CHAPTER-I

INTRODUCTION
INTRODUCTION

Venture capital is financing that investors provide to startup companies and small businesses
that are believed to have long-term growth potential. Venture capital generally comes from
well-off investors, investment banks and any other financial institutions. However, it does not
always take just a monetary form; it can be provided in the form of technical or managerial
expertise.

Though it can be risky for the investors who put up the funds, the potential for above-average
returns is an attractive payoff. For new companies or ventures that have a limited operating
history (under two years), venture capital funding is increasingly becoming a popular – even
essential – source for raising capital, especially if they lack access to capital markets, bank
loans or other debt instruments. The main downside is that the investors usually get equity in
the company, and thus a say in company decisions.

BREAKING DOWN Venture Capital

In a venture capital deal, large ownership chunks of a company are created and sold to a few
investors through independent limited partnerships that are established by venture capital
firms. Sometimes these partnerships consist of a pool of several similar enterprises. One
important difference between venture capital and other private equity deals, however, is that
venture capital tends to focus on emerging companies seeking substantial funds for the first
time , while private equity tends to fund larger, more established companies that are seeking
an equity infusion or a chance for company founders to transfer some of their ownership
stake.

Angel Investors
For small businesses, or for up-and-coming businesses in emerging industries, venture capital
is generally provided by high net worth individuals (HNWIs) – also often known as ‘angel
investors’ – and venture capital firms. The National Venture Capital Association (NVCA) is
an organization composed of hundreds of venture capital firms that offer funding to
innovative enterprises.

Angel investors are typically a diverse group of individuals who have amassed their wealth
through a variety of sources. However, they tend to be entrepreneursthemselves, or
executives recently retired from the business empires they've built.
Self-made investors providing venture capital typically share several key characteristics. The
majority look to invest in companies that are well-managed, have a fully-developed business
plan and are poised for substantial growth. These investors are also likely to offer funding to
ventures that are involved in the same or similar industries or business sectors with which
they are familiar. If they haven't actually worked in that field, they might have had academic
training in it. Another common occurrence among angel investors is co-investing, where one
angel investor funds a venture alongside a trusted friend or associate, often another angel
investor.

The Venture Capital Process

The first step for any business looking for venture capital is to submit a business plan, either
to a venture capital firm or to an angel investor. If interested in the proposal, the firm or the
investor must then perform due diligence, which includes a thorough investigation of the
company's business model, products, management and operating history, among other things.

Since venture capital tends to invest larger dollar amounts in fewer companies, this
background research is very important. Many venture capital professionals have had prior
investment experience, often as equity research analysts; others have Masters in Business
Administration (MBA) degrees. Venture capital professionals also tend to concentrate in a
particular industry. A venture capitalist that specializes in healthcare, for example, may have
had prior experience as a healthcare industry analyst.

Once due diligence has been completed, the firm or the investor will pledge an investment of
capital in exchange for equity in the company. These funds may be provided all at once, but
more typically the capital is provided in rounds. The firm or investor then takes an active role
in the funded company, advising and monitoring its progress before releasing additional
funds.

The investor exits the company after a period of time, typically four to six years after the
initial investment, by initiating a merger, acquisition or initial public offering (IPO).

A Day In The Life

Like most professionals in the financial industry, the venture capitalist tends to start his or her
day with a copy of the Wall Street Journal, The Financial Times and other respected business
publications. Venture capitalists that specialize in an industry tend to also subscribe to the
trade journals and papers that are specific to that industry. All of this information is often
digested each day along with breakfast.

For the venture capital professional, most of the rest of the day is filled with meetings. These
meetings have a wide variety of participants, including other partners and/or members of his
or her venture capital firm, executives in an existing portfolio company, contacts within the
field of specialty and budding entrepreneurs seeking venture capital.

At an early morning meeting, for example, there may be a firm-wide discussion of a

potential portfolio investment. The due diligence team will present the pros and cons of
investing in the company. An "around the table" vote may be scheduled for the next day as to
whether or not to add the company to the portfolio.

An afternoon meeting may be held with a current portfolio company. These visits are
maintained on a regular basis in order to determine how smoothly the company is running
and whether the investment made by the venture capital firm is being utilized wisely. The
venture capitalist is responsible for taking evaluative notes during and after the meeting and
circulating the conclusions among the rest of the firm.

