MODULE-7

INFORMAL RISK CAPITAL AND VENTURE CAPITAL

Risk Capital Markets are markets that provide Debt and Equity to non secure financing
situations.
There are 3 Risk Capital Markets that can be involved in financing a firms growth, they are:1. Informal Risk Capital Market
- Area of Risk Capital Markets consisting mainly of individuals.
2. Venture Capital Market
- One of the Risk Capital Markets consisting of formal firms.
3. Public Equity Market
- One of the Risk Capital Markets consisting of publicly owned stocks of
companies.
THE INFORMAL CAPITAL MARKET covers a wide range of investors, from founders,
families and friends through to business angels. It is generally distinguished from the formal
capital market by the fact that the investment is done by individuals directly rather than via a
specific entity (normally a company, such as a venture capital fund).
Business Angels is the name given for the individuals in the Informal Risk Capital Market
which is also known as Angle Capital Market.
Informal capital markets are the leading source of external risk capital fuelling
entrepreneurial start up and small business growth. They are virtually the only practical
source of risk or venture type capital for most entrepreneurs once their capital needs surpass
family resources. Informal Risk Capital is equity and near-equity money invested by private
individuals directly [informally] in entrepreneurs without formal intermediation.
The angel capital market can be defined by the stage of a company's development at
which the capital is applied. The following diagram is consistent with international
studies of the informal capital market, with some modification to reflect what we
understand to be the situation in New Zealand

Figure 1: Private Capital Market

Typical characteristics of an Angle Capital Market

Angel capital is a subset of the private equity market.

It is generally accepted that this market lies somewhere between the capital provided
by founders/families/friends and venture capital.

It comprises high net worth and high income individuals with a high tolerance for
risk, investing alone or in informal groups or syndicates.

It is a key source of seed and start-up capital to entrepreneurs with a specific and
commercially promising idea.

It is less structured than the venture capital market, but angels are probably more
objective than the friends and family capital providers.

It provides relatively small amounts of capital to new businesses and is frequently

supplemented with human capital (the latter may be business, technical, or marketing
advice that will be provided in exchange for equity). It is colloquially known as smart
money.

Characteristics of Informal Investors

Demographic Patters and Relationships

They tend to be well educated with many of them having graduate degrees.
Will finance firms anywhere in the US and a few in other parts of the world.
Most firms financed within one days travel.
Majority expected to play an active role in ventures financed.
Usually have clusters of 9 to 12 other investors.

Investment Record

Range of investments: $10,000 - $5,00,000

Average investment: $1,75,000
One or two deals each year

Venture Preference

Most financings are in start-ups or ventures less than 5 years old

Most interests in financing:
- Manufacturing industrial or commercial products.
- Manufacturing consumer products
- Energy/natural resources
- Services
- Retail/wholesale trade

Risk/Reward Expectations

Average [median] Capital gains of 10 times for start-ups.

Average [median] Capital gains of 6 times for firms under 1 year old.
Average [median] Capital gains of 5 times for firms 1-5 years old.
Average [median] Capital gains of 3 times for established firms over 5 years old.

Reasons for Rejecting Proposals

Risk/return ration not adequate

Inadequate management team
Not interested in proposed business area
Unable to agree on price
Principles not sufficiently committed
Unfamiliar with area of business

Referral Sources for Entrepreneurs.

Angel investors generally find their deals through referrals by business associated, friends,
active personal research, investment bankers and business brokers.
Few institutions have initiated a system for such referrals like:
- Venture Capital Network [VCN] at Massachusetts Institute of Technology [MIT]
- Venture Capital Exchange [VCE] at Oklahoma Investment Forum.
Each of this has a computerized system that matches entrepreneurs with investing
angels on a confidential basis.
VENTURE CAPITAL:
Origin: the origin of venture capital as been traced to USA in 19 th century. The American
research and developments was formed as first venture organization which formed over 900
companies. Venture capital had been a major contributor in development of the advanced
countries like UK, Japan, & several European countries.
Merchant bankers can assist venture proposals of technocrats, with high technology which
are new and high risk, to seek assistance from venture capital funds or companies. Venture
capital is an important source of funds for technology based industries which contributes
significantly to growth process.
The term venture capital denotes institutional investors that provide equity financing to young
businesses and play an active role advising their management.
It is more accurate to view venture capital broadly as a professionally managed pool of equity
capital.
Venture capital refers to organized private or institutional financing that can provide
substantial amounts of capital mostly through equity purchase and occasionally through debt
offerings to help growth oriented firms to develop and succeed. It is more accurate to view
venture capital broadly as a professionally managed pool of equity capital.

