified into four major categories.

  1. Companies Promoted by All India Financial institutions:
    • RCTC (Risk Capital & Technology Finance Corporation)
    • TDICI (Technology Development & Information Company of India Ltd.)

  2. Companies Promoted by State Financial institutions:
    • GVFL (Gujarat Venture Finance Ltd.)
    • APIDC (Andhra Pradesh Industrial Development Corporation Venture Capital Ltd.)

  3. Companies Promoted by Banks:
    1. Can Bank Venture Capital Fund
    2. SBI Venture Capital Fund
    3. Indian Investment Fund
    4. Infrastructure Leasing

  4. Companies in Private Sector:
    1. Indus Venture Capital Fund
    2. Credit Capital Venture Fund
    3. 20th Century Venture Capital Fund
    4. Venture Capital Fund

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