After spending much of the afternoon writing up that report and reviewing other market
news, there may be an early dinner meeting with a group of budding entrepreneurs who are
seeking funding for their venture. The venture capital professional gets a sense of what type
of potential the emerging company has, and determines whether further meetings with the
venture capital firm are warranted. After that dinner meeting, when the venture capitalist
finally heads home for the night, he or she may take along the due diligence report on the
company that will be voted on the next day, taking one more chance to review all the
essential facts and figures before the morning meeting.
NEED OF THE STUDY

It is a private or institutional investment made into early-stage / start-up companies (new

ventures). As defined, ventures involve risk (having uncertain outcome) in the expectation of
a sizeable gain. Venture Capital is money invested in businesses that are small; or exist only
as an initiative, but have huge potential to grow. The people who invest this money are called
venture capitalists (VCs). The venture capital investment is made when a venture capitalist
buys shares of such a company and becomes a financial partner in the business.

Venture Capital investment is also referred to risk capital or patient risk capital, as it includes
the risk of losing the money if the venture doesn’t succeed and takes medium to long term
period for the investments to fructify.

Venture Capital typically comes from institutional investors and high net worth individuals
and is pooled together by dedicated investment firms.

It is the 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.

Venture Capital is the most suitable option for funding a costly capital source for companies
and most for businesses having large up-front capital requirements which have no other
cheap alternatives. Software and other intellectual property are generally the most common
cases whose value is unproven. That is why; Venture capital funding is most widespread in
the fast-growing technology and biotechnology fields.
OBJECTIVES:

1. To understand the current scenario of venture capital finance in India.

2. To understand the criteria used for assessing the credit worthiness of clients.
3. To study the sectorial preference of venture capital finance companies of Hyderabad.
4. Challenges faced in recovery of loans and measures taken.
5. Analyze the future growth prospects of venture capital finance companies in
Hyderabad.
SCOPE OF THE STUDY

The study of Venture Capital trends in India will be helpful in understanding the
concept of Venture Capital and to understand the importance of Venture Capital in
developing countries like India. The study will also throw light on the major
institutions providing Venture Capital in India. The review of trend of Venture
Capital deals in India will help the VC firms to identify the developing sectors in the
country. The report will also help the start up companies in identifying the Venture
Capital firms which can provide financing for their growth.

 RESEARCH DESIGN

venture capital theory has been developed nor are there many comprehensive books on the
subject. Even the number of research papers available is very limited. The research design
used is descriptive in nature. (The attempt has been made to collect maximum facts and
figures available on the availability of venture capital in India, nature of assistance granted,
future projected demand for this financing, analysis of the problems faced by the
entrepreneurs in getting venture capital, analysis of the venture capitalists and social and
environmental impact on the existing framework.)

The research is based on secondary data collected from the published material. The data was
also collected from the publications and press releases of venture capital associations in India.

Scanning the business papers filled the gaps in information. The Economic times, Financial
Express and Business Standards were scanned for any article or news item related to venture
capital. Sufficient amount of data about the venture capital has been derived from this project.
Source of data

Primary Sources: The primary data was collected through structured unbiased questionnaire and
personal interviews of investors. For this purpose questionnaire included were both open ended &
close ended & multiple-choice questions.

Secondary method: The secondary data collection method includes:

 Websites
 Journals
 Text books
Method Used For Analysis of Study

The methodology used for this purpose is Survey and Questionnaire Method. It is a time consuming
and expensive method and requires more administrative planning and supervision. It is also subjective
to interviewer bias or distortion.

Sample Size: 100 respondents

Sampling Unit: Businessmen, Government Servant, Retired Individuals

Statistical Tools: MS-excel and pie and bar diagrams are used to analyze the
data.
LIMITATIONS

Though the project is completed successfully a few limitations may be there.

 Since the procedure and policies of the company will not allow disclosing
confidential financial information, the project has to be completed with the
available data given to us.

 The period of study that is 6 weeks is not enough to conduct detailed study of
the project.

