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VENTURE CAPITAL

HOW THE VENTURE CAPITAL INDUSTRYWORKS

VENTURE CAPITAL
What is a venture?
An undertaking that is dangerous, daring or of uncertain out come. A business enterprise involving high risk in expectation of gain. Something, money or cargo, at hazard, in a risky enterprise.

What is Venture Capital? Venture capital is the investment of long term equity finance where the venture capitalist earns his return primarily in the form of capital gains.(Patient Risk Capital). VCs provide their own money for seed capital to research an idea, referred as Angels called Angel Capital.(Informal Venture Capital). Corporate Venture Capital- dedicated pool of money, refers to venture capital investments made by large corporations to further their strategic( Enhancement of financial or market position) interest.

VENTURE CAPITAL: STATUS


VC funds are regulated by SEBI guidiles-2000. VC funds ,unlike in USA, can be organized only as a company or

trust. Mostly, VC funds, in India, are organized as limited life trusts, liquidated when the objectives are met. US funds are organized as Limited Liability Partnership while Indian VCs governed mostly by the Indian Trust Act. Both are created for a limited period with a clearly defined purpose and liquidated after achieving the objectives. It is now possible to form LLPs in India under Limited Liability Partnership Act-2008 but VCs are majorly organized as trusts due to 1. In sufficient clarity on the taxation aspects. 2. Ambiguity regarding the applicability of SEBI regulation to LLPs viz lack of clarity about LLPs activities.

VENTURE CAPITAL SERVICES


Do VCs provide only money? VCs provide Smart Money. They function as guides and mentors and help the entrepreneur in making the business success. VCs are backers of ideas and potential & provide expertise to enable a start up business to succeed and grow. VCs are knowledgeable about their dynamics and the business landscape. VCs require a sharp nose to smell investment opportunities and also to keep themselves updated with the different markets, business technology trends etc to arrive at the odds of a business success. VCs are not only good with numbers but is also very proficient at networking and judging people, opportunities and business dynamics. VCs do not actually want to run a business . They are only interested in adding value to the business they invest in so that they can multiply their investment manifold.

HOW VC FUNDS ORGANIZED


Like USA , the unique category of business entities called Limited

Liability Partnerships now also legal in India. Protects external investors from direct liability while providing them of a partnership agreement. VCs are managed by experienced money managers, called General Partners(GPs), responsible for managing the affairs of the fund. Investors are called Limited Partners(LPs).Their involvement is limited , to provide money to create the VC fund. Passive Investors: Institutions, pension funds, banks, insurance companies etc . Professional Money Managers, the GPs, providing limited money & have complete control on the management of the fund with some checks and balance.
VC may be raising money for one fund, investing/monitoring the

money of another, the earlier fund.

HOW VC FUNDS ORGANIZED


Limited Partners

Ins com

Pens fund

Large corp

HNWI

General Partners

VC fund

Mgrs

Portfolio

Com-A

Com-B

Com-C

Com-D

Com-E

Com-F

RAISING VC FUNDS:STEPS
1)Private Placement Memorandum(PPM): Document contains information such as the fund size, investment strategy, returns expected, minimum contribution expected, expected life of the firm. Investors make commitment & signs subscription or investment agreement with the VC fund. 2) Closing: The fund remains open for investment for a defined period , say 1 to 2 months, after which it is closed. Usually, 10% to 20% of the amount is collected from the investors at the closing stage. 3) CALLED: The rest of the commitment is Called by the fund in accordance with the call down schedule. Typically, the money is collected from investors in tranches (around 15% to 25% of the commitment amount) over the first two years of the funds life. In the process, money does not remain idle helping VC to maintain the targeted return.

VENTURE CAPITAL :PHASES


VC fund goes through the following distinct phases: (Year 8-10) Establishment(Year 0): Creating entity and pooling investors fund for onward activities Seeking Investors (Year 0-1): (Three steps)
A. Private Placement Memorandum B. Called C. Closed

Investing the Corpus and Calling Commitments (Year 0-3):

Invested in ventures with defined targeted profile. Substantially Invested and Monitoring Portfolio (Year 4-7): Monitored and to ensure that the requisite value is created. Exit through IPOs and Strategic Sales (Year 5-7): Monies realized will be propotionately distributed to the investors of the fund. Distributions (Year 7-9):Liquidation and distribution to investors in the ratio, invested.