Venture capitalists provide early stage financing it includes development, expansion and
buyouts financing for units which are unable to raise funds through normal financing
channels. Units in developing countries need funds for financing various stages of
development. Such a broad approach would help venture funds to diversify their investment
and spread risks.
Venture capital enables entrepreneurs to actualize scientific ideas and enables inventions.
It can contribute as well as benefit from securities market developments.
Investors of venture capital have no liquidity for a period of time. Venture capitalists or funds
hope that the companies they are backing will thrive and after five to seven years from
making the investment it will be large and profitable enough to sell its shares in 6the stock
market. But a reward is there for illiquidity and waiting the venture capitalists hope to sell
their shares for many times what they paid for. If the unit fails the venture capitalists looses
everything. The probability distribution of expected return for most venture capital
investment is highly skewed to the right. The success rate is 10% to 20%.
Characterizes of venture capital
1. The venture capital is equity or quasi equity investment: because the investor assumes
risk. There is no security for his investment.
2. It is long term investment: venture capital is long term investment involving both money
and time.
3. It is an active form of investment: venture capital investment involves participation in the
management of the company .venture capital participates in the board and guides the firm on
strategic & policy matters.
Criteria for Investment:
Objective criteria used by venture capitalists are similar to criteria for most of the investments
and include potential growth and profitability. Unlike other investor and lenders, venture
capitalists must achieve very high returns on their investments because their underwriting
risky businesses. Their rule of thumb for profit potential is at least ten times return in a period
between five and ten years.
This rate of return may seem exorbitant, and venture capitalists are often criticized as
financial barons whose exploits small business owners. High returns are necessary, however,
because venture capitalists have a track record of succeeding new ventures in only about one
of every three investments. Their subsequent net profits range between 20 and 35 percent,
which reasonably account for risk- adjusted expectations.

NATURE OF VENTURE CAPITAL:

Venture capital is one of the least understood areas in entrepreneurship. Some think
that venture capitalists do the early state financing of relatively small, rapidly
growing technology companies.

It is a professionally managed pool of equity capital. Frequently, the equity pool is

formed from the resources of wealthy limited partners.

Other principal investors in venture-capital limited partnerships are pension funds,

endowment funds, and other institutions, including foreign investors.

The pool is managed by a general partner that is, the venture capital firm in
exchange for a percentage of the gain realized on the investment and a feel.

The investments are in early stage deals as well as second and third stage deals and
leveraged buyouts.

Venture capital can best be characterized as a long term investment discipline,

usually occuring over a five-year period, that is found in the creation of early-stage
companies, the expansion and revitalization of existing businesses, and the financing
of leveraged buyouts of existing divisions of major corporations or privately owned
businesses.

The venture capitalist takes an equity participation through stock, warrants, and/or
convertible securities and has an acitve involvement in the monitoring of each
portfolio company bringing investment, financing planning, and business skills to the
firm.

Overview of the Venture Capital Industry

The role of venture capital was intrumental throughout the industralization of the
United States, it did not become institutionalized until after World War II. Before
World War II, venture investment activity was a monopoly led by wealthy individuals,
investment bankinhg syndicates, and a few family organizations with a professional
manager. The first step toward instituionalizing the venture-capital-industry took
place in 1946 with the formation of the American Research the Development
Corportation (ARD) in Boston.

The next major development, the Small Business Investment Company Act of 1958,
married private capital with government funds to be used by professionally managed

small business investment companies (SBIC firms) to infuse capital into start-ip and
growing small businesses. With the tax advantages, government funds for leverage,
and a private capital company. SBICs were the start of the now formal venture capital
industry. The 1960s saw a significant expansion of SBICs with the approval of
approximately 585 SBI licenses that involved more than $205 million in private
capital. Many of these early SBICs failed due to inexperienced portfolio managers,
unreasonable expectations, a focus on short-term profitability, and are excess of
government regulations. These early failures caused the SBIC program tobe
restructured, which in turn eliminated some of the unnecessary government
regulations and increased the amount of capitalization needed.