 The study is carried basing on the information and documents provided by the
Organization and based on the interaction with the various employees.
 CHAPTER-II
REVIEW OF LITERATURE
  CONCEPT OF VENTURE CAPITAL

The term venture capital comprises of two words that is, “Venture” and “capital”. “Venture”
is a course of processing the outcome of which is uncertain but to which is attended the risk
or danger of “Loss”. “Capital” means recourses to start an enterprise. To connote the risk and
adventure of such a fund, the generic name Venture Capital was coined.

Venture capital is considered as financing of high and new technology based enterprises. It is
said that Venture capital involves investment in new or relatively untried technology,
initiated by relatively new and professionally or technically qualified entrepreneurs with
inadequate funds. The conventional financiers, unlike Venture capitals mainly finance proven
technologies and established markets. However, high technology need not be prerequisite for
venture capital.

Venture capital has also been described as ‘unsecured risk financing’. The relatively high risk
of venture capital is compensated by the possibility of high return usually through substantial
capital gains in term. Venture capital in broader sense is not solely an injection of funds into a
new firm, it is also an input of skills needed to set up the firm, design its marketing strategy,
organize and manage it. Thus it is a long term association with successive stages of
company’s development under highly risky investment condition with distinctive type of
financing appropriate to each stage of development. Investors join the entrepreneurs as co-
partners and support the project with finance and business skill to exploit the market
opportunities.

Venture capital is not a passive finance. It may be at any stage of business/ production cycle,
that is startup, expansion or to improve a product or process, which are associated with both
risk and reward. The Venture capital gains through appreciation in the value of such
investment when the new technology succeeds. Thus the primary return sought by the
investor is essentially capital gain rather than steady interest income or dividend yield.
The most flexible Definition of Venture Capital is:-

“The support by investors of entrepreneurial talent with finance and business skills to
exploit market opportunities and thus obtain capital gains.”

Venture capital commonly describes not only the provision of start up finance or ‘seed corn’
capital but also development capital for later stages of business. A long term commitment of
funds is involved in the form of equity investments, with the aim of eventual capital gains
rather than income and active involvement in the management of customer’s business.

 FEATURES OF VENTURE CAPITAL

 High Risk
 High Tech
 Equity Participation & Capital Gains
 Participation In Management
 Length Of Investment
 Illiquid Investment

 High Risk

By definition the Venture capital financing is highly risky and chances of failure are high as it
provides long term start up capital to high risk- high reward ventures. Ventures capital
assumes four type of risks, these are:

o Management risk -Inability of management teams to work together.

o Market risk -Product may fail in the market.
o Product risk -Product may not be commercially viable.
o Operation risk -Operation may not be cost effective resulting in
increased cost decreased gross margin.

 High Tech

As opportunities in the low technology area tend to be few of lower order, and hi-tech
projects generally offer higher returns than projects in more traditional area, venture capital
investments are made in high tech. areas using new technologies or producing innovative
goods by using new technology. Not just high technology, any high risk ventures where the
entrepreneur has conviction but little capital gets venture finance. Venture capital is available
for expansion of existing business or diversification to a high risk area. Thus technology
financing had never been the primary objective but incidental to venture capital.

 Equity Participation & Capital Gains

Investments are generally in equity and quasi equity participation through direct purchase of
share, options, convertible debentures where the debt holder has the option to convert the
loan instruments into stock of the borrower or a debt with warrants to equity investment. The
funds in the form of equity help to raise term loans that are cheaper source of funds. In the
early stage of business, because dividends can be delayed, equity investment implies that
investors bear the risk of venture and would earn a return commensurate with success in the
form of capital gains.

 Participation In management

Venture capital provides value addition by managerial support, monitoring and follow up
assistance. It monitors physical and financial progress as well as market development
initiative. It helps by identifying key resource person. They want one seat on the company’s
board of directors and involvement, for better or worse, in the major decision affecting the
direction of company. This is a unique philosophy of “hand on management” where Venture
capitalist acts as complementary to the entrepreneurs. Based upon the experience other
companies, a venture capitalist advice the promoters on project planning, monitoring,
financial management, including working capital and public issue. Venture capital investor
cannot interfere in day today management of the enterprise but keeps a close contact with the
promoters or entrepreneurs to protect his investment.