HOW VC MAKES MONEY


VC fund makes money in two ways: A. Management Fees 1. Charged (Between 1% to 3% documented in Private Placement Memorandum- PPM) to investors on the committed or invested capital. 2. VC charge at the higher end of the scale say 3%,if he has a past track record of providing superior return. 3. Fees are to be paid on quarterly basis B. Share of Profits: 1. Carried Interest(Carry) : It is usually about 20% of the funds profit. It is defined at the initial stages of the funds formation and is usually dependent on excess returns to investors over and above the normal return from other investment. 2. Hurdle Rate: VC is not entitled to share in the profits below the above threshold. VC fund Manager gets his 20% carry only if he can produce return higher than the hurdle rate.

VC RETURN METRICS
Internal Rate of Return:
A. The internal rate of return is an annualized rate of return over the

period between investment and final return and expressed as a percentage. B. VC fund having a fixed life of 10 years earns returns at an IRR 30% per annum, means that the corpus has grown at a compounded rate of 30% per annum over the entire period of 10 years. Exception in VC fund:
A. VC funds, investments are made in stages and also returned in

stages B. IRR measures the time value of money by taking into account the timing of cash flows, in and out, of the fund.

VC RETURN METRICS
Investment Multiple: 1. It is a simple cash-on cash return. 2. Calculated by the monies received divided by the monies invested. 3. Simple measure and does not take into account the number of years the monies remain invested. 4. IRR falls if the money remains invested for a longer period but return the same investment multiple. Example: INR 100 reached at INR176 after 5 years of investment in Bank , at an IRR of 12%.If same amount of money received after 8 years, IRR reduced to 7.5%.The main reasons why VCs are constantly looking for a good exit at the earliest. IRR% for Different Multiples of X
Year 3 5 2x 26.0 14.9 3x 44.2 24.6 4x 58.7 32.0 5x 71.0 38.0 6x 81.7 43.1 7x 91.3 47.6 8x 100.0 51.6 9x 108.0 55.2 10x 115.4 58.5

RISK VCs TAKE


Invest in Equity or Quasi Equity, carry the expected risks of 1. Economic downturn 2. Bankruptcies 3. Impact of regulatory policies on Stock Market 4. Global Competition Further exposed to the following negatives: 1. Adverse Selection 2. Very high due diligence cost in terms of time & money. 3. Ill-liquidity, tied up in long term investment, can not be sold easily. 4. For dilution of shareholding & longer holding period for exit, VC requires constant follow up on investments. 5. Possibilities of wiping out even the principal investment as the business may not live up to VCs expectation.

RISK VCs TAKE


Venture Capital Backed Companies Known for Innovative Business Models, Technology and Products, Employment at IPO and Now.
Company Microsoft Intel Medtronic Apple Inc Google JetBlue The Home Depot Starbucks Corpn Staples eBay As of IPO 1,153 460 1,287 1.015 3,021 4,011 650 2,521 1,693 138 Year March1986 Oct1971 Year 1977 Jan1981 April2004 April2002 Year 1981 June1992 April1989 Sept1998 Current 100,500 100,100 45,000 76,100 53,861 12,070 331,000 160,000 89,019 31,500 Change 99,347 99,640 43,713 75,085 50,840 8,059 330,350 157,479 87,326 31,362

VENTURE CAPITAL BACKED IPOs

TRANSLATING VC RISK INTO VC TARGET RETURN


A. VCs target is much higher than the expected return as they take

higher risk by investing in unlisted , risky & even new business. B. Relationship between risk and the build up of return as compensation for assuming greater risks. Risk Free rate of 8%: Usually reflected by the yield on the 10 year Government Bonds. Investors always aim, at least to make an average around 8%, in tune with the Govt bonds yield. Equity Premium of Another 8% for Market Risk Additional return over and above the risk free return , compensating the risks taken due to investing money in the equity, of unlisted company. VC Risk Premium of Another 8%(Investors expectation) Investors like another 50% return over and above they could make by investing in listed securities ,considering average equity return of 16% for longer term.

