VARIOUS STAGES OF VENTURE CAPITAL FINANCING

UNDERTAKING BY STUDENT

I declare that project work entitled “Various stages of Venture Capital financing” is my own work
conducted as a part of my syllabus.

I further declare that the project work presented has been prepared personally by me and it is
not sourced by any outside agency.

I understand that any such malpractice will have very serious consequence and my admission
to program will be cancelled without any refund of fees.

I am also aware that, I may face legal action, if I follow such malpractice.

Joy Crasto.

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TABLE OF CONXTENTS

Undertaking by Student .............................................................................................................................................1

Introduction ...................................................................................................................................................................4

Features of Venture Capital ...........................................................................................................................................8

A brief History ..............................................................................................................................................................10

Process of Venture Capital ..........................................................................................................................................13

Step 1: Deal Origination ..........................................................................................................................................13

Step 2: Screening .....................................................................................................................................................13

Step 3: Evaluation....................................................................................................................................................14

Step 4: Deal Structuring ..........................................................................................................................................14

Step 5: Post Investment Activity .............................................................................................................................15

Stage 6: Exit plan .....................................................................................................................................................15

Valuation of Venture Capital .......................................................................................................................................17

Pre-money Valuation ..............................................................................................................................................17

Post money Valuation .............................................................................................................................................26

Stages of Venture Capital Financing ............................................................................................................................27

Stage 1: Seed Capital – Development of idea .........................................................................................................27

Stage 2: Startup – Implementation stage................................................................................................................31

Step 3: First Round - Growth ...................................................................................................................................33

Stage 4: Second Round - Expansion ........................................................................................................................35

Stage 5: Third Round – Mezzanine financing stage .................................................................................................36

Stage 6: Fourth Round – Bridge Financing ..............................................................................................................37

Methods of Financing ..................................................................................................................................................39

Alternatives to Venture Captial Financing...............................................................................................................41

Regulations governing Venture capital by SEBI ...........................................................................................................45

Registration of Venture Capital Fund ......................................................................................................................46

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 Investment conditions and restrictions...................................................................................................................48

General obligations and Responsibilities ................................................................................................................49

Procedure in case of default ...................................................................................................................................52

Difference between Private equity and Venture Capital .............................................................................................55

Top 10 Venture Capital Funds in India .........................................................................................................................59

Statistics .......................................................................................................................................................................61

Problems faced by the firms in India ...........................................................................................................................64

Lack of web based crowd funding for Equity ..........................................................................................................64

Conclusion ...................................................................................................................................................................66

Bibliography .................................................................................................................................................................67

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INTRODUCTION

Venture capital not only refers to an injection of funds in to a newly formed firm but also a
continuous input of skilled people to set up, organize and manage the firm well. It is an
association with successive stages of the new firms’ development with distinctive type of
financing appropriate to each stage of development.

Most new entrepreneurs are capital constrained so they seek funding from an external source.
Also at times it is difficult to approach banks for a new set of firms due to the risks involved. An
alternative to banks are investors willing to invest in the idea of entrepreneur. These individual
investors are known as angel investors.

Angel investors are widely spread in the market which makes it difficult to trace them. Also the
amounts these investors contribute are small which may not suffice the projects requiring huge
capital. Lack of funding hampers the new businesses in many ways around the globe.

WHAT IS A VENTURE CAPITAL?

Venture capital is a means to overcome these funding problems / capital constrains faced by
firms seeking initial funding. It is a firm which provides initial capital in form of private equity /
debentures / conditional loans to young and unproven entrepreneurs along with an expertise
needed to manage the business. It is a type of funding designed to finance especially high risk
and high reward projects. Venture capital combines qualities of a banker, stock market investor
and entrepreneur in one. The finance to startups is provided to the firms in exchange of equities
or preferred stock of the company.

WHO IS A VENTURE CAPITALIST?

A venture capitalist here serves as financial intermediary collecting money from investors and
invests the money in to companies on behalf of investors. The venture capitalists will only invest
in a private firm. He actively monitors and helps the management of portfolio firms. It mainly
focuses on maximizing financial return by exiting through a sale or an initial public offering.

A core skill within VCs is an ability to identify projects which will yield high returns and not fail.
Along with the opportunity to gain high return also comes a risk to lose all the investment money
if the investment fails in a given startup company. As a consequence, most venture capital
investments are made in a pool format, where several investors combine their investment into
one large fund that invests in many different startup / young companies. By investing in pool
format they are spreading out the risk to many different investments rather than taking a chance
and losing in one investment.

In these regards Venture Capital financing will be something where a venture capitalist pools in
private equity on behalf of entrepreneur to meet the financial and managerial needs of the start-
up firm. It is a long term investment made with an expectation of making high returns.
Investments are generally done in an innovative idea which the venture capitalist believes to
yield returns in future. In recent time’s venture capital have been supporting technology and

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biotechnology sector in India. The financing can also be in form of an in-convertible debentures
or a conditional loan. Suppliers of venture capital also participate in management of company to
provide to the professional expertise of the newly started company.

From our above statements we can conclude a venture capital will have following characteristics
in general sense:

 It is basically financing of new companies which are finding it difficult to get initial funding
in order to start up a business.
 This finance can be a private equity, in-convertible debentures or a conditional loan so
that it carries a fixed yield of interest (returns) for the investors of venture capital.
 It is a long term investment and made in the firms which have a high growth potential.
 The venture capital provider will also take part in the management of business where by
the financer is not only interested in providing finance to the borrowing company but also
interested in providing the needed managerial skills for a beginner.
 Venture capital contains high risk as it related to investing an idea of an individual which
may or may not grow in future. Not all venture capital face high risks.
 This investment in high risk is compensated by high returns which are made by business
once it has settled in and growing.
 It mainly involves financing of small and medium sized firms which are in their early
stages.
 Venture capital financing also creates employment indirectly by financing in businesses.

FUNCTIONS OF VENTURE CAPITALIST

Venture capital is growingly becoming popular in different parts of the world because of the
crucial role it plays in providing industrial development by exploring vast and untapped
potentialities and overcoming threats. Venture capitalist plays this role with the help of following
major functions:

Venture capitalist provides finance as well as skills to new enterprises and new ventures of
existing ones based on high technology innovations. It provides ‘seed capital funds’ to finance
innovations even in the pre-start stage in few cases. In the development stage that follows the
conceptual stage venture capitalist develops a business plan (in partnership with the
entrepreneur) which will detail the market opportunity, the product, the development and
financial needs. In this crucial stage, the venture capitalist has to assess the intrinsic merits of
the technological innovation, ensure that the innovation is directed at a clearly defined market
opportunity and satisfied himself that the management team at the helm of affairs is competent
enough to achieve the targets of the business plan. Therefore, venture capitalist helps the firm
to move to the exploitation stage, i.e., launching of the innovation. While launching the
innovation the venture capitalist will seek to establish a time frame for achieving the
predetermined development marketing, sales and profit targets.

In each investment, as the venture capitalist assumes absolute risk, his role is not restricted to
that of a mere supplier of funds but that of an active partner with total investment in the assisted
projects. Thus, venture capitalist is expected to perform not only the role of a financier but also a
skilled faceted intermediary supplying a broad spectrum of specialist services – technical,

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commercial, managerial, financial and entrepreneurial.

Venture capitalist fills the gap in the owner’s funds in relation to the quantum of equity required
to support the successful launching of a new business or the optimum scale of operations of an
existing business. It acts as a trigger in launching new business and as a catalyst in stimulating
existing firms to achieve optimum performance.

Venture capitalist’s job extends even as far as to see that the firm has proper and adequate
commercial banking receivable financing.

Venture capitalist assists the entrepreneurs in locating, interviewing and employing outstanding
corporate achievers to professionalism the firm.

STRUCTURE OF VENTURE CAPITAL

In order to understand the concept of venture capital better it is important to understand the
members present and contribution of each member in the entire process of financing a
business. Below diagram will simplify details for us:

Venture Capital Fund

(Limited Partnership)

All the financing in a venture capital happens from Venture capital fund. Venture capital firm
pools in money from the investors in a main fund which is called as ‘Venture Capital Fund’. All
investments are made through this fund. Each investor is structured as a limited partnership
governed by partnership agreement covenants. The members here are as mentioned below:

 Limited Partners: The one who commits capital to venture fund. These are group of
institutional investors such as pension fund, insurance companies, endowments,
foundations, family offices and high net worth individuals.
 General Partners: They are the venture capital partners of Management Company.
General Partners raise and manage venture funds, make investment decisions and help

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 their portfolio companies exit. They have a fiduciary responsibility to their Limited
Partners.
 Portfolio Companies (Startups): The recipient of funds to raise and establish a company
in the market in exchange of shares or preferred equity.
 Management Company: is the business of the fund. The management company
receives the management fee from the fund (about 2%) and uses it to pay the overhead
related to operating the venture firm, such as rent, salaries of employees, etc. It makes
carried interest only after the Limited Partners have been repaid.

The flow of funds in a venture capital is a cyclical in nature as mentioned below in the diagram.

Exit of Venture
Capital Limited Partners
pooling money in
(Initial Public Offer Venture Capital
or Mergers and fund
Acquisitions)

Exchanging shares Venture Capital

of the portfolio funds managed by
company in the general
exachange of the partners or aka
funds provided to Management
borrowing firm. Company

VC decides upon
the projects to be
financed and
investing monet in
the Portfolio
company

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FEATURES OF VENTURE CAPITAL

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”.

These are some of the common features identified in the recent studies made:

HIGH RETURNS FOR HIGH RISK

As stated the process is to develop a business which is non-existent which in itself makes the
funding/ financing to such firms highly risky. However the returns expected to finance this risky
ventures are also high as demanded by lending firms.

It is said a venture capital assumes these four types of risks while funding a firm for their startup
i.e. management risk, market risk, product risk and operation risks.

LATEST TECHNOLOGY

A capitalist will prefer investing their funds in latest technology as compared to the firms using
traditional and out dated technology. The reason being latest technology will gain faster
outcomes and higher returns within a given time as compared to the outdated technology which
may require more of a manual work on part of entrepreneur. Financing latest technology is not a
primary objective or goal of a venture capitalist however it is in line to the goals set by venture
capitalist firms due to which they prefer in investing firms using latest technology.

COMPENSATION FOR RISK

The investments are generally in equity and quasi equity through direct purchase of shares,
options, convertible debentures where the debt holder has an option to convert these debt
instruments into stock of the borrower or a debt with warrant to equity investment. The fund in
form of equity helps to raise term loans which are cheaper source of funds.

PARTICIPATION IN MANAGEMENT

Venture capital firms not only offer additional capital needed by firms but also takes an active
part in management team of startups. It monitors the progress of firm at each stage. It helps to
identifying the weaknesses of the firm and providing expertise on it. It requests for one seat on
the company’s board for involvement in management decisions. Based on the experience, the
venture capitalist on board of directors suggests project planning, monitoring, financial
management, including working capital and public issue. Venture capital investor cannot
interfere in the day to day business activities but keeps in contact with the promoters and
entrepreneur to provide expert advice on the current situations.

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LENGTH OF INVESTMENT

Venture capitalists help a company grow but they eventually exit the company in few years. If
the investment was made at an early stage the length of maturity would be 7 – 10 years. If the
investment is at a later stage the maturity will be sooner based on when funds were infused in
the firm.