 Length of Investment

Venture capitalist help companies grow, but they eventually seek to exit the investment in
three to seven years. An early stage investment may take seven to ten years to mature, while
most of the later stage investment takes only a few years. The process of having significant
returns takes several years and calls on the capacity and talent of venture capitalist and
entrepreneurs to reach fruition.
  Illiquid Investment

Venture capital investments are illiquid, that is not subject to repayment on demand or
following a repayment schedule. Investors seek return ultimately by means of capital gain
when the investment is sold at market place. The investment is realized only on enlistment of
security or it is lost if enterprise is liquidated for unsuccessful working. It may take several
years before the first investment starts too locked for seven to ten years. Venture capitalist
understands this illiquidity and factors this in his investment decision.

 THE VENTURE CAPITAL SPECTRUM/STAGES

The growth of an enterprise follows a life cycle as shown in the diagram below. The
requirements of funds vary with the life cycle stage of the enterprise. Even before a business
plan is prepared the entrepreneur invests his time and resources in surveying the market,
finding and understanding the target customers and their needs. At the seed stage the
entrepreneur continue to fund the venture with his own fund or family funds. At this stage the
fund are needed to solicit the consultant’s services in formulation of business plans, meeting
potential customers and technology partners. Next the funds would be required for
development of the product/process and producing prototypes, hiring key people and building
up the managerial team. This is followed by funds for assembling the manufacturing and
marketing facilities in that order. Finally the funds are needed to expand the business and
attaint the critical mass for profit generation. Venture capitalists cater to the needs of the
entrepreneurs at different stages of their enterprises. Depending upon the stage they finance,
venture capitalists are called angel investors, venture capitalist or private equity
supplier/investor.

Venture capital was started as early stage financing of relatively small but rapidly growing
companies. However various reasons forced venture capitalists to be more and more involved
in expansion financing to support the development of existing portfolio companies. With
increasing demand of capital from newer business, venture capitalists began to operate across
a broader spectrum of investment interest. This diversity of opportunities enabled venture
capitalists to balance their activities in term of time involvement, risk acceptance and reward
potential, while providing ongoing assistance to developing business.
 Introduction stage

Growth

Later Stage Stage

Seed Capital Early Stage

Second Stage

Startup Capital

Venture Capital Spectrum/Stage

Different Venture capital firms have different attributes and aptitudes for different types of
Venture capital investments. Hence there are different stages of entry for different venture
capitalists and they can identify and differentiate between types of venture capital
investments, each appropriate for the given stage of the investee company, these are:-

1. Early stage Finance

 Seed capital
 Start up Capital
 Early/First Stage Capital
 Later/Third Stage capital

2. Later Stage Finance

 Expansion/Development Stage Capital

 Replacement Finance
 Management Buy Out and Buy Ins
  Turnarounds
 Mezzanine/Bridge Finance

Not all business firms pass through each of these stages in sequential manner. For instance
seed capital is normally not required by service based ventures. It applies largely to
manufacturing or research based activities. Similarly second round finance does not always
follow early stage finance. If the business grows successfully it is likely to develop sufficient
cash to fund its own growth, so does not require venture capital for growth.

The table below shows risk perception and time orientation for different stages of venture
capital financing.

Financing Stage Period (funds Risk perception Activity to be financed

locked in years)

Early stage finance 7-10 Extreme For supporting a concept or

idea or R & D for product
development
Start up 5-9 Very high Initializing operations or
developing prototypes
First stage 3-7 High Start commercial production
and marketing
Second stage 3-5 Sufficiently high Expand market & growing
working capital need
Later stage finance 1-3 Medium Market expansion, acquisition
& product development for
profit making company
Buy out-in 1-3 Medium Acquisition financing

Turnaround 1-3 Medium to high Turning around a sick

company
Mezzanine 1-3 Low Facilitating public issue

Venture Capital- Financing Stages

  Seed Capital

It is an idea or concept as opposed to a business. European venture capital association defines

seed capital as “The financing of the initial product development or capital provided to an
entrepreneur to prove the feasibility of a project and to qualify for start up capital.”