TRANSLATING VC RISK INTO VC TARGET RETURN


VC Fund Managers Fees and Fund: (Expeted overall 8%) VC fund manager will take 2% to 3% as annual management fees and about 20% (Carried Interest) of the return the fund makes on its operation. VC overall target return of 32%: 1. VC funds target an IRR of around 32% as arrived above. 2. However it varies depending upon the market condition like inflation, risk free interest rate, capital market situation, money availability from investors etc.
Most VC investors is satisfied with about 30% return on an average for all their investments as a whole. Reality: VC Industry- One third Principle: (1/3rd multiple return, 1/3rd just investment amt, 1/3rd write off) VC Portfolio of investments: 2/3rd written off or return of original investment amount.

PORTFOLIO PERFORMANCE
Overview of VCs portfolio return amounting to INR100Million Investment Type No of Companies Total Invested Value after 5 Yrs Stages Industry Sunk 3 30 0 Seed Electro nics Average 3 30 120 Start up Computer Software Superior 2 20 100 Early Stage Consumer related Solid 1 10 80 Later Stage Industrial Products Super Stars 1 10 100 Turnaround Medical (INR in M) Total Portfolio 10 100 400

Return Multiple
IRR%

0X
0%

4X
32%

5X
38%

8X
52%

10X
58%

4X
32%

A. The fund has earned an IRR32% over 5 years in spite of the fact that

30% of its investment were total loses. B. Conclude that in general, every three of VCs investments could able to succeed to generate return multiple.

VENTURE CAPITAL: STRATEGY


The strategies VCs adopt in order to achieve their objectives varies with their:
1. Experience 2. View on the need in the market 3. Estimate of what the future in various industries is likely

to be 4. Risk they can take 5. Sources and cost of funds 6. Style of investment i.e. how much involvement in the management, monitoring and control of the business they consider necessary to ensure a profitable exit.

VENTURE CAPITAL: RISK STRATEGY


Seed Stage(Very High Risk) Turnaround Stage (Medium to High Risk)

(High Risk)

Start up Stage (High Risk)

Mature Stage (Medium to Low Risk)

VC RISK STRATEGY
Early Growth Stage (Medium to High Risk)

Expansion Stage (Medium Risk)

VENTURE FUNDING STAGES:PURPOSE


A. Seed Stage(VH): (Drawing Board Status) Research, Prototype development, Business Plan Development B. Start Up Stage(H): (Validated Status) Product & Basic Infrastructure Development , Market survey etc C. Early Growth Stage(MH): (Full Scale Operation Status) Creating Market, Process Creation, Market Development , Working Capital (First Round Funding by VC) D. Expansion Stage(M): ( Product Refinement Status) Market Development , Geographical Expansion, Incremental Working Capital. ( 2nd & 3rd Round Funding by VC) E. Mature Stage(ML): (New Market & Product Dev Status) Acquisition, Global Marketing, Increased Capacity (Mezzanine or Bridge for IPO by VC) F. Turnaround Stage(MH): (Special Situation Stage) Reorganization of Business, Surviving till disinvestment and positive cash flow (Restructuring : Reduction of debt by specialized VC)

VENTURE FUNDING STAGES


SEED STAGE FINANCING( 5 years to 8 years , expected return100%)
This stage is a relatively small amount of capital provided to an

inventor or entrepreneur to prove a concept. This involves product development and market research as well as building a management team and developing a business plan, if the initial steps are successful, is a pre-marketing stage. EARLY STAGE FINANCING ( 4 to 7 years , expected return 50%-80%)
This stage provides financing to companies completing development

where products are mostly in testing or pilot production. In some cases, product may have just been made commercially available. Companies may be in the process of organizing or they may already be in business for three years or less. Usually such firms will have made market studies, assembled the key management, developed a business plan, and are ready or have already started conducting business.