ILLIQUID INVESTMENTS

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 gains 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 to locked for seven to ten years. Venture capitalist understands this
illiquidity and factors this in his investment decisions.

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A BRIEF HISTORY

Ever since the industrial revolution, there has been a drastic increase in private equity investor
who wished to invest in projects which would yield them huge returns. These investors were
known to be angel investors. These were local but wealthy professional people who wanted to
invest into business available in market; however since they were widely spread in the market it
would be difficult for a young entrepreneur to trace them. Post Small Business Investment Act,
these private equity owners started small businesses financing the startup then known as
Development Capital now known as Venture Capital.

It was not until World War II that what is considered today to be true private equity investments
began to emerge marked by the first two venture capital firms in 1946 they are American
Research and Development Corporation (ARDC) and J H Whitney and Company. ARDC was
founded by Georges Doriot, the "father of venture capitalism”.

Since then the industry has developed in many other countries like Europe, North America and
Asia. The real development Venture Capital took place in 1985 when the Business
Administration Act was passed by US Congress. In USA alone it is claimed that there are
around 800 Venture Capital firms managing around $40 billion of capital and annual accretions
of between $1 billion and $5 billion. It is believed that some present day giants like Apple,
Microsoft, Xerox, etc. are the beneficiaries of venture capital.

. Here comes a brief history on how Venture capital developed over the decades.

1960s

As technology improved, time truly became an item of luxury. If a venture capitalist moved too
slowly, VC might miss out on a deal of a lifetime. VCs knew they had to move quickly not only to
keep up with the times, but also to secure deals.

1970s

A change in government regulations allowed pension funds to be considered a “prudent”

investment. This spurred change within the venture capital community because VCs were now
armed with pension funds as extra money, which they then used to invest in early stage
companies.

1980s

Venture capitalists realized what were once top returning sectors were no longer the top
returning sectors. Something had to give, and VCs started to invest in different directions and
new sectors. Many VCs ended up investing in later-stage companies and already-established
markets, thereby going against what they had learned in the 70s about investing in early stage
and not heavily established markets.

1990s

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The Internet changed everything. After seeing the early successes of Internet companies like
Amazon and Netscape and their IPOs, venture capitalists ramped up investments in Internet
companies. An influx of VCs looking to invest meant an influx of money so that anybody and
everybody associated with the Internet received investment from VCs.

Early 2000s

The hype caught up to venture capitalists. Unfulfilled promises sent stock prices tumbling thus
defining the 2000s as the era of the dot com crash. However, because of their investments, VCs
helped usher in a new era of technology, and their failed investments may have actually helped
humanity in the long run.

Late 2000s

Not all was lost in the 2000s. Social media took off like a rocket and created another market for
venture capitalists to get into. VCs have backed well-known social media companies that now
shape our daily lives and habits.

Today

There are thousands and thousands of companies in already established markets seeking
funding from venture capitalists. If this trend continues, VCs, entrepreneurs, and the rest of the
world may face stagnation. VCs are in danger of returning back to the ways they invested in the
1980s.

VENTURE CAPITAL INDUSTRY IN INDIA

History of Venture Capital in India dates back to early 1970 when government of India appointed
a committee laid by Late Sri R.S. Bhatt to find out the ways to meet a void in conventional
financing for funding start-up companies based on absolutely new innovative technologies.
Such companies either did not get any financial support or the funding was inadequate which
resulted into their early mortality. The committee recommended starting of Venture Capital
industry in India.

In mid 80s three all India financial institutions viz. IDBI, ICICI, IFCI started investing into the
equity of small technological companies. In November 1988, Govt. of India decided to
institutionalize Venture Capital Industry and announce guidelines in the parliament. Controller of
Capital issues implemented these guidelines known as Controller of Capital Issues (CCI) for
Venture Capital (VC). These guidelines were very restrictive and following a very narrow
definition of Venture Capital (VC). They required Venture Capital to be invested in companies
based on innovative technologies started by first generation entrepreneur.

This made VC investment highly risky and unattractive. Nonetheless about half a private
initiative were taken. At the same time World Bank organized a VC awareness seminar and
selected 6 institutions to start VC investment in India. This included Technology Development

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and Information Company of India Ltd (TDICI), Gujarat Venture Finance Limited (GVFL),
Canbank Venture Capital Fund, Andhra Pradesh Industrial Development Corporation Limited
(APIDC), Risk Capital and Technology Finance Corporation Ltd. (RCTFC), and Pathfinder. The
other significant organizations in private sector were ANZ Grindlays, 3i Investment Services
Limited, IFB, and Jardine Electra.

After the reforms were commenced in 1991, CCI guidelines were abolished and VC Industry
became unregulated. In 1995, Government of India permitted Foreign Finance companies to
make investments in India and many foreign VC private equity firms entered India. In 1996, after
the lapse of around 8 years, government again announced guidelines to regulate the VC
industry. There were many shortcomings in these guidelines at the starting point. These
guidelines did not create a homogeneous level playing field for all the VC investors. This
impeded growth of domestic VC industry.

Lack of incentives also made Indian Corporate and wealthy individuals shy of VC funds. With
the result, VC scene in India started getting dominated by foreign equity fund. In 1997, IT boom
in India made VC industry more significant. Due to symbiotic relationship between VC and IT
industry, VC got more prominence as a major source of funding for the rapidly growing IT
industry. Indian Venture Capitalist’s (VC’s) which were so far investing in all the sectors
changed their focus to IT and telecom industry.

The recession during 1999-2002 took the wind out of VC industry. Most of the VC either closed
down or wound-up their operations. Most of them with the exception of one or two like Gujarat
Venture Finance Limited (GVFL) changed their focus to existing successful firms for their growth
and expansion. VC firms also got engaged into funding buyouts, privatization and restructuring.
Currently, just a few firms are taking the risk of investing into the start-up technology based
companies.

The Development Of Venture Capital In India Can Be Summarized Into Four Phases:

Phase 1 Formation of TDICI in the 80s and regional fund as GVFL and APIDC in the early 90s.

Phase 2 Entry of Foreign Venture Capital funds (VCF) like Draper, Warburg Pincus between
1995-1999
Phase 3 2000 onwards, Emergence of successful India-centric VC firms like Helion, Infinity,
Chryscapital, Westfridge, etc.
Phase 4 (Current) Global VCs and PE actively investing in India

Source: Indian Private Equity and Venture Capital Association Publication (IVCA)

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PROCESS OF VENTURE CAPITAL

Now that we have had a brief of what is venture capital and had a brief background of it. We
shall discuss on the process through which Venture capital financing is carried. The process
and method are essential to understand the stages of venture capital financing.

The term Venture Capital comprises of two words ‘Venture ‘and ‘Capital’. Venture refers to a
course of journey where outcomes are uncertain and being carried out with uncertain risks.
While Capital refers to the resource to carry out the journey, hence the name Venture capital
was coined.

This section will shed light on the process undertaken by Venture capitalists to go through the
stages of financing. Tyebjee and Bruno in 1984 gave a model of venture capital process as
mentioned below. The process is divided into six parts as mentioned.

STEP 1: DEAL ORIGINATION

Deal origination is a process by which firms source investment prospects. During the origination
process, the vendor submits a variety of financial information to gain credibility in the market. It
basically means pitching deals to the buyers to initiate a deal.

The process begins with origination of a deal. Venture capitalists usually create a pipeline of
investment opportunities that an entrepreneur will consider for investing in. There can be two
sources or origination one is through referral system and the other is through active search of
the entrepreneur.

Under referral system a deal is referred to venture capitalist by the parent organization, trade
partners, industry associations, friends etc.

Under active searches, the entrepreneur would have received information via a conference,
through networks, trade fairs, seminars, etc.

In certain countries intermediaries are used to carry on the process of deal origination.

STEP 2: SCREENING

The venture capitalist to choose the best project he scrutinizes the projects on some broad
criteria such as technology used by the firm, the product, market scope and demand or it in near
future and log run, size of investment, geographical location and stage of financing.

Venture Capitalists in India ask the applicants to provide a brief profile of the proposed venture
to establish prime facie eligibility.

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In certain cases where the profile is ambiguous, entrepreneurs are called for a face to face
discussion to seek clarification on those topics.

It should be notes that there are many proposals which are rejected by venture capital firms at
this stage in the initial screening.

The screening process involves many analyses done by venture capital firms. Few of the
examples of analysis are;

1. Market Analysis.
2. Technology analysis
3. Customer Analysis
4. Competitor Analysis
5. Management Team Analysis.
6. Analysis on financial projections of the company as provided in their email.
7. Detailed background check of the entrepreneur.

STEP 3: EVALUATION

Once the proposal has passed through initial screening stage, it is further evaluated in-depth to
ascertain the feasibility of proposal and risk involved prior to making decision.

A detailed study of project profile, track records of entrepreneur, market potential, technological
feasibility, future turnover, profitability etc. is undertaken.

In an Indian scenario, the entrepreneurs’ background especially in terms of integrity, long term
vision, urge to grow managerial skills and business orientation. They also consider the technical
competence, manufacturing and marketing abilities and years of experience. Further the
projects viability in terms of product, market and technology is examined.

Besides this they also undertake a risk analysis of proposal to ascertain product risk, market
risk, technological and entrepreneurial risk. After screening these details in-depth a final
decision is taken and conveyed to the entrepreneur.

STEP 4: DEAL STRUCTURING

In this process the venture capital and the borrowing company negotiate the terms and
conditions of the deal. This deal contains the amount and price of investment as two important
criteria.

Apart from these there are also provisions made such as the venture capitalists rights to control
the buyer company and to change its management when needed, buyback arrangements,

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acquisition, making Initial Public offer etc. The share venture capitalists’ equity as well as the
objectives to be achieved is mentioned.

Deal should be flexible and should be structured with the mutual understanding of venture
capitalist and entrepreneur.

STEP 5: POST INVESTMENT ACTIVITY

Once the deal has been structured and accepted by both parties, the venture capitalist assumes
his role of partner in the business and provides valuable inputs foe the shaping and direction of
business. The degree of the venture capitalist’s 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.

This phase of the process lasts longer than others where capitalist is contributing to the
development of business.

STAGE 6: EXIT PLAN

The last stage of venture capital financing is the exit to realize the investment so as to make a
profit/minimize losses. The venture capitalist should make exit plan, determining precise timing
of exit that would depend on an a myriad of factors, such as nature of the venture, the extent
and type of financial stake, the state of actual and potential competition, market conditions, etc.

At exit stage of venture capital financing, venture capitalist decides about

disinvestments/realization alternatives which are related to the type of investment, equity/quasi-
equity and debt instruments. Thus, venture capitalize may exit through IPOs, acquisition by
another company, purchase of the venture capitalist’s share by the promoter and purchase of
the venture capitalist’s share by an outsider.

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

 Initial Public Offer (IPO)

 Acquisition by another company
 Re-purchase of venture capitalist’s share by the investee company
 Purchase of venture capitalist’s share by a third party.

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INITIAL PUBLIC OFFER (IPO)

A good exit with good returns is something investors / limited partners / venture capitalists eye
for all the time. Within the provided options Initial Public Offer (IPO) seems the best as it will
earn better realizable value as compared to selling the shares to an investor. A good exit during
IPOs makes money for limited partners those who park their monies at PE fund.