The characteristics of the seed capital may be enumerated as follows:

o Absence of ready product market

o Absence of complete management team
o Product/process still in R & D stage
o Initial period/licensing stage of technology transfer

Broadly speaking seed capital investment may take 7 to 10 year to achieve realization. It is
the earliest and therefore riskiest stage of Venture capital investment. The new technology
and innovations being attempted have equal chance of success and failure. Such projects,
particularly hi-tech, projects sink a lot of cash and need a strong financial support for their
adaptation, commencement and eventual success. However, while the earliest stage of
financing is fraught with risk, it also provides greater potential for realizing significant gains
in long term. Typically seed enterprises lack asset base or track record to obtain finance from
conventional sources and are largely dependent upon entrepreneur’s personal resources. Seed
capital is provided after being satisfied that the entrepreneur has used up his own resources
and carried out his idea to a stage of acceptance and has initiated research. The asset
underlying the seed capital is often technology or an idea as opposed to human assets (a good
management taem0 so often sought by venture capitalists.

Volume of Investment Activity

It has been observed that Venture capitalist seldom make seed capital investment and these
are relatively small by comparison to other forms of Venture finance. The absence of interest
in providing a significant amount of seed capital can be attributed to the following three
factors:-

a) Seed capital projects by their very nature require a relatively small amount of capital.
The success or failure of an individual seed capital investment will have little impact
on the performance of all but the smallest venture capital investments. This is because
 the small investments are seen to be cost inefficient in terms of time required to
analyze structure manage them.
b) The time horizon to realization for most seed capital investment is typically 7-10
years which is longer than all but most long-term oriented investors will desire.
c) The risk of product and technology obsolescence increases as the time to realization I
extended. These types of obsolescence are particularly likely to occur with high
technology investments particularly in the fields related to Information Technology.

 Start Up Capital

It is stage second in the venture capital cycle and is distinguishable from seed capital
investments. An entrepreneur often needs finance when the business is just starting. The start
up stage involves starting a new business. Here in the entrepreneur has moved closer towards
establishment of a going concern. Here in the business concept has been fully investigated
and the business risk now becomes that of turning the concept into product.

Start up capital is defined as; “Capital needed to finance the product development, initial
marketing and establishment of product facility.”

The characteristics of start-up capital are:-

a) Establishment of company or business: the company is either being organized or is

established recently. New business activity could be based on experts, experience or a
spin-off from R & D.
b) Establishment of most but not all the members of the team: the skills and fitness
to the job and situation of the entrepreneur’s team is an important factor for start up
finance.
c) Development of business plan or idea: the business plan should be fully developed
yet the acceptability of the product by the market is uncertain. The company has not
yet started trading.

In the start up preposition Venture capitalists’ investment criteria shifts from idea to people
involved in the venture and the market opportunity. Before committing any finance at this
stage, venture capitalist however, assesses the managerial ability and the capacity of the
entrepreneur, besides the skills, suitability and competence of the managerial team are also
evaluated. If required they supply managerial skill and supervision for implementation. The
time horizon for start up capital will be typically 6 or 8 years. Failure rate for start up is 2 out
of 3. Start up needs funds by way of both first round investment and subsequent follow-up
investments. The risk tends to be lower relative to seed capital situation. The risk is
controlled by initially investing a smaller amount of capital in start-ups. The decision on
additional financing is based upon the successful performance of the company. However, the
term to realization of a start up investment remains longer than the term of finance normally
provided by the majority of financial institutions. Longer time scale for using exit route
demands continued watch on start up projects.

Volume of Investment Activity

Despite potential for secular returns most venture firms avoid investing in start-ups. One
reason for the paucity of start up financing may be high discount rate that venture capitalist
applies to venture proposals at this level of risk and maturity. They often prefer to spread
their risk by sharing the financing. Thus syndicates of investor’s often participate in start up
finance.

 Early Stage Finance

It is also called first stage capital is provided to entrepreneur who has a proven product, to
start commercial production and marketing, not covering market expansion, de-risking and
acquisition costs.

At this stage the company passed into early success stage of its life cycle. A proven
management team is put into this stage, a product is established and an identifiable market is
being targeted.

British Venture capital Association has vividly defined early stage finance as: “Finance
provided to companies that have completed the product development stage and require
further funds to initiate commercial manufacturing and sales but may not be generating
profits.”
The characteristics of early stage finance may be:-

 Little or no sales revenue.

 Cash flow and profit still negative.
 A small but enthusiastic management team which consists of people with technical
and specialist background and with little experience in the management of growing
business.
 Short term prospective for dramatic growth in revenue and profits.