VENTURE FUNDING STAGES


EXPANSION STAGE (3 years to 6 years, expected return 40% -70%)
This stage involves working capital for the initial expansion of a

company. It may or may not be showing a profit. Some of the uses of capital may include further plant expansion, marketing, working capital, or development of an improved product. More institutional investors are more likely to be included. VCs role evolves from a supportive role to a more strategic role. LATER STAGE ( 3 years to 5 years, expected return 30% to 50%)
Capital in this stage is provided for companies reached at a fairly

stable growth rate , may not be growing as fast as the earlier stage. These companies may or may not be profitable, but are more likely to be better than in previous stages of development. Other financial characteristics include positive cash flow. This also includes companies considering IPO.

VENTURE FUNDING STAGES


ACQUISITION FINANCING (1 to 3 years ,expected return 20% -35%)
An acquisition of 49% stake or less. Firm acquires minority shares

of a company. ACQUISITION: EXPANSION ( 2 to 5 years, expected return 30-50%)


Funds provided to a company to finance its acquisition of other

companies or assets. A consolidator of companies in specific industries. MANAGEMENT/LEVERAGED BUYOUT (Depends on the situation)
These funds enable an operating management group to acquire a

product line or business, at any stage of development , from either a public or private company , may be closely held or family owned. Management/leveraged buyouts usually involve revitalizing an operation, with entrepreneurial management acquiring a significant equity interest.

VENTURE FUNDING STAGES

VENTURE FUNDING STAGES

VC INVESTMENT PROCESS
A. Deal Sourcing: Identification of attractive investment opportunities B. Evaluation of business aspects: ( 85% to 90% rejection) Management: (Composition,motivation,commitment,vision,partner) Growth Potential (Product/Market Dynamics), (Scalability, industry) Profitability:( Economies, infrastructure, capital intensity,WC Reqr) Investment Requirements:(size, Rounds of finance, portfolio size) Exit Opportunities, timing & Return:( Risks & Reward, exit time) C. Deal Structuring and Negotiation: Creating Documents on accepted agreements-called Term Sheet D. Due Diligence Review: (Scrubbing the Deal) Detailed examination by VC on the business plan & representation. E. Legal Documentation: Finally, Legal vetting of term sheet

NEED FOR VENTURE CAPITAL FUND


Funding Gap: 1. Arises at the initial stages of venture, when the venture can neither attract debt finance nor can it get venture capital funding. 2. Founder/Entrepreneur finance the required amount through personal savings or avail credit on the strength of their own credit history. 3. Sources: Family/ friends , Leasing , Bank,Angel,Venture Capital 4. The initial gap is managed by the Entrepreneur with his own efforts and resources-referred as Bootstrapping skills Really venture need Money? 1. Money invested in venture has always a cost 2. Adoption of Prudent Money Management Style 3. Optimal use of all the available sources of financing. 4. Avoid getting money in exchange of Equity at the early life cycle of the venture, cost heavily.

CREATIVE FINANCING IDEAS


1. Find ways sharing expenses with others. 2. Carry minimum head count on your payroll 3. Structure performance linked compensation for employees 4. Do not block your money in fixed asset 5. Minimum inventory carrying cost 6. Suppliers can be a cheap source of funds 7. Ways to receive advance from buyers against future services 8. Sales commission to sales staff, on receipt of cash. 9. Create Cash is King perception in the organization. 10 Strategic alliances/JVs with suppliers and customers. 11. Ideal capacity for bartering services.

ENTREPRENEURS ANXIETY
Myth 1: Take over of Business: VCs primary business is money management. Objectives are protection and harvesting their investment for huge profit. Myth 2: Looking control of Business by Vc. VCs have control over the crucial decision making process, not on day to day operational affairs. Myth 3: Selling of Business to enable the VC to Exit. VCs look clear path to realize their profit, selling is the last resort Myth 4: Need to change the way of working. Founder is more responsible than VCs- to recognize all time Myth 5: Open up of Business secret causing detrimental to business. VC is a partner of your business having same footing like you. Myth 6: VCs unreasonable demand for high return. VC funding carries high risk. High return is the only alternative.