During the late 1960s, small private venture-capital fims emerged. These were usually
formed as limited partnerships, with the venture- capital company acting as the genral
partner that received a management fee and a percentage of the profits earned on a
deal. The limited partners, who supplied the funding, were frequently institutional
investors such as insurance companies, endowment funds, bank trust departments,
pension funds, and wealthy individuals and families. There are about 980 venture
capital establishments in the United States today.

In response to the need for economic development, a fourth type of venture capital
firm has emerged in the form of the state sponsored venture capital fund. These
state sponsored funds have a variety of formats. While the size and investment focus
and industry orientation vary from state to state, each fund typically is required to
invest a certain percentage of its capital in the particular state. Generally, the funds
that are professionally managed by the private sector, outside the states bureaucracy
and political processes, have performed better.

LOCATING VENTURE CAPITALIST:

One of the most important decisions for the entrepreneur lies in selecting which
venture capital firm to approach. Since venture capitalists tend to specialize either
geographically by industry ( mfg industrial products or consumer products, high
technology or services). Or by size and type of investment, the entrepreneur should
approach only those that may have an interest in the investment opportunity.
Where do U find these venture capitalists..?

Although venture capitalists are located throughout the UNITED STATES, the
traditional areas of concentration are found in LOS ANGELES, NEW YORK,
CHICAGO, BOSTON and SAN FRANCISCO.
An entrepreneur should carefully research the names and addresses of prospective venture
capital firms that might have an interest in the particular investment opportunity. There
are also regional and national venture capital associations. For a nominal fee or nothing at
all, these associations will frequently send the entrepreneur a directory that lists their
members, the types of businesses their members invest in, and any investment
restrictions. Whenever possible, the entrepreneur should be introduced to the venture
capitalists. Bankers, accountants, lawyers and professors are good sources for
introductions
APPROACHING VENTURE CAPITALIST:
The entrepreneur should approach a venture capitalist in a professional business manner.
Since venture capitalists receive hundreds of inquiries and are frequently out of the office
working with portfolio companies or investigating potential investment opportunities, it is
important to begin the relationship positively. The entrepreneur should call any potential
venture capitalist to ensure that the business is in an area of investment interest. Then the
business plan should be sent, accompanied by a short professional letter
Questions to ask before approaching a Venture Capitalist
**Does my company have high growth prospects and is my team ambitious to grow the
company rapidly?
**Does my company have a product or service with a competitive edge or unique selling
point?
**Can it be protected by Intellectual Property Rights?
**Can I demonstrate relevant industry sector experience?
**Does my team have the relevant skills to deliver the business plan fully?
**Am I willing to sell some of the company's shares to a private equity investor?

**Is there a realistic exit opportunity for all shareholders in order to realise their
investment?
**Am I prepared to accept that my exiting this business may be in the best interest of all
shareholders?
How to Approach a Venture Capitalist
Approaching a venture capital

firm is a difficult and complex task that carries risks

as big as the potential gains. Venture capitalists deal with hundreds of potential clients,
and reject the majority of them. Follow these tips to approach venture capital firms in a
professional manner that will improve your chance of raising capital.
1) Make professional contact with the venture capital firm. Walking in off the street,
calling or sending an unsolicited email with a business plan does not usually succeed.
Find a connection to a venture capital firm to introduce you or, if you don't have such
a connection, use an online networking tool like Linkedin.com to make one. Coming
to a venture capital firm through a mutual contact will hugely increase your esteem in
the eyes of the firm.
2) Know your product inside and out. You should be able to give an hour-long lecture as
easily as a thirty-second "elevator speech" about what your product is and why the
market needs it. If you can't explain your product in both a long speech and an
extremely short sentence, you need to get back to the drawing board before raising
venture capital.
3) Develop an airtight business plan

. A business plan is a rigorous document that

takes a very specific format. It is generally not considered optional by venture capital
firms, so you should have a professional looking business plan, complete with profit
and overhead projections, before you go out to raise venture capital. Check out the
Center for Business Planning for ideas.

4) Find the right kind of venture capital firm. Venture capital firms are divided by size
and industry. Look for a firm that fits your project and focuses on the industry in
which your product belongs.
5) After making initial contact with the right firm, send an executive summary-a one- or
two-page document outlining the project's important elements. You can do this by
email, but it is also appropriate to send a good-looking hard copy by mail or courier.