Currently this exit strategy seems the most attractive at it may earn highest return on their
investment. Two such investments are ChrysCapital made 13 times returns on its Yes bank
investment over three and a half years. ICICI made 4 times their investment in PVR.

ACQUISITION BY ANOTHER COMPANY

Also commonly known as Mergers and Acquisitions, these transactions usually imply a merging
with a similar and larger company. This type of exit is often chosen by big companies that are
looking for complimentary skills in the market, and buying a smaller startup is a better way to
develop a product than creating it in-house.

Mergers and Acquisitions are less common than IPOs and straight acquisitions. With this the
share prices will boost up based on the company which has bought the shares.

REPURCHASE OF SHARES BY INVESTEE COMPANY

This is the most common exit strategy adopted in India. This route is suitable for Indian
Companies as it keeps the ownership with Indian company intact. The limitation here is the
buyback will be at a price quoted by the promoters and board of directors which may or may not
be lesser from the resizable value of per share.

PURCHASE OF VENTURE CAPITALIST SHARES BY THIRD PARTY

The promoter of a new venture, which has taken off, may salt it to its managers. The managers
will generally raise venture capital to buyout the venture. This transaction is called management
buyouts. When the buyers (managers or outsiders) much heavy debt to buy the venture, the
deal is called leveraged buyout management buyouts will take place in the case of those
ventures which have high growth potential. Managers are very familiar with the venture;
therefore, they can make a good assessment of its prospects. After acquiring the venture, if they
are able to covert the high growth of the business in high profitability and value, they could mark
substantial gains. But there is high risk as the potential growth may not be realized later on.

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VALUATION OF VENTURE CAPITAL

It is necessary for an entrepreneur to know how to value the business. The investors will
perform valuation of business prior to investing in a business. Valuation is done to know the risk
involved in the business as well as to know the value of a certain start up investor is about to
invest his funds. These can be divided in two:

1. Pre money Valuation.

2. Post money valuation

PRE-MONEY VALUATION

Let’s just say a startup is like a box. A very special box.

The box has a value. The more things you put in the box, the more its value increases. Add a
patent in the box, the value increases. Add an efficient management team in the box, the value
increases.

Your startup is now worth 2. Yay!

The box is also magic. When you put $1 inside, it will return you $2, $3 or even $10! Amazing!

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I want to build one of those little boxes for myself!

Problem is building a box can be very expensive. So you need to go and see people with
money — let’s call them investors — and offer them a deal that sound a bit like this:

“Give me $1M to build a box, and you get X% of everything that comes out of it”

But how much should “X” be?

It depends on the Pre-Money Valuation, e.g. the value of the box at the moment of the
investment. But calculating the Pre-Money Valuation is tricky. This article will take you through 9
different valuation methods to better let you understand how to determine Pre-Money Valuation.

VALUATION BY BERKUS METHOD

The Berkus Method is a simple and convenient rule of thumb to estimate the value of your box.
It was designed by Dave Berkus, a renowned author and business angel investor. The starting
point is: do you believe that the box can reach $20M in revenue by the fifth year of business? If
the answer is yes, then you can assess your box against the 5 key criteria for building boxes.

This will give you a rough idea of how much your box is worth (AKA pre-money valuation) and
more importantly, what you should improve. Note that according to Berkus, the pre-money
valuation should not be more than $2M.

The Berkus Method is meant for pre-revenue startups.

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VALUATION WITH RISK FACTOR SUMMATION METHOD

The Risk Factor Summation Method or RFS Method is a slightly more evolved version of the
Berkus Method. First, you determine an initial value for your box. Then you adjust said value for
12 risk factors inherent to box-building.

Initial value is determined as the average value for a similar box in your area, and risk factors
are modelled as multiples of $250k, ranging from $500k for a very low risk, to -$500k for a very
high risk. The most difficult part here, and in most valuation methods, is actually finding data
about similar boxes.

The Risk Factor Summation Method is meant for pre-revenue startups.

VALUATION BY SCORECARD METHOD

The Scorecard Valuation Method is a more elaborate approach to the box valuation problem. It
starts the same way as the RFS method i.e. you determine a base valuation for your box, then
you adjust the value for a certain set of criteria. Nothing new, except that those criteria are
themselves weighed up based on their impact on the overall success of the project.

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Your box is 17.5% better than an average similar box

This method can also be found under the name of Bill Payne Method, considering 6 criteria:
Management (30%), Size of opportunity (25%), Product or Service (10%), Sales channels
(10%), Stage of business (10%) and other factors (15%).

The Scorecard Valuation Method is meant for pre-revenue startups.

VALUATION WITH COMPARABLE TRANSACTION METHOD

The Comparable Transactions Method is really just a rule of three.

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Depending on the type of box you are building, you want to find an indicator which will be a
good proxy for the value of your box. This indicator can be specific to your industry: Monthly
Recurring Revenue (Saas), HR headcount (Interim), Number of outlets (Retail), Patent filed
(Medtech/Biotech), Weekly Active Users or WAU (Messengers). Most of the time, you can just
take lines from the P&L: sales, gross margin, EBITDA, etc.

Depending on the comparable considered, the box is worth $685 or $6,736

The Comparable Transactions Method is meant for pre- and post-revenue startups.

VALUATION BY BOOK VALUE METHOD

Forget about how magical the box is, and see how much 1 pound of cardboard is worth.

21
The book value refers to the net worth of the company i.e. the tangible assets of the box i.e. the
“hard parts” of the box.

The Book Value Method is particularly irrelevant for startups as it is focused on the “tangible”
value of the company, while most startups focus on intangible assets: Research and
Development (for a biotech), user base and software development (for a Web startup), etc.

VALUATION BY LIQUIDATION VALUE METHOD

Rarely good from a seller perspective, the liquidation value is, as implied by its name, the
valuation you apply to a company when it is going out of business.

Things that count for a liquidation value estimation are all the tangible assets: Real Estate,
Equipment, Inventory, etc. Everything you can find a buyer for in a short span of time. The
mindset is: if I sell whatever the company can in less than two months, how much money does
that make? All the intangibles on the other hand are considered worthless in a liquidation
process (the underlying assumption is that if it was worth something, it would have already been
sold at the time you enter in liquidation): patents, copyright, and any other intellectual property.

Practically, the liquidation value is the sum of the scrap value of all the tangible assets of the
company.

For an investor, the liquidation value is useful as a parameter to evaluate the risk of the
investment: a higher potential liquidation value means a lower risk. For example, all other things
equal, it is preferable to invest in a company that owns its equipment compared to one that

22
leases it. If everything goes wrong and you go out of business, at least you can get some
money selling the equipment, whereas nothing if you lease it.

So, what is the difference between book value and liquidation value? If a startup really had to
sell its assets in the case of a bankruptcy, the value it would get from the sale would likely be
below its book value, due to the adverse conditions of the sales.

So liquidation value is less than or equal to book value. Although they both account for tangible
assets, the context in which those assets are valued differs. As Ben Graham points out, the
liquidation value measures what the stockholders could get out of the business, while the book
value measures what they have put into the business.

VALUATION BY DISCOUNTED CASH FLOW METHOD

If your box works well, it brings in a certain amount of cash every year. Consequently, you could
say that the current value of the box is the sum of all the future cash flows over the next years.
And that is exactly the reasoning behind the DCF method.

23
Let’s say you are projecting cash flows over n years. What happens after that? This is the
question addressed by the Terminal Value (TV)

Option 1: you consider the business will keep growing at a steady pace, and keep generating
indefinite cash flows after the n year’s period. You can then apply the formula for Terminal
Value: TV = CFn+1/(r- g) with “r” being the discount rate and “g” being the expected growth rate.

Option 2: you consider an exit after the n year period. First, you want to estimate the future
value of the acquisition, for example with the comparable method transaction (see above).
Then, you have to discount this future value to get its net present value.

TV = exit value/ (1+r) n

Although technically, you could use it for post-revenue startups, it is just not meant for startup
valuation.

VALUATION BY FIRST CHICAGO METHOD

The First Chicago Method answers to a specific situation: what if your box has a small chance
of becoming huge? How to assess this potential?

The First Chicago Method (named after the late First Chicago Bank — if you ask) deals with this
issue by making three valuations: a worst case scenario (tiny box), a normal case scenario
(normal box), a best case scenario (big box).

24
SUMPRODUCT, where the magic happens

Each valuation is made with the DCF Method (or, if not possible, with internal rate of return
formula or with multiples). You then decide of a percentage reflecting the probability of each
scenario to happen. Your valuation according to the First Chicago Method is the weighted
average of each case.

The First Chicago Method is meant for post-revenue startups.

VALUATION BY VENTURE CAPITAL METHOD

As its name indicate, the Venture Capital Method stands from the viewpoint of the investor.

An investor is always looking for a specific return on investment, let’s say 20x. Besides,
according to industry standards, the investor thinks that your box could be sold for $100M in 8
years. Based on those two elements, the investor can easily determine the maximum price he
or she is willing to pay for investing in your box, after adjusting for dilution.

25
The Venture Capital Method is meant for pre- and post-revenue startups.

POST MONEY VALUATION

Post-money valuation refers to a company's valuation after new investments from venture
capitalists or angel investors have been made to the enterprise. Valuations that are calculated
before these funds are added are called pre-money valuations. The post-money valuation, then,
is equal to the pre-money valuation + the amount of any new equity received from
outside investors. A simple illustration of example would be as below.

 Pre-money valuation = Post money valuation – Investment.

This can be also written as below

 Post money valuation = Pre money valuation + Investment

26
STAGES OF VENTURE CAPITAL FINANCING

Venture Capital is a private institutional investment made to start-up companies at early stage.
Venture capital funds are the investments made by the investors who seek private equity stakes
in small to medium business which are potent enough to grow. These investments are generally
high-risk/high-return opportunities. The ventures involve risk in the expectation of sizable gain.
The people who invest this money become the financial partners are called venture capitalist.

Venture capital is the most suitable option for funding a costly capital source for companies and
mostly for business that have huge capital requirement with no other cheap alternatives. The
most common cases of venture capital investments are seen in the fields of Software and other
Intellectual property as the value is unproven and are considered to be the fastest growing.

Venture capital financing is a type of financing by venture capital. It is private equity capital
provided as seed funding to early-stage, high-potential, growth companies (start-up) or more
often it is after the seed funding round as a growth funding round (also referred to as series A
round). It is provided in the interest of generating a return on investment through an eventual
realization event such as an IPO or trade sale of the company.

It is essential to understand the requirement of each business; they vary from business to
business. Even before a business plan is prepared the entrepreneur spends time surveying
market; understand the target customers and their needs. Venture capitalists cater to the needs
of entrepreneur at different stages of his business which will depend upon the stage
entrepreneur calls upon firm for assistance.

There are four successive stages of development of a project they are development of a project
idea, implementation of idea, commercial production and marketing and finally large scale
investment to exploit the economies of scale and achieve stability. Financial institutions and
banks usually start financing at the second or third stage as the firm stabilizes during this time
and is at a medium risk. There are essentially six stages of venture capital:

 Seed Capital
 Start Capital
 First Round
 Second Round
 Third Round
 Fourth Round

Let’s discuss these stages in little more detail.