BUSINESS WHERE VCs PROVIDE MONEY


Ventures which can become big business rapidly. Businesses have better odds of reaching an IPO. Business achieving a strategic sale within 3 to 5 years for VCs exit. Business, majorly two types : A. Limited Opportunity Business: Provides regular income to its owners/investors. Geographically confined and serve the local community. Retail/ consulting/service/ transportation/ restaurants firms. Do not sell equity to VC to retain overall control. It is very difficult to have a profitable exit by VC. Investors here received dividend, interest payments & do not rely on the IPO market, strategic merger or sale for their return. Sourced funds from individuals, strategic partners, lenders etc Positive, high cash flow early in business development. Initial losses are funded through founder, angel, Strategic Investors. Return to investors through annual dividends or interest payments.
1. 2. 3.

BUSINESS WHERE VCs PROVIDE MONEY


B. Scalable Growth Business: 1. Ability for a rapid business growth due to the combination of The market in which they operate Their differentiated product offerings Management capability of the founding team. 2. Sufficiently large and growing industrial segments. 3. Opportunity of a new segment in a matured market. 4. New method of solving industrys existing problem. 5. Rationalization in regulatory environment due to changes in social attitudes or structural changes in the market. 6. New technology enlarge the existing market & create new market. 7. Create entry barriers for potential competitors under IPRs. 8. Business having strong competitive positioning. 9. Deregulation of market creates huge opportunity to entrepreneur. 10.Management capability: Core Mgt Team, Teams internal roles, responsibilities, rewards. Creative,Dynamic,business acumen of Team.

VC FINANCE : YES LIST


Founder and his team are passionate about their business. Definite need of ventures product and service in the market besides

to address any existing pain in the targeted customers. Offering any unique and differentiated products than competitors. Having huge market size & growing rapidly. Existence of entry barriers. Expected revenue to grow over 50% pa over the next five years. Motivated management team, aiming to grow the business. Roles, responsibilities, rewards of the Leaders are clearly defined. No legal violation, compliance of all regulatory requirements. Policy, procedures & process should promote efficiency/scalability. Ready to sell off a part to VC. Willing to be accountable for performance to the VC. Willing to change working style to accommodate VCs monitoring. Have a clear exit strategy.

PROCESS OF RAISING VC BY ENTREPRENEURS


Step 1: Preparation of Documents. Detailed Business Plan Executive Summary Elevator Pitch Presentation Step 2: Selection of Target VCs (Short Listing). Industry Stage of Business Investment Amount Target Return Post Investment monitoring Requirement Geographical Area Step 3: Meeting the VC Present, business case. Impress the VC and aim at to receive term sheet

PROCESS OF RAISING VC
Step 4: Term Sheet Negotiation Awareness of VC terms sheet , transformed to be a legal document Sound negotiating strategy prior to start of the funding by VC. Step 5: Due Diligence. Investigation of ventures business by VC VCs validation of historical and operational information, submitted by ventures Prior competency to know expected issues that lead VCs, saying no. Step 6: Legal Documentation Investment Agreement Share holders Agreement Confidentiality and non disclosure agreement Service Contracts for Key employees and Directors Non negotiable key clauses from the VCs stand point , awareness.

WHEN ENTREPRENEURS SHOULD RAISE FUND

Initiate VC funding activities, when venture has least need of the money . Have a financially good year, move to VC at the end of the fiscal year with audited balance sheet and with current year forecast besides updated achievements. Major event ( Products trial run , acquisition of new customer or big order etc) , having positive impact on the future growth of your business lead to be a positive point to consider by VC. External environment like booming of capital market will help the ventures to get a higher valuation of their business. VCs are also able to raise more money and keen to invest into the best opportunities

What Can Go Wrong, Raising VC


1. General: Underestimating the length of time taken to obtain funding Underestimating Management time taken to prepare Not having a scalable growth business Not using experienced advisers Inappropriate timing of fund raising 2. Targeting Stage: Inexperienced advisers or incorrect advice Badly made business plan, executive summary and elevator pitch Selecting wrong VC(Industry focus, Investment size/amount, return) Portfolio needs of the VC preclude investment IRR not good enough Timing and mode of exit is unsuitable