The early stage finance usually takes 4 to 6 years time horizon to realization. Early stage
finance is the earliest in which two of the fundamentals of business are in place i.e. fully
assembled management team and a marketable product. A company needs this round of
finance because of any of the following reasons:-

 Project overruns on product development.

 Initial loss after start up phase.

The firm needs additional equity funds, which are not available from other sources thus
prompting venture capitalist that, have financed the start up stage to provide further
financing. The management risk is shifted from factors internal to the firm (lack of
management, lack of product etc.) to factor external to the firm (competitive pressures, in
sufficient will of financial institutions to provide adequate capital, risk of product
obsolescence etc.)

At this stage, capital needs, both fixed and working capital needs are greatest. Further, since
firms do not have foundation of a trading record, finance will be difficult to obtain and so
venture capital particularly equity investment without associated debt burden is key to
survival of the business.

The following risks are normally associated to firms at this stage:-

a) The early stage firms may have drawn the attention of and incurred the challenge of a
larger competition.
b) There is a risk of product obsolescence. This is more so when the firm is involved in
high-tech business like computer, information technology etc.
  Second stage Finance

It is the capital provided for marketing and meeting the growing working capital needs of an
enterprise that has commenced the production but does not have positive cash flows
sufficient to take care of its growing needs. Second stage finance, the second trench of Early
Stage Finance is also referred to as follow on finance and can be defined as the provision of
capital to the firm which has previously been in receipt of external capital but whose financial
needs have subsequently exploded. This may be second or even third injection of capital.

The characteristics of a second stage finance are:

 A developed product on the market

 A full management team in place
 Sales revenue being generated from one or more products
 There are losses in the firm or at best there may be a breakeven but the surplus
generated is insufficient to meet the firm’s needs.

Second round financing typically comes in after start up and early stage funding and so have
shorter time to maturity, generally ranging from 3 to 7 years. This stage of financing has both
positive and negative reasons.

Negative reasons include:

 Cost overruns in market development

 Failure of new product to live up to sales forecast.
 Need to re-position products through a new marketing campaign
 Need to re-define the product in the market place once the product deficiency is
revealed.

Positive reasons include:

 Sales appear to be exceeding forecasts and the enterprise needs to acquire assets to
gear up for production volumes greater than forecasts.
  High growth enterprises expand faster than their working capital permit, thus needing
additional finance. Aim is to provide working capital for initial expansion of an
enterprise to meet needs of increasing stocks and receivables.

It is additional injection of funds and is an acceptable part of venture capital. Often provision
for such additional finance can be included in the original financing packages as an option,
subject to certain management performance targets.

 Later Stage Finance

It is called third stage capital is provided to an enterprise that has established commercial
production and basic marketing set-up, typically for market expansion, acquisition product
development etc. it is provided for market expansion of the enterprise.

The enterprises eligible for this round of finance have following characteristics:

 Established business, having already passed the risky early stage.

 Expanding high yield, capital growth and good profitability.
 Reputed market position and an established formal organization structure.

“Funds are utilized for further plant expansion, marketing, working capital or development of
improved products.” Third stage financing is a mix of equity with debt or subordinate debt.
As it is half way between equity and debt in US it is called “mezzanine” finance. It is also
called last round of finance in run up to the trade sale or public offer.

Venture capitalists prefer later stage investment vis a Vis early stage investments, as the rate
of failure in later stage financing is low. It is because firms at this stage have a past
performance data, track record of management, established procedures of financial control.
The time horizon for realization is shorter, ranging from 3 to 5 years. This helps the venture
capitalists to balance their own portfolio of investment as it provides a running yield to
venture capitalists. Further the loan component in third stage finance provides tax advantage
and superior return to the investors.

There are four sub divisions of later stage finance:

 Expansion/Development Finance
  Replacement Finance
 Buyout Financing
 Turnaround Finance

Expansion/ Development finance

An enterprise established in a given market increases its profit exponentially by achieving the
economies of scale. This expansion can be achieved either through an organic growth, that is
by expanding production capacity and setting up proper distribution system or by way of
acquisitions. Anyhow, expansion needs finance and venture capitalists support both organic
growth as well as acquisitions for expansion.