STAGE 1: SEED CAPITAL – DEVELOPMENT OF IDEA

This is the first stage of financing is private investors infusing funds into an idea of an
entrepreneur. In this stage a business is usually not setup, entrepreneur has a business idea
and is seeking for investors to invest in his idea. New ideas being risky Private Equity investors

27
are in a dilemma to invest. It involves a high risk of the business defaulting at this stage and the
funds invested may or may not be realized. An informal survey has shown that most of the
companies die off in the seed financing itself. Current trend indicate that only 27% of companies
that are seed funded actually raise the angel round, 16% of these companies shut down at
Seed stage. At this stage the maturity of finance infused is from 4 years to 10 or more years.

Venture capital firms usually do not provide funds at this stage as the company is at very high
risk with no returns at all. Here funding is received by FFA (Family, Friends and Associates) and
Angels.

Private investors are as diverse as entrepreneurs. There is a wide range of profiles in terms of
their industry expertise, business experience and, most importantly, their ability to work
effectively with you. Successful angels make their investment decisions based on four
fundamental criteria: management, market, products, and financial opportunity. They evaluate
each criterion from the perspective of minimizing their risk and maximizing their return.

WHERE TO FIND ANGELS?

Here are the profiles generally attributed to Angels:

 Most are entrepreneurs themselves.

 Generally middle aged; 47+ looking for diversification.
 Have high incomes, but are not necessarily millionaires.
 Most are highly educated with advanced technical degrees, M.S. or Ph.D.
 They are very active investors averaging 3-4 deals per year.

These individuals can be reached through numerous sources. They attend trade shows,
venture capital type meetings, and visit universities to find deals. Finding them is a matter of
personal networking. Many will remain hidden from the individual entrepreneur, so using an
intermediary is often the only way to meet them.
Examples of intermediaries:
 'Gate Keepers', who screen projects for wealthy investors, and usually represent three
to five individuals, a trust, family investment pool, or a group of medical professionals.
 Business Development Consultants who work specifically with startup, business
development, mergers and acquisitions.
 Bankers, finance companies and savings or investment houses such as stock
brokerages.
 CPA's, tax, accounting and bookkeeping companies.
 Attorneys, bankruptcy courts, and arbitration groups.

28
HOW TO IDENTIFY?

The company with show these common features by which one can identify on which stage the
company belongs.

1. Absence of ready product market.

2. Absence of complete management team.
3. Product / Process still in research and development stage.
4. Initial period / licensing stage of technology transfer.

TYPE OF SEED INVESTORS

A. First Type: The first type of seed investor coms from friends and family. This is usually
the fastest way to get the money needed by a startup. Although the capital provided is
limited in capacity and does not include much potential for future investment. These are
based more on the emotional trust rather than on ability to analyze business idea.
B. Second Type: The second type includes investors which has the knowledge of know-
how in the industry and usually have a portfolio of several companies in which they
already invested. They are sometimes referred as angels. These investors are diverse in
market and are willing to invest if they see the potential in a business idea after
analyzing.
C. Third Type: The third type includes venture capital funds. Most of these will not invest in
the early seeds whereas only minority will be willing to invest into a new venture. This is
a valuable source as these investors provide assistance in bringing up the venture to
market. The process to gain funds from VC is complicated compared to the above two
types of investors.
D. Fourth Type: The fourth type investor is a little different type of incubators and
accelerators where each has its own unique model to distribute funds. Like VC these
investors will be interested in managing the business and will provide assistance in
stabilizing the business after providing funds.

HOW TO APPROACH THESE INVESTORS?

It is essential to remember a professional agenda should be made to present before each type
of investor. Also it should be understood that each investor has a different risk taking capacity
as well as a different expectations of rate of returns on funds invested. The following checklist
can be used to help one in approaching an investor.

A. Before meeting an investor:

a. Research your potential investor’s professional background in order to
understand how it can correlate with your venture (use Google search, their
LinkedIn profile etc.)
b. Gather information about the previous investments he made.
c. Understand how can this investor can help you in other ways rather than just give
you money

29
 d. Understand his ability to invest in future rounds rather than just give a one-time
initial seed investment.
B. Meeting with investor:
a. Put a lot of effort in showing your investor the team behind the idea, put the same
amount of effort in this as you do in explaining the idea and its potential success
b. Make sure you manage to pitch the idea within the initial part of the meeting,
leaving you with enough time for further discussion. Try to learn as much as you
can from their questions and insights.
c. Make sure to make a good impression. In order to gain your investor’s trust,
convey that it is about you and your team’s ability to create. By cultivating a right
atmosphere where two people can speak and listen with empathy is always
helpful.

Here venture capitals are willing to usually provide a small amount due to the very high risky
nature of business.

TO DOS AT THIS STAGE

At this stage the entrepreneur only has an idea of his product which needs a round of funding in
order to be a part of market. The entrepreneur generally at this stage develops the idea only
after analyzing the need for product, his personal survey on how beneficial it is to the current
market and with a hope that the product will last for a long run. However lacks capital. Here is a
list of to dos an entrepreneur at this stage should focus on per my research to stabilize or make
clearer the uncertainties that exists at this stage.

 Clarity of idea: The entrepreneur must have clarity of idea at this stage. A vague series
of ideas and suggestions will result in the death of firm at this stage.
 Preparing a flow: Once the entrepreneur has clarity in his idea of business, it is
essential to create a flow chart which would include the planning of sources of funds,
place of business, estimates of the funding needed the growth of business from this first
stage and further, its target customers etc.
o Your company / Logo / Tag Line
o Your vision – Your most expansive take on why your new company exists.
o The Problem – What are you solving for the customer–where is their pain?
o The Customer – Who are they and perhaps how will you reach them?
o The Solution – What you have created and why now is the right time.
o The (huge) Market you are addressing – Total Available Market (TAM) >$1B if
possible. Include the most persuasive evidence you have that this is real.
o Market Landscape – including competition, macro trends, etc. Is there any
insight you have that others do not?
o Current Traction – list key stats / plans for scaling and future customer
acquisition.
o Business model – how users translate to revenue. Actuals, plans, hopes.
o Team – who you are, where you come from and why you have what it takes to
succeed. Pics and bios okay. Specify roles.
o Summary – 3-5 key takeaways (market size, key product insight, traction)

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 o Fundraising – Include what you have already raised and what you are planning
to raise now. Any financial projections may go here as well. You can optionally
include a summary product roadmap (6 quarters max) indicating what an
investment buys.

 Be Honest: As it is said, honesty is best policy; the funding companies like to

investigate on the documents presented to them.


REASONS FOR FAIL

There are typical reasons for fail at this stage. Few of the reasons are:

 Majority of the times investors decline to invest as the product does not seem to be must
have in long run.
 The technology made for business is not scalable.
 The business model isn’t sustainable.
 Many of the startups do not have expertise in managing business which leads to losses.
 The execution of business is not as planned leading to inefficient business.

Examples of few failed seed capital:

1. Jewelskart, watchkart, Bagskart by Vayloo Technologies.

2. Dazo by Shashank Kumar.

STAGE 2: STARTUP – IMPLEMENTATION STAGE

This is the second stage of venture capital financing. This stage is similar to the seed financing,
however the difference here, business framework is ready with initial market analysis conducted
and business plans in place. Here companies look to begin marketing and advertising the
product and acquiring customers.

Businesses at this stage usually have their prototypes of products / testing of products in
progress. At times management committee is formed at this stage and if venture capital firm has
financed it a representative is part of management team. Venture capital firm closely monitors
the feasibility of product and the capability of management team to handle the business which
has not just about to be set up.

Once the prototype product is prepared a thorough market research is carried to understand the
sustainability of product in long run. The market research is carried to have a realistic forecast in
order to push this product /start up to the next stage.

Once the entrepreneur has approached Venture capital firm to finance his product, the firm do a
screening process (as mentioned in the methods of finance) and this product will then be
forwarded to the Limited Partners for review prior to deal structuring. If the Limited partners

31
approve the product they may arrange for a meeting and proceed with a deal structuring
process.

At this stage the maturity of finance infused is from 3 to 7 or more years.

HOW TO IDENTIFY?

These businesses will share these features in common for one to identify the stage of financing:

1. Establishment of company or business.

2. Establishment of most but not all members of management team.
3. Development of business plan or idea.

TO DOS

To have a startup going it is essential to take action on all the urgent matters as soon as
possible to avoid any issues with the firms’ survival in the market. Here are some basic actions
which firms at this stage need to understand and implement as per my research:

 Show urgency: Market researches and feedbacks are being conducted at this stage with
the prototype. There would surely be defects which would be brought forward by the
clients or customers; these should be fixed on highest priority. All firms need to show
urgency in fixing the defects in product to get realistic feedback and forecasts which will
help the investors to go ahead with next level of financing.
 Hardworking team: The investors are keen on knowing the interests of management
team and hence it is essential to build a team of hardworking people. Few investors
even invest on products due to the management team working on product.
 Price the product carefully: It is important to price the product correctly; a higher price
will flee the clients while a lower price will discourage customers to go for alternative
products available in the market. It is also necessary to understand that the credit facility
should not be made available at this stage as the business is not yet stabilized.
 Seek feedbacks: Feedbacks are very important at this stage to perfect a product. Ask for
feedbacks from your clients, customers, users of product etc. to build a better product.
 Overhead costs: Costs should be closely monitored by the startup firms and try to avoid
any wastage of funds provided by investors.
 Marketing strategies: Firm should adopt an excellent marketing strategy to create a
demand for product in market.
 Legal framework: The startups should have a legal framework plan ready which includes
all the legal formalities involved and the estimated costs of these.
 Monitoring progress: Startups should closely monitor the progress of their product in
order to provide an update the investors who have already invested in the product as
well as to the investors they will approach for next stage financing.

RISKS

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Compared to the earlier stage risk would shrink as the uncertainties would now be clearer.
However risk still exists, firm is still exposed to risk as it is at a start stage.

 Returns risk: The amount of returns available is highly variable at this stage and is yet
not guaranteed. Some startups may be successful and may generate sufficient returns
to interest the investors to infuse more capital while some may generate low to no
returns at this stage.
 Growth risk: A lot of companies fail while trying to scaling up in the business due to lack
of funds and other reasons.
 Failure risk: Unlike the investment in a mature company, investment in a startup is highly
speculative and is exposed to risk for failure. The same depends on how well the
product developed is being marketed.
 Fraud risk: As it is a startup the policies and procedures may or may not be in place
where the firm is highly exposed to fraud internally as well as externally.
 Competition: The startup will face high competition from its competitors already available
in the market. There can be firms providing similar product /service as the startup firm
with lesser prices.
 Demand risk: While the company believes there will be market demand for the product
the market may not behave in the same way as expected and pose a threat to the firm
causing adverse effect on the survival ability of firm.

Examples:

1. Shubhamilana.com by Channaia failed due to lack of technology support

2. Pirate’s Kitchen by Gaurav failed due to lack of know-how in the industry.

STEP 3: FIRST ROUND - GROWTH

This stage is known as the growth round, the first stage as known. Even though this stage
comes after Seed and Startup it is still known as First round as it is the first step towards growth
of the venture with the existing firms which are already stabilized in the market. This is a growth
stage where the firm has been legally established and has set up its production and
manufacturing units. Funding which is received at this stage will be directed towards the
manufacturing/ production and marketing of products.