What Can Go Wrong , Raising VC


3. Screening Stage: Business Plan not well drafted Management Lacking in Creditability Lack of integrity (selective disclosure, false/partial statement. Lack of chemistry between the founder and VC. High equity stake by VC Funding amount is too high or too low What Can Go Wrong, Raising VC No syndicate VCs available. 4. Due Diligence Stage: Shareholder issues, Employee issues Legal cases or contingent liabilities Post due diligence valuation adjustment not agreed by entrepreneur 5. Legal Agreement Stage: Control issue Anti dilution issues Share transfer issues

VC: METHODS OF FINANCING(INDIA)


EQUITY: I. Provides VC in the form of equity and acts as co-owner. II. Generally less than the promoters contribution ,not exceeding 49% III. Effective control retains by the promoters CONDITIONAL LOANS: I. Not repayable and does not carry interest. What Can Go Wrong, Raising VC II. Repayment is linked to the sales of the company in the form of loyalty III. Royalty(2% to 15%) usually collected from the third to fifth year. IV. Repayment terms being decided keeping in view the gestation period & the repayment ability. CONVENTIONAL LOANS: I. Long term loan , 10-12 years ,at a concessional rate of interest with a clause to raise when the project is commercially successful.

VC: METHODS OF FINANCING(INDIA)


INCOME NOTES:
Hybrid security combining the features of both conventional & conditional loans. II. A floor rate of interest (Say10%) and a royalty on sales are charged. III. Funds are made available in the form of unsecured loan.
I.

IV. Higher interest rate during the development phases.

OTHER INSTRUMENTS: (Innovative Financial Instrument) A. Participating Debentures stipulating a three phase system charges;
Interest Holiday till the project is implemented successfully. II. Lower rate of interest till the project operates at a particular level of capacity utilization. III. Increased rate of interest and a small royalty on sales once the project takes off. B. Partially convertible debentures, Cumulative convertible preference Shares, C. Hire purchase, lease finance & even overdraft in selected cases.
I.

VC: CASE STUDY-4


PDQ plc is a software company and Internet provider that was

established in the dot-com boom of the year 2000. The three funding shareholders who are still directors and managers of the company own 30% of PDQ plc. Employees, friends and relatives of the founders own a further 15%. The majority 55% shareholding is owned by a venture capital company that bought a stake in PDQ plc four years ago for INR12M. The venture capital company now wishes to dispose of the holding. The 45% minority shareholders and non-shareholding employees are considering a management buyout. PDQ plc has sustained losses for the past three years but believes it is now moving into profit. Because of this losses, no liability to tax will arise in AY 2014 but the company will begin to pay tax at 30% per annum from AY 2015. It has not declared or paid a dividend since the company was formed.

KEY FINANCIAL INFORMATION


Income statement for the years ended
Particulars Sales Revenue 31/3/2014(Est) 15.25

(INR M)
31/3/2013 14.52 16.97 (2.45) 0.50

Direct Costs & Expenses 12.50 Profit/(Loss) before tax 2.75 BALANCESHEET FOR THE YEAR ENDED Fixed Asset(NV) 0.50 Inventory 1.25 1.25 Receivables 4.25 3.25 Cash & Marketable Securities Current Assets Less Current Liabilities Trade Payables Bank Overdraft Total Net Asset Ordinary Share capital of INR1 Total Reserve Net Worth 0.50 00

6.00
2.80 00 3.20 0.85

4.50

2.80 3.70 0.25 3.45 3.70

4.05 0.95 0.25 0.70 0.95

VC: CASE STUDY-4


The Directors expect growth of 20% each year for the three years

2015-2017 inclusive, falling to 5% each year after that. The average P/E ratio for established listed companies in the industry is currently 28.4 but there is a wide range of between 7.5 and 51.5. The average post tax cost of equity capital for the industry, according to a recent study, is 15%. Requirements Advise the founders/employees on the following: The price they might have to offer the venture capitalist to succeed with a management buyout. You should include in your discussion the various methods of share valuation that might be suitable in the circumstances. Make and state whatever assumptions you feel are necessary and appropriate. The Advantages and disadvantages of pursuing a management buyout at the present time compared with the possibility of a sale of the venture capitalists shareholding to another investor.

VENTURE CAPITAL

GOOD WISHES
TO ALL

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