At this stage the real market feedback is used to analyze competition. It may be found that the
entrepreneur needs to develop his managerial team for handling growth and managing a
larger business.

Realization horizon for expansion/development investment is one to three years. It is favored

by venture capitalist as it offers higher rewards in shorter period with lower risk. Funds are
needed for new or larger factories and warehouses, production capacities, developing
improved or new products, developing new markets or entering exports by enterprise with
established business that has already achieved break even and has started making profits.

Replacement Finance

It means substituting one shareholder for another, rather than raising new capital resulting in
the change of ownership pattern. Venture capitalist purchase share from the entrepreneurs and
their associates enabling them to reduce their shareholding in unlisted companies. They also
buy dividend coupon. Later, on sale of the company or its listing on stock exchange, these are
re-converted to ordinary shares. Thus Venture capitalist makes a capital gain in a period of 1
to 5 years

Buy-out / Buy-in Financing

It is a resent development and a new form of investment by venture capitalist. The funds
provided to the current operating management to acquire or purchase a significant share
holding in the business they manage are called management buyout.
Management Buy-in refers to the funds provided to enable a manager or a group of managers
from outside the company to buy into it.

It is the most popular form of venture capital amongst stage financing. It is less risky as
venture capitalist in invests in solid, ongoing and more mature business. The funds are
provided for acquiring and revitalizing an existing product line or division of a major
business. MBO (Management buyout) has low risk as enterprise to be bought have existed for
some time besides having positive cash flow to provide regular returns to the venture
capitalist, who structure their investment by judicious combination of debt and equity. Of late
there has been a gradual shift away from start up and early finance towards MBO
opportunities. This shift is because of lower risk than start up investments.

Turnaround Finance

It is rare form later stage finance which most of the venture capitalist avoid because of higher
degree of risk. When an established enterprise becomes sick, it needs finance as well as
management assistance for a major restructuring to revitalize growth of profits. Unquoted
company at an early stage of development often has higher debt than equity; its cash flows
are slowing down due to lack of managerial skill and inability to exploit the market potential.
The sick companies at the later stages of development do not normally have high debt burden
but lack competent staff at various levels. Such enterprises are compelled to relinquish
control to new management. The venture capitalist has to carry out the recovery process
using hands on management in 2 to 5 years. The risk profile and anticipated rewards are akin
to early stage investment.

Bridge Finance

It is the pre-public offering or pre-merger/acquisition finance to a company. It is the last

round of financing before the planned exit. Venture capitalist help in building a stable and
experienced management team that will help the company in its initial public offer. Most of
the time bridge finance helps improves the valuation of the company. Bridge finance often
has a realization period of 6 months to one year and hence the risk involved is low. The
bridge finance is paid back from the proceeds of the public issue.
  VENTURE CAPITAL INVESTMENT PROCESS

Venture capital investment process is different from normal project financing. In order to
understand the investment process a review of the available literature on venture capital
finance is carried out. Tyebjee and Bruno in 1984 gave model of venture capital investment
activity with some variations is commonly used presently. As per this model this activity is a
five step process as follows:

1. Deal Organization
2. Screening
3. Evaluation or due Diligence
4. Deal Structuring
5. Post Investment Activity and Exit
 Investors

Screening

VC MGT Fund
Selection

Investment
process

Structuring
Prospective
Investee

 Deal Origination: Monitoring

In generating a deal flow, the VC investor creates a pipeline of deals or investment

opportunities that he would consider for investing in. deal may originate in various ways.
Exit
Referral system, active search system, and intermediaries. Referral system is an important
source of deals. Deals may be referred to VCFs by their parent organizations, trade partners,
industry associations, friends etc. Another deal flow is active search through networks, trade
fairs, conferences, seminars, foreign visits etc. intermediaries is used by venture capitalists in

developed countries like USA, is certain intermediaries who match VCFs and the potential
entrepreneurs.

 Screening:

VCFs, before going for an in-depth analysis, carry out initial screening of all projects on the
basic of some broad criteria. For example, the screening process may limit projects to areas in
which the venture capitalist is familiar in terms of technology, or product, or market scope.
The size of investment, geographical location and stage of financing could also be used as the
broad screening criteria.