At this stage Venture capitalists are more interested in financing the product as the business
does have a high risk but the uncertainties at the start of business are much clearer. Also the
businesses have usually identified its target market and are keen on providing services to this
category.

The amount invested here is significantly higher compared to the previous stages. Company is
not only focusing on manufacturing and production but is also moving towards profitability and is

33
starting to push its products to the wider audience compared to the local markets in the previous
stage.

At this stage the firm tries to penetrate the market which is also one of the main goals. The
management team by now has a decent experience to manage business in a better way.
Management closely monitors its operations in all the areas (production, marketing, after sales
etc.). The firm tries to reach at a break-even point and above to make profits in order to gain the
trust of investors as well as to continue functioning of business.

Venture Capitalist monitors the managing expertise of the management team, in case it finds
the team incompetent it suggests the firm to restructure its management team and extend this
stage to a longer period. In case the firm is incurring loses the venture capital and investors start
cutting the finances.

At this stage maturity of finance is from 2 to 5 or more years.

Growth
Startup

Seed

HOW TO IDENTIFY?

The firm will share these features making it easy for one to identify.

1. Little or no sales revenue.

2. Cash flow and profits will be minimal and in some cases negative.
3. A small but good management team with expertise in the fields.
4. Short term growth plan.

34
RISKS

At this stage there is a subsequent decrease in risk as management team has expertise to
tackle the problem of firm. However risk still exists for these firms, they are:

 Obsolete Technology: Firms should ensure they are updated with the technology in
order to stay ahead of its competitors.
 Larger completion: Firm has officially entered market and is trying to gain clients of its
competitors. Firm will face larger competition as compared to the previous stage.
 Management inefficiency: Though man firms are now well developed with the
management team, there is still a possibility of the management team being in efficient.

STAGE 4: SECOND ROUND - EXPANSION

At this stage of the firm funds are again received by Venture capital, however this time the funds
are directed to grow working capital needs of the firm which has commenced the manufacturing
and production but yet these are not enough to gain positive cash flows and profits to the
business as expected.

At this stage capital is infused in the firm for a second time for the expansion reasons. This
stage of financing usually comes up after start and early stage of financing (aka first round in
our discussion earlier).

At this stage the capital infused has a maturity of 1 to 4 or more years.

The management team includes expertise of fields and focuses on profitability of the firm and is
more aggressive in the business. As capital is infused sooner for second time the maturity of
this capital is lesser from 1 – 4 years and more.

HOW TO IDENTIFY?

At this stage the firms usually share these characteristics in common.

1. A developed product in the market.

2. A full management team in place.
3. Sales and revenue being generated from the one or more products. Cash flows
gradually rising post the second funding.
4. The surplus is minimal and the generated surplus is not sufficient to meet firm’s needs.

RISKS

There are minimal risks at this stage as the company and the product is developed and is doing
better compared to the startup stage. However the company still has a larger group of

35
competitors. The firm will also be somewhat competing with established public companies in the
market, this makes it difficult for the firm to provide services at a cheaper rate.

STAGE 5: THIRD ROUND – MEZZANINE FINANCING STAGE

This stage is also known as third stage where the company is about to end the Growth and
Expansion stage. At this stage an enterprise has established basic commercial production units
and has a basic marketing setup, typically for expansion and product development.

Funds are received from Venture Capitals firms at this stage as well. Unlike previous stage here
funds are used to expand the production units and the marketing units in order to reach out to a
larger population than earlier.

It is also known as Mezzanine financing. Companies that use mezzanine capital access more
capital and can achieve higher returns on equity. Mezzanine investors are often non-banking
and specialty fund seeking absolute return on capital.

Mezzanine financing is a loan to the owner with terms that subordinate the loan both to different
levels of senior debt as well as to secured junior debt. But the mezzanine lender typically has a
warrant (meaning a legal right fixed in writing) enabling him or her to convert the security into
equity at a predetermined price per share if the loan is not paid on time or in full. Many variants
exist, of course, the most common being that a portion of the money is paid back as equity.
Being unsecured and highly subordinated, mezzanine financing is very expensive, with lenders
looking for 20 percent returns and up. Unless a market is very flush with money and "irrational
exuberance" reigns (to use a phrase coined by the retired chairman of the Federal Reserve,
Alan Greenspan), the mezzanine lender will be reluctant to lend unless the company has a high
cash flow, a good history of earnings and growth, and stature within its industry. Mezzanine is
decidedly not a source of start-up funding. Major sources of mezzanine financing include private
investors, insurance companies, mutual funds, pension funds, and banks.

The maturity of mezzanine financing is usually 5 years or longer.

Example to understand Mezzanine debt better:

Let's say you want to buy a small pizzeria in your hometown. The pizza shop earns $200,000
per year in operating income, and the owners will sell it to you for $1 million. You don't have $1
million lying around to invest, so you find a senior lender who will finance $600,000 of the
purchase price at a rate of 8% per year.

 The capital structure looks like this:

 The senior lender contributes $600,000 of debt financing at a cost of 8% per year.
 You, the equity investor, contribute $400,000 in equity.

36
With this in mind, we can calculate the return on your investment. We know the business
produces $200,000 in operating income per year. We need to subtract the $48,000 in interest
payable to the senior lender, thus arriving at pretax profits of $152,000. We'll assume that the
profits are taxed at 35%, so the after-tax profit is $98,800.

Thus, your return on your $400,000 equity investment is $98,800 annually, or 24.7% per year --
not bad!

Example A: Financing the pizzeria with senior debt and equity

Operating income $200,000
Interest Expense -$48,000
Pretax income $152,000
After-tax income $98,800
Annual return on your $400,000 investment 24.7%

HOW TO IDENTIFY?

These firms can be identified with these features that they possess.

1. Strong management.
2. Strong cash flow.
3. Insufficient senior financing.
4. Insufficient collateral.
5. High leverage.

RISK

Here the company is all settled and is almost on the verge of going public. Unlike the risks
involved earlier the same would not apply at this stage. While at the stage of mezzanine
financing, company needs to calculate the debt with the sources of cash flows so that the
interests on debt incurred can be cleared in time without defaulting.

If company is unable to make payments to its creditors they may request to liquidate and the
firm will need to file for bankruptcy.

STAGE 6: FOURTH ROUND – BRIDGE FINANCING

This is the last round of funding before the planned exit of a venture capital. Venture capitalists
help in building a stable and experienced management team that will help company with its
Initial Public offer.

To explain this stage in lay man words is a company takes loan from bank for its immediate
short terms finance requirements. And once the company issues its IPO the loan is paid off. The

37
Bridge financing acts as a bridge that bridges the gap of company’s short terms and long term
financing needs.

Bridge financing is an interim financing option used by companies and other entities to solidify
their short-term position until a long-term financing option can be arranged. Bridge financing
normally comes from an investment bank or venture capital firm in the form of a loan or equity
investment. This type of financing only occurs when a company's runway is shorter than its
future financing options, and it needs to remain solvent in order to obtain such long-term
financing.

A bridge loan is issued in exchange of shares of the company till the company has issued its
Initial Public Offer. Once the company has gone public, the issuers of bridge loan can sell these
shares provided by the company and can offset the loan amount. Generally these shares are
issued by the firm at a discount and when the shares are traded by investor firm they are usually
traded for a higher amount. The difference acts as an interest or return for the risk taken to
invest in the financing company.

This stage is generally the exit stage of the Venture Capitalists, angel investors etc. which has
provided financing to the company in these past start up period.

A brief summary of various stages of financing:

Financing Stage Locking period Risk Activity

Supporting idea of
Seed 7 - 10 years Extreme
entrepreneur
Startup 5-9 years Very High Initial operations
Start production and
First round 3-7 years high
manufacturing
Second round 3-5 years High Expanding market
Expansion and
Third Stage 1-3 years Medium
development
Fourth Round 1-3 years Low Facilitating public issue

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METHODS OF FINANCING

A prerequisite for the development of an active Venture Capital industry is the availability of a
variety of financial instruments which cater to the different risk-return needs of investors. They
should be acceptable to entrepreneurs as well. In developed countries, innovation in financial
instruments is a distinct feature of Venture Capital. Venture finance, conceptually being risk
finance, should be available in the form of quasi-equity (conditional or convertible loans). A
straight or conventional loan, involving fixed payments, would be an unsuitable form of providing
assistance to a risky venture.

EQUITY

This is one mode of financing which is adopted by Venture capital firms, Equity. The Venture
capital firms provide equity to the needy firms in order to finance them. However, usually their
share of Equity does not exceed 49 per cent of the total equity capital. When a venture capitalist
contributes equity capital, he acquires the status of an owner, and becomes entitled to a share
in the firm’s profits as much as he is liable for losses.

The 49 per cent criteria is to ensure that the effective control and majority ownership of the firm
remains with entrepreneur. They buy shares of the firm with an ultimate goal to sell them to
make capital gains.

Equity helps new enterprises, as it does not put any pressure on their cash flows. There is no
obligation to pay dividend if the company does not have cash liquidity. Venture capitalists
usually wait till the firm has become public in order to trade the shares of company in market
and so receive high returns on their investments.

The advantage to the VCF is that it can share in the high value of the venture and makes capital
gains if the venture succeeds. But the flip side is that the VCF will lose if the venture is
unsuccessful. Venture financing is a risky business.

This method is the most common method of financing to the startup; this is done in order to
increase the cash liquidity of the tart up firms.

CONDITIONAL LOAN

This is the second form of financing adopted by the Venture capital firms. As the name suggests
these loans come with a condition. The condition is paying royalty after the venture is able to
generate enough sales.

No interests are paid on such loans.

39
Venture Capital firms charge royalties between 2 to 15 per cent. The actual rate depends on
many other factors such as the period /stage of financing, risk undertaken and other factors of
the company which needs finance. This form of financing is largely used by the developing
countries such as India.

They were very common in India in the initial years of venture capital operations. However as
any other mode of financing it has its own problems such as high cost of well performing
companies, difficulties in administering the schemes, determining the amount of royalty, minority
shareholding since conditional loan is a subordinate instrument.

INCOME NOTE

This is the third ode of financing. A unique way rather compared to other two. This is a hybrid
security which combines the features of conventional loan as well as conditional loan. He
entrepreneur has to pay both interest and royalty to the investors on sales, but comparatively
low rates.

Income notes suffer from limitations similar to conditional loans, which do not promise high
returns on the venture capital investments made in the firm. Along with these it is also an
expensive mode when spoken in relation to the profitable ventures.

Some venture funds provided funding equal to about 80 percent of a project’s cost for
commercial application of indigenous technology adapting imported technology to wider
domestic applications. Funds were made available in the form of unsecured loans at a lower
rate of interest during development phase and at a higher rate after development. In addition to
interest charges, royalty on sales could also be charged.

PARTICIPATING DEBENTURES

Under this method of financing, the interest on participating debentures is payable at three
various rates as per the phase / stage of operation:

1. Startup phase: Nil.

2. Initial operation phase: Low rate of interest.
3. Post initial operation phase: High rate of interest

The rates will vary at all three different phases.

CONVERTIBLE LOANS

Convertible loans give a flexibility of the investor to convert his loan into equity when the interest
on loan is not paid within a given period as mentioned on the agreement.

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The advantage from the perspective of an entrepreneur is that a convertible loan before its
conversion behaves very much like a standard loan: the investor typically does not have many
of the rights of a preferential shareholder (board seats, liquidation preferences, etc.). Since it is
a fairly short and simple document, it also gets executed faster (that’s why convertible loan
investment can be processed faster than an equity investment, typically by a couple of weeks).