 Due Diligence:

Due diligence is the industry jargon for all the activities that are associated with evaluating an
investment proposal. The Venture capitalists evaluate the quality of entrepreneur before
appraising the characteristics of the product, market or technology. Most venture capitalists
ask for a business plan to make an assessment of the possible risk and return on the venture.
Business plan contains detailed information about the proposed venture. The evaluation of
ventures by VCFs in Indian includes; Preliminary evaluation: the applicant required to
provide a brief profile of the proposed venture to establish prima facie eligibility.

Detailed evaluation: once the preliminary evaluation is over, the proposal is evaluated in
greater detail. VCFs in India expect the entrepreneur to have: - integrity, long-term vision,
urge to grow, managerial skills, commercial orientation.

VCFs in India also make the risk analysis of the proposed projects which includes: product
risk, market risk, technological risk and entrepreneurial risk. The final decision is taken in
terms of the expected risk-return trade-off as shown in figure.

 Deal Structuring:

In this process, the venture capitalist and the venture company negotiate the terms of the
deals, that are the amount form and price of the investment. This process is termed as deal
structuring. The agreement also include the venture capitalists right to control the venture
company and to change its management if needed, buyback arrangement specify the
entrepreneurs equity share and the objectives share and the objectives to be achieved.

 Post Investment Activities:

Once the deal has been structured and agreement finalized, the venture capitalist generally
assumes the role of a partner and collaborator. He also gets involved in shaping of the
direction of the venture. The degree of the venture capitalists involvement depends on his
policy. It may not, however be desirable for a venture capitalist to get involved in the day-to-
day operation of the venture. If a financial or managerial crisis occurs, the venture capitalist
may intervene, and even install a new management team.

 Exit:

Venture capitalists generally want to cash-out their gains in five to ten years after the initial
investment. They play a positive role in directing the company towards particular exit routes.
A venture may exist in one of the following ways:

There are four ways for a venture capitalist to exit its investment:

 Initial Public Offer (IPO)

 Acquisition by another company
 Re-purchase of venture capitalists share by the investee company
 Purchase of venture capitalists share by a third party

Promoters Buy-back

The most popular disinvestment route in India is promoters buy-back. This route is suited to
Indian conditions because it keeps the ownership and control of the promoter intact. The
obvious limitation, however, is that in a majority of cases the market value of the shares of
the venture firm would have appreciated so much after some years that the promoter would to
be in a financial position to buy them back.

In India, the promoters are invariably given the first option to buy back equity of their
enterprise. For example, RCTO participates in the assisted firm’s equity with suitable
agreement for the promoter to repurchase it. Similarly, Confina-VCF offers an opportunity to
the promoters to buy back the shares of the assisted firm within an agreed period at a
predetermined price. If the promoter fails to buy back the shares within the stipulated period,
Confine-VCF would have the discretion to divest them in any manner it deemed appropriate.
SBI capital Markets ensures through examining the personal assets of the promoters and their
associates, which buy back, would be a feasible option. GV would make disinvestment, in
consultation with the promoter, usually after the project has settled down, to a profitable level
and the entrepreneur is in a position to avail of finance under conventional schemes of
assistance from banks or other financial institutions.
  METHODS OF VENTURE FINANCING

Venture Capital is typically available in three forms in India, they are:

 Equity: All VCFs in India provide equity but generally their contribution does not
exceed 49% of the total equity capital. Thus, the effective control and majority
ownership of the firm remains with the entrepreneur. They buy shares of an enterprise
with an intention to ultimately sell them off to make capital gains.
 Conditional Loan: it is repayable in the form of a royalty after the venture is able to
generate sales. No interest is paid on such loans. In India, VCFs change royalty
ranging between 2% to 15%; actual rate depends on other factors of the venture such
as gestation period, cost flow patterns, riskiness and other factors of the enterprise.
 Income Note: it is a hybrid security which combines the features of both
conventional loan and conditional loan. The entrepreneur has to pay both interest and
royalty on sales, but at substantially low rates.
 Participating Debenture: 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.
 Quasi Equity: 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 hand 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
follows:

o Cumulative convertible preference shares.

o Partially convertible debentures.
o Fully convertible debentures.

 Other Financing methods: a few venture capitalists, particularly in the private

sector, have started introducing innovative financial securities like participating
debentures, introduced by TCFC is an example.