The disadvantage also comes from the very nature of the loan: until the loan gets converted to
equity, the investor has a priority right at maturity date to claim any assets (i.e. cash & hardware
for most startups) in order to get the loan and interest repaid.

This form of financing is usually used post the third round stage in order to arrange for a quick
cash to meet the short term finance issues.

ALTERNATIVES TO VENT URE CAPTIAL FINANCING

As discussed earlier Venture capital has a formal approach to accept or reject a project / idea
from a startup. Many of the startups are unable to meet the criteria mentioned by venture capital
firm due to which they are rejected in the screening process itself. The business may have a
potential to grow given a chance. However it is essential to understand that there are many
alternatives to Venture capital unexplored by the businesses and can be beneficial for the young
entrepreneurs. Following are few of alternatives which young entrepreneurs may explore:

FAMILY AND FRIENDS

They form the first source of any young entrepreneurs and should be used. As family and
friends are trusted sources and can be the most convenient source of capital. It is generally
easy to obtain financing from these sources compared to the unknown sources that may trust
the idea. However it cones with its own cons, a relationship is at risk if the business does not
provide returns as expected.

PRIVATE PLACEMENT

A private placement offering is perhaps one of the oldest forms of legitimately sourcing capital.
In a private placement, a private offering memo, often referred to as a Private Placement
Memorandum or PPM, is a crafted document that includes a business plan, full & complete risk
disclosures and a host of other investor “warnings”. It also includes a table of how shares are
being sold at an offering.

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While the rules have opened somewhat for advertising broadly, the rules geared toward
structure of such deals need to be strictly observed. It is best to get in touch with a reputable law
group to ensure any private placement offering documents meet the requisite rules for how you
wish to approach your investor groups. Such an offering requires knowledge and understanding
of your targeted investor, the structure of your deal and, as always, the ability to sell your
business plan to investors while still maintaining transparency of risk involved.

One of my personal favorite groups to source PPM doc creation: RegD Resources out of
Colorado. Their services are fairly priced and highly professional.

DONATION CROWD FUNDING

Donation based crowd funding means reaching out to a large group of small investors probably
by internet to provide donation to a startup business. This is generally known for philanthropic
ideas, not of profit acts. The websites such as Kickstarted, Rockethub, etc. have provided
financing to a lot of startups, without which these would have dies at the seed round.

The idea and management effectiveness are advertised through these portal, where the
investors may donate their share. This is an amazing share where owner does not have to dilute
his share capital.

EQUITY CROWD FUNDING

Unlike the earlier donation based crowd funding, here the investors are interested in the share
capital of the business. Sites like EquityNet, Crowdfunder and others simply act as platforms
where interested companies can now generally solicit their private placement or offering
documents to a touted network of thousands of accredited investors (i.e. an investor with
>$1MM in liquid assets outside the value of his/her home).

DEBT CROWD FUNDING

Debt crowd lending is as non-dilutive as rewards crowdfunding, the financing fit for most
companies seeking capital this way is not likely to be there. As a capital-sourcing option, it is,
however likely to continue its upward climb in growth, albeit more slowly than its equity
counterpart.

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Personal and alternative small business lending is being facilitated by the likes of Lendoor,
Prosper and LendingClub. Most of these lenders for small business have emerged from the
consumer world of P2P finance.

DIRECT PUBLIC OFFERINGS

Alternative and direct public offerings are typically not a good fit for most, but they can still a way
to produce the capital necessary to take your venture to the next level without traditional venture
capital. Some of the other items discussed below will require a public offering in order for them
to be used legitimately. An RTO or reverse merger is a pre-requisite for some of the alternatives
to VC funding.

PRIVATE PLACEMENT IN PUBLIC EQUITY

Similar to a traditional private placement a Private Placement in Public Equity (PIPE) solicits
financing from a group of well-connected private investors with the plan that such financing will
be immediately placed in a public vehicle (or in escrow until a transaction is complete). It’s the
financing side of a typical alternative public offering. Shares offered in PIPEs are often provided
to private investors at some type of discount to sweeten the deal. PIPEs can be used for
existing public companies seeking additional capital, but who may be having a hard time raising
it through the market.

SBA LOANS

This one is applicable only in USA, where there are small business associations that work with
lenders to provide guarantees against the loan. Since, the SBAs are run by the federal
government, they can typically provide favorable terms and they regulate the rates charged by
their partner institutions for lending (typically prime + x %).

The small business associations still remain as a go to source of many startups.

ALTERNATIVE SMALL BUSINESS LENDING

Entrepreneurs can attempt to walk into a Chase or Wells Fargo to get financing, but without
significant collateral or a good historical context to your business story, you’re more likely than
ever to get turned down. The tightening of the belt on many traditional financial institutions has
benefited some of the latest start-ups aiming to provide alternative debt financing to small
business.

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Lendio is an example of this type of funding. Lendio has about 40 partners that provide
alternative financing options for small business, outside of the traditional bank ecosystem. Their
lending partners work to provide affordable debt financing for small business. The terms are
typically pretty favorable and the options are even better than some of the other available
methods.

FACTOR FINANCING

The factoring of receivables is an age-old method of supplying companies with working capital
needs without sacrificing equity or being hampered by debt. In a factor financing business, a
lender will generally pay up-front for quality receivables at about 90% to 95% of their face value.
In doing so, the financier will likely collect on the A/R within 30 to 60 days.

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REGULATIONS GOVERNING VENTURE CAPITAL BY SEBI

DEFINITIONS

There are many definitions mentioned under Securities and Exchange board of India (venture
capital fund) regulations, 1996. For convenience we have just handpicked a few important to
understand the law in relation to venture capital fund.

As per Securities Exchange Board of India, venture capital is defined as (SEBI regulations,
1996).

“A venture capital fund means a fund established in the form of a trust or a company including a
body corporate and registered under these regulations which-

i. has a dedicated pool of capital,

ii. raised in a manner specified in the regulations, and
iii. Invests in venture capital undertaking in accordance with the regulations.”

A venture capital undertaking means a domestic company:-

i. whose shares are not listed on a recognized stock exchange in Indian;

ii. Which is engaged in the business for providing services, production or manufacture of
article or things or does not include such activities or sectors which are specified in the
negative list by the Board with the approval of the Central Government by notification in
the Official Gazette in this behalf.

Also the law specifies what a venture capital firm cannot be in its negative list. The negative list
mentioned in act is:-

1. Real Estate
2. Non-banking financial services
3. Gold financing
4. Activities not permitted under industrial policy of Government of India
5. Any other activity which may be specified by the Board in consultation with Government
of India from time to time.

Associate in relation to venture capital fund means a person:-

i. who, directly or indirectly, by himself, or in combination with relatives, exercises control

over the venture capital fund; or
ii. in respect of whom the venture capital fund, directly or indirectly, by itself, or in
combination with other persons, exercises control; or
iii. Whose director is also a director, of the venture capital fund.

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REGISTRATION OF VENT URE CAPITAL FUND

The act proposes a process to have a venture capital fund registered. This section contains all
the details which are required by SEBI to have a venture capital fund registered under the act.

APPLICATION FOR GRANT OF CERTIFICATE

Any company or trust or body corporate proposing to carry on any activity as a venture capital
fund must apply to SEBI for grant of a certificate of carrying out venture capital activity in India.
An application for grant of certificate must be made in from A and must be accompanied by a
non-refundable application fee of Rs 25,000/- payable by bank draft in favor of the Securities
and Exchange Board of India at Mumbai. Registration fee for grant of certificate is Rs 500,000.

The structure of fees is mentioned in the form B.

Sample of how a venture capital certificate issued by SEBI looks like this

ELIGIBILITY CRITERIA

A. For the purpose of grant of certificate by SEBI, the following conditions must be
satisfied:-

If the application is made by a company

i. The main object of the company as per its Memorandum of Association must be
the carrying on of the activity of venture capital fund.
ii. It is prohibited by its Memorandum and Articles of Association from making an
invitation to the public subscribe to its securities.

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 iii. None of its directors or its principal officer or employee is involved in any litigation
concerned with the securities market which may have an adverse bearing on the
business of the applicant. The directors or the principal officer or employee must
not have been at any time convicted for an offence involving moral turpitude or
any economic offense and is a fit and proper person to act as director or principal
officer or employee of the company.
A. If the application is made by a trust
i. The instrument of trust (Trust Deed) is in the form of a deed and has been duly
registered under the provisions of the Indian Registration Act, 1908.
ii. The main object of the trust is to carry on the activity of a venture capital fund.
iii. None of its trustees or directors of the trustee company, if any, is involved in any
litigation connected with the securities market which may have an adverse
bearing in the business of the venture capital fund.
iv. The directors of its trustee company or the trustees have not at any time being
convicted of an offense involving moral turpitude or any economic offense.

In both cases, the applicant must not have already applied for certificate from SEBI or its
certificate must not been suspended by SEBI or cancelled by SEBI and the applicant must be a
fit and proper person.

FURNISHING OF INFORMATION

SEBI may require the applicant to furnish such further information as it considers necessary for
processing the application. An application, which is not complete in all respects, shall be
rejected by SEBI. However, before rejecting any application, the applicant will be given an
opportunity to make representation before SEBI and to remove any defect in the application
within 30 days of the date of receipt of communication from SEBI regarding the defect. SEBI
may extend the period of 30 days for up to another 90 days on being satisfied that it is
necessary and is equitable to do so.

PROCEDURE FOR GRANT OF CERTIFICATE

If SEBI is satisfied that the application is eligible for grant of certificate, it shall send Intimation to
the applicant of its eligibility. On receipt of intimation, the applicant must pay to SEBI,
registration fee of Rs 500,000 and on the receipt of such fees; SEBI shall grant a certificate of
registration in form B.

Conditions of certificate

The certificate granted shall be subject to the following conditions

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 1. The venture capital fund shall abide by the provisions of the SEBI Act and these
regulations.
2. The venture capital fund shall not carry on other activity other than that of a venture
capital fund.
3. The venture capital fund shall inform SEBI in writing of any
information or details previously submitted to SEBI which have changed after grant of
the certificate.
4. If this formation or details submitted are found to be false or are misleading in any
particular manner, suitable penal action can be taken.

After considering any application, if SEBI is of the opinion that the certificate cannot be granted
under law, it may reject the application after giving the applicant a reasonable opportunity of
making its representation. The decision of SEBI to reject the application shall be communicated
to the applicant within 30 days.

Effect of refusal to grant certificate an applicant whose application is rejected cannot carry out
any activity as a venture capital fund.

INVESTMENT CONDITIONS AND RESTRICTIONS

A venture capital fund may raise money from any source, whether Indian, foreign or non-
resident Indian by way of issue of units. No venture capital fund shall accept any investment
from any investor less than Rs 5, 00,000.00. However this condition is not applicable to:-

a) employees or the principal officer or directors of the venture capital fund has been
established as a trust,
b) the employees of the fund manager or asset management company for the purpose of
these regulations, fund raised means actual money raised from investors for subscribing
to the securities of the venture capital fund and includes money that is raised from the
author of the trust (in case the venture capital fund has been established as a trust) but
does not include the paid up capital of the trustee company, if any.

Each scheme launched or fund set up by a venture capital fund shall have firm commitment
from the investors for contribution by the venture capital fund.

All investment made or to be made by a venture capital fund shall be subject to the following
conditions, namely:-

A. venture capital fund shall disclose the investment strategy at the time of application for
registration;
B. venture capital fund shall not invest more than 25% corpus of the fund in one venture
capital undertaking
C. shall not invest in the associated companies; and

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 D. venture capital fund shall make investment in the venture capital undertaking as
enumerated below:-
i. At least 75% of the investible funds shall be invested in unlisted equity shares or
equity linked instruments. However, if the venture capital fund seeks avail of
benefits under the relevant provisions of the Income Tax Act applicable to a
venture capital fund, it shall be required to disinvest from such investments within
a period of one year from the Date on which the shares of the venture capital
undertaking are listed. In a recognized stock Exchange.
ii. Not more than 25% of the investible fund may be invested by way of:
a) subscription to initial public offer of a venture capital undertaking
whose shares are proposed to be listed subject to lock-in period of one
year;
b) Debt or debt instrument of a venture capital undertaking in which
the venture capital fund has already made an investment by way of
equity.

GENERAL OBLIGATIONS AND RESPONSIBILITIES

PROHIBITION ON LISTING

No venture capital fund shall be entitled to get its securities or units listed on any Recognized
stock exchange up to the expiry of three years from the date of issue of Securities or units or
units by the venture capital fund.

PRIVATE PLACEMENTS

A venture capital fund may raise money only through private placement of its securities or units.
The venture capital fund before issuing any securities or units must file with SEBI a placement
memorandum.

Contents of a Placement Memorandum or Subscription Agreement

The venture capital fund must:-

issue a placement memorandum which shall contain detain details of the terms and condition
subject to which monies are proposed to be raised from investors; or enter into contribution or
subscription agreement with the investors which shall specify the terms and condition subject to
which monies are proposed to be raised the venture capital fund must file with the board for
information the ,copy of the placement memorandum or copy of the contribution or subscription
agreement entered with the investors along with a report of money actually collected from the
investor.

The placement memorandum and/or subscription agreement must give the following details:

A. In case the venture capital fund is a trust

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 1. Details of the trustee or the trustee company and the directors or chief executives
of the venture capital fund.
2. The proposed corpus of the fund and the minimum amount to be raised for the
fund to be operational.
3. The maximum amount to be raised for each scheme and the provision for refund
of monies to investor in the event of non-receipt of minimum amount.
4. Details of entitlement on the securities including units of venture capital fund for
which subscription is being sought.
5. Tax implications that are likely to apply to the investor.
6. Manner of subscription to the units or securities of the Venture Capital Fund.
7. Period of maturity of the Fund.
8. Matter in which the fund is to be wound up.
9. Matter in which the benefits accruing to the investor in the units of the trust are to
be distributed.
10. Details of the fund or asset Management Company if any, and the fees to be paid
to such manager.
11. The details about performance of the fund, if any, managed by the Fund
Manager investment strategy of the fund any other information specified by the
Board

MAINTENANCE OF BOOKS AND RECORDS

Every venture capital fund must maintain for a period of 8 years books of accounts, records and
documents which must give a true and fair picture of state of affairs of the venture capital fund.
The books of accounts, records and document relating to the venture capital fund.
Any of the following reason:-

1. To ensure that the books of accounts records and document are being maintained by
the venture capital fund in the manner specified in these regulation.
2. To inspect or investigate into complaints received from investors, clients or any other
person on any matter having a bearing on the activity of the venture capital fund.
3. To ascertain that the provision of the SEBI Act and these regulations are being complied
with by the venture capital fund.
4. To inspect or investigate its moto into the affairs of the venture capital fund in the interest
of the securities market and the interest of investors.

Notice before inspection or investigation

Before ordering an inspection or investigation, SEBI shall give not less than 10 days. Notice to
the venture capital fund. However, where SEBI is satisfied that in the interest of the investors,
no such notice need be given, it may by order in writing not give such notice.

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OBLIGATION OF VENTURE CAPITAL FUND ON INSPECTION OR INVESTIGATION

1. It shall be the duty of every officer of the venture capital fund in respect of whom an
inspection or investigation has been ordered and any other associate person who is in
Possession of relevant information pertaining to conduct and affairs of such venture
Capital fund including fund manager or asset management company, if any to produce
to the investigating or inspecting officer such books, account and other documents in his
custody or control and furnish him with such statement and information as the said
officer may require for the purpose of the investigation or inspection.
2. It shall be the duty of every officer of the venture capital fund and any other associate
person who is in possession of relevant information pertaining to conduct an affair of the
venture capital fund to give to the inspecting or Investigating officer all such assistance
and shall extend all such co-operation as may be required in connection with the
inspection or investigating and shall furnish such information sought by the inspecting or
investigating officer in connection with the inspection or investigation.
3. The investigating or inspecting officer shall, for the purpose of inspection or
investigation, have power to examine on oath and record the statement of any
employees, directors or person responsible for or connected with the activities of venture
capital fund or any other associates person having relevant information pertaining to
such venture capital fund.
4. The Inspecting or Investigating officer shall, for the purposes of inspection or
investigation, have power to obtain authenticated copies of documents, books account of
venture capital funds, from any person having control or custody of such documents,
books or account.
5. The inspecting or investigating officer in the course of inspection or investigation shall be
entitled to exam or record the statement of any director, trustee, and officer or employee
of venture capital fund.
6. It shall be the duty of director, trustee, officer or employee to reasonably assist the
inspecting or investigating officer in connection with the inspection or investigation.

SUBMISSION OF REPORT TO SEBI

The inspecting or investigating officer on completion of the inspection submits his inspection or
investigation report to SEBI. He may also submit an interim report if so required.

SEBI shall after consideration of inspection or investigation report or the interim report
communicate the finding of the inspecting officer to the venture capital fund and give it an
opportunity to make a representation. On receipt of the reply if any, from the venture capital
fund, SEBI may call upon the venture capital fund to take such measures as the board may befit
in the interest of the securities market or for due compliance with the provision of the SEBI act.

The board may after consideration of the investigation or inspection report and after giving

51
reasonable opportunity of hearing to the venture capital fund or its trustees, director’s issue.
Such direction as it deems fit in the interest of securities market or the investors including
directions in nature of:-

1. requiring a venture capital fund not to launch new schemes or raise money from
investors for a particular period;
2. prohibiting the person concerned from disposing of any of the properties of the fund or
scheme acquired in violation of these regulations;
3. requiring the person connected to dispose of the assets of the fund or scheme in a
manner as may be specified in the directions;
4. requiring the person concerned to refund any money or the assets to the concerned
investors along with the requisite interest or otherwise, collected under the scheme;
5. Prohibiting the person concerned from operating in the capital market or from
accessing the capital market for a specified period.

PROCEDURE IN CASE OF DEFAULT

SEBI may cancel the certificate granted to venture capital fund where the venture capital fund is
guilty of fraud or as been convicted of any offence involving moral attitude or where the venture
fund has been guilty of repeated default under regulation.

No order of suspension or cancellation shall be made by except after holding an enquiry in

accordance with the following procedure:-

For the purpose of holding an enquiry, SEBI may appoint one or more enquiry officer.
The enquiry, officer shall issue to venture capital fund at registered office or principal place of
business a notice stating the ground on which the action proposed to be taken and show cause
why such action need not be taken within a period of 14 days from the date of receipt of notice.

The venture capital fund may within 14 days from the date of receipt of such notice, furnish
enquiry officer its reply ad make its representation before him a venture capital fund may appear
through any person duly authorized by it. The enquiry officer shall after taking into account all
relevant facts and circumstance, submit a report to SEBI and recommend penal action, if any, to
be taken against the venture capital fund as also the ground on which such action is justified.

On receipt of the report from the enquiry officer, SEBI shall consider the same and may issue to
venture capital fund a shown cause notice as to why such penal action as proposed by enquiry
officer or such appropriate action should not be taken against it. The venture capital fund, within
14 days from the date of receipt of such cause notice sends a reply to SEBI after considering
the reply, if any of the venture capital SEBI shall pass an order as it deems fit.

On and from the data of suspension of certificate, he venture capital fund shall cease to carry on
any activity as a venture capital fund during the period of suspension and shall be subject to
such direction of SEBI with regards to any records documents securities as may be in its

52
custody or control relating into its activity as a venture capital as SEBI specifies. On and from
the date of cancellation of certificate, the venture capital fund with immediate effect shall cease
to carry on activity of the venture capital fund and shall be subject to such direction of SEBI with
regards to transfer of records documents and securities that may be in its custody or control
relating to the activities of the venture capital fund as SEBI may specify.

The order of suspension or cancellation of certificate may be published by SEBI in least two
newspapers.

ACTION AGAINST INTERMEDIARIES

SEBI may initiate action for suspension or cancellation of registration of an intermediary holding
a certificate of registration who fails to exercise due diligence in the performance of its function
or fails to comply with its obligations under this regulation. However no such certificate of
registration shall be suspended or cancelled unless the procedure specified in the regulation
applicable to such intermediary is complied with.

 Appeal to the central government

 Any person aggrieved by an order of the board under these regulation may prefer an
appeal to securities appellant tribunal

POWER TO CALL FOR INFORMATION

SEBI may at any time call upon the venture capital fund in respect to any matter relating to its
activity as a venture capital fund. Such information must be submitted within the time specified
by days to SEBI.

SUBMISSION OF REPORTS TO SEBI

SEBI may at any time call upon the venture capital fund to file such report as it deems fit with
regards to the activity carried out by venture capital fund.

WINDING- UP
A scheme of venture capital fund setup as a trust shall be wound up:-

1. When the period of the scheme as mentioned in the placement memorandum is over; or
2. if in the opinion of the trustees or the trustee company, it is in the interest of the investors
that be wound-up ; or
3. If 75% of the investors in the scheme pass a resolution at a meeting of unit holder of the
scheme that the scheme be wound up; or
4. If SEBI so directs, in the interest of investors.

53
A venture capital fund set up as a body corporate shall be wound up in accordance with the
provision of the statute under which it is constituted Companies Act, 1956.

The trustees or trustee company of the venture capital fund is set up as a trust or the board of
director in the case of the venture capital fund is set up as a company (including body
corporate) shall intimate the board and investors of the circumstance leading to the winding up
of the fund scheme.

EFFECT OF WINDING UP

On and from the date of intimation of the winding up, no further investment shall be made on
behalf of the scheme to be wound up. Within three months from the date of intimation, the
assets of the scheme shall be liquidated and the proceeds accruing to the investors in the
scheme distributed to them after satisfying all liabilities.

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DIFFERENCE BETWEEN PRIVATE EQUITY AND VENTURE CAPITAL

Basically, Venture Capital is just a subset of private equity. They both invest in companies, they
both recruit former bankers, and they both make money from investments rather than advisory
fees. But researcher found that they are significantly different.

PRIVATE EQUITY

Private Equity is a number of different types of investments that can be made with private
money. These investments may be made to purchase a company, provide funding for a project,
or simply make a private investment. Private equity firms generally focus on financial
statements.

They want to see what expertise they can bring to the income statement or balance sheet.
These investors tend to emphasize the bottom line. They may propose operational changes or a
comprehensive management restructuring to help the firm make more money. Capital structure,
the amount and Source of debt and equity a company has, may also be an area the private
equity firm want to change.

They are established investment bankers that:

1. Invest only in the proven and established business that they are able to trust.
2. These usually have a financial partner approach.
3. Invests an amount between USD 5 – 100 million.

VENTURE CAPITAL

Venture Capital is a specific investment strategy designed to provide funding for startup
companies. It’s currently a very popular financing source for technology based companies. It
allows for fast growth without any need of revenue at an early stage.

It’s highly risky, but can be quite lucrative. Rather than looking for immediate cuts, the Venture
Capitalist may encourage the company to devote more time and money to planning and
research.

This type of financing is known for buying stakes in emerging industries. They get in early, faster
innovation, and earn a profit after the product is ready for mass distribution. These different
types of financing have significant impact on the companies they invest in. Small firms seeking
private equity should be prepared for changes.

Venture Capital investors are likely to have more patience and give the owners of the company
they’re investing in time to realize their vision. In practical terms, Venture Capital firms provide
money and patience.

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Venture Capitalists (VCs) are organizations raising funds from numerous investors and hiring
experienced Professional managers to deploy the same. They typically:
1. Invest at “second” stage
2. Invest over a spectrum over industries
3. Have hand-holding “mentor” approach
4. Insist on detailed business plans
5. Invest into proven ideas/businesses
6. Provide “brand” value to investee
7. Invest between USD 2 – 5 million

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 Private Equity Venture Capital

Here firms buy across all Focused on technology and bio-

industries technology industries.

They only acquire a minority

Firms buy almost 100% in the
stake that is up to 49%.
Leveraged buyouts

Firms make larger investments Makes comparatively smaller

investments

They use combination of Debt and They take part In Equity

Equity

The number of investment is smaller Expects investments to make

and size of investment larger larger returns
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Buys mature public companies Takes part in usually startups

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TOP 10 VENTURE CAPITAL FUNDS IN INDIA

BLUME VENTURES

This Mumbai-based homegrown venture capital firm likes to take a collaborative approach to
investing; roping in other investors and angels into the ventures it backs. Blumers they call
themselves, but they have a number of successes under their belt. Cool startups like cab
aggregator TaxiForSure and robot-maker grey Orange are in the Blume basket.

ACCEL PARTNERS

Investments in ecommerce biggie Flipkart and Myntra’s series E, as well as BabyOye’s US$12
million series B and real estate portal CommonFloor’s series C and D rounds, among others,
made Accel Partners one of the movers and shakers in India in the last four quarters. Freshdesk
and BookMyShow are among the many Indian stars this California-headquartered firm has
backed.

KALAARI CAPITAL

Technopreneur-turned-investor Vani Kola, who returned to India after a billion-dollar exit from
Silicon Valley, is the managing director of this Bangalore based venture capital firm which took a
punt on Snapdeal and Myntra long before the ecommerce boom. Kalaari, which derives its
name from a martial arts tradition in South India, continues to pick winners like Urba ladder and
Zivame.

TIGER GLOBAL MANAGEMENT

This ‘Tiger Cub’ from New York has funded some of the tech pioneers in India like Flipkart,
MakeMyTrip and JustDial. In fact, it was one of the early players in the Indian tech startup
scene, before unexpectedly shutting shop in 2009, ostensibly because it did not find the scale it
was looking for. But it has been back with a bang since 2011.

NEXUS VENTURE PARTNERS

With offices in Silicon Valley and Bangalore, this venture capital firm started by a bunch of
Indian entrepreneurs is well-positioned to spot emerging talent and innovation. A number of
cloud-based solutions have caught its fancy, but the big play was in ecommerce site Snapdeal –
clearly seeing value in the online marketplace model.

IDG VENTURES INDIA

IDG Ventures from San Francisco is one of the biggest investors in Asia, with funds in China,
Korea, and Vietnam, apart from India. Major investments this year by IDG venture India have
included business process management provider Newgen, tablet-based education provider
iProf, online ophthalmic health provider Forus, and baby care product retailer FirstCry.

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HELION VENTURE PARTNERS

This is a USD 600 million Indian funds based in Mauritius. Eyw-Q and Denty‘s, bringing eyecare
and dentistry online for Indian consumers, illustrate the kind of consumer-facing internet-driven
ventures that Helion likes to back. Real estate portal Housing.com has also been a big
beneficiary.

KAE CAPITAL

Here is another homegrown venture capital firm, like Blume and Kalaari, actively investing in
Indian tech startups. Its founder Sasha Mirchandani was the managing director for India of US-
based BlueRun Ventures, before striking out with his own firm. Little Eye Labs, the first Indian
company to be acquired by Facebook, was one of its investments.

INTEL CAPITAL

Intel Inside India has a nice ring to it, and that’s what it is proving to be, as the global chip-
maker’s venture capital arm develops a growing appetite for tech plays out of India. Recent
evidence of this came when it led a US$16 million round of funding in hot data analytics firm
Vizury. A preference for hardware startups like high-end modem-maker Saankhya Labs is in its
DNA.

It’s worth pointing out again; this is a ranking of investors who were the most active in the last
financial year. Others like Sequia Capital, Inventus Capital Partners, SAIF Partners, GSF
Global, and VentureEast may not have been that active just recently but have many great Indian
startups in their portfolio already. Sequoia is also sitting on a new USD 500 million plus funds for
India so we can expect some smart moves soon.

And we haven’t looked at the angel investors yet – the ones who put their money down even
before a product or service gains traction. So stay tuned for the second part of this article.

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STATISTICS

To have an accurate picture of the venture capital firms in India have tried to include the
statistics as provided in the report (The fourth wheel) published by Grand Thornton.

Indian economy has been on an uptrend since the global meltdown. with GDP picking up pace
at the back of the various economic and political factors as well as structural reforms promoted
by the Government over the last few years. This has led to a positive investment sentiment that
has helped attract higher PE investments over the last seven years. This is evident from the
increase in the PE to GDP ratio from a low of 0.3 percent in 2009 to 0.6 percent in 2016,
suggesting the increasing contribution that the PE industry has made to the growth of the Indian
economy. However, when compared to the PE to GDP ratio of developed markets, which is
generally understood to be greater than a percent, the ratio of that of India is currently lower.

The fund raising activity has seen a decline in Private equity as well as venture capital firms
close to 6 per cent in 2016 as compared to $25.7 billion in 2015. On a cumulative basis a total
of $67 billion fund has been raised in total from 2014 to 2016 by PE and VCs.

VC HIGHLIGHTS FOR 2016

The year 2016 saw a large number of investments in startups varying from angel, seed, growth,
bridge, crowd, series A, and series B funding rounds ranging between few thousands US dollar
to USD 10 million. The investments made in 2016 were almost double that were made in year

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2014. Graph below mention in report shows the increasing activity.

The number of deals increased from 399 in year 2014 to 809 in year 2016. However the
industry saw a decrease in average deal size of that is from USD 2 million to USD 1 million.

ACTIVE PRIVATE EQUITY AND VENTURE CAPITAL INVESTORS.

The table below taken from the report provided by Grand Thornton shows us key active players
in the year 2015 and year 2016.

As we see there has been a drastic rise in the count of Angel investors. The report further
indicates there may be a steep rise in number of startups from current 4300 to 11500 by year
2020 considering this rising VC market.

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SECTOR THAT ATTRACTED MOST PE MONEY

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PROBLEMS FACED BY THE FIRMS IN INDIA

As per my research I see there are few challenges with the firms that need resolution for the
Venture capital market to grow further. There is one such issue which I have handpicked and
wish to provide a recommendable solution from my point of view.

 Lack of web-based crowdfunding for equity

LACK OF WEB BASED CROWD FUNDING FOR EQUITY

United States has a market of web based crowdfunding a lot of which are donation based
crowdfunding. Examples of these web based crowd funders would be Kickstarter, Indiegogo,
PledgeMusic etc. It becomes easier for the young entrepreneur to enter the market with the help
of minimum capital required to set up a business in their market. Majority of these crowdfunding
are for social causes but there are few small projects which are financed through these
websites.

Here the investors are wide spread throughout the nation and not limited to the particular region.
Due to its vast reach the projects receive investments in smaller size but with a huge count of
investors.

India lacks these web based portal due to the regulations laid down by the Indian government. It
is believed that the restrictions are due to the lack of know-how of the investors present in India
of the web based activities, the online crowdfunding has not yet taken effect in India. As per
SEBI, crowd funding is made applicable but with restrictions such as retail investors should not
be more than 200 and the investment should not be more than Rs 60,000.00.

This type of crowd funding is very essential for the small businesses which are in to arts, not for
profit ventures etc. as they get a larger base of people to fund them.

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RECOMMENDATIONS

Despite the evolution of Venture capital Funds (VCFs) and Private Equity (PE) investors, it is
not easy for a start-up or an SME to raise money. The Crowd Funding route entities would be
able to solicit investment in smaller sums from large number of investors. It provides new
investment avenues and also provide new product portfolio diversification of
investors. It seems to be the key towards boosting the start-up eco-system in India.

Now that we have discussed problem in detail, lets us understand the possible options we have
available at hand to make this platform available in India.

1. Technical Know—how

In order to increase the technical know-how of the project government along with venture capital
firm (web based) may launch custom programs / seminars / online trainings. These trainings will
serve as a base on how the web based market operates and the process and methods of
financing projects displayed online. This will not only increase the technical now how of the
investors but will also promote online transactions.

2. Crowd funding is not a new concept:

Crowd funding basically means investments from a large group pf people for a specific cause.
The best example of this would be the religious places. The crowd funding will operate on same
model but will be online and the dealing will investors will be web based on the portals.

3. Trust factor among investors

Since the project is a new venture there is a lack of trust on part of investors to fund such
projects as they would not be unable to review the actual existence of entity being funded and if
so the profitability criteria. Secondly due to the scams in the finance industry makes it all the
more difficult to gain confidence of investors.

To meet this limitation it is a suggestion to have regulations in effect which will approve the
genuineness of the projects posted online on the portals. This will maintain a balance between
investor protection and role of equity market play.

PROS OF HAVING A WEB BASED FACILITY

Minimizes the tedious fund raising process for smaller businesses, also the minimum amount of
capital will be invested in order to raise the capital needed to set up a business.

The businesses will be protected with the patents and copyrights in order to avoid the ideas to
be stolen by the businesses.

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CONCLUSION

From the above we can conclude that India is on an upward trend in terms of Private equity and
Venture Capital industry. There has been a consistent rise in the industry since the global
meltdown as the statistic section shows. Indian has a lot off untapped potential which is waiting
to be triggered by these Venture capital firms.

With India aiming at more than 9.0 per cent growth and a lot more scope remaining for
infrastructure development, private equity investment will have a major role to play in the
coming years. However, the rapid growth and globalization of the PE and VC industry has
raised demands for increased regulation and disclosure within the sector due to concerns
regarding anti-competitive behavior, excessive tax benefits and stock manipulation.

However, there is a popular discourse as how much restriction is optimum restriction for an
evolving industry. This question is particularly important for India. At present the industry is
largely self-regulated. In India, the quality and end-use of foreign PE capital is well regulated
under FDI norms. These high regulations restrict the capacity of firm to operate at their optimal
levels and thus not being able to provide much output in the economy.

One issue that has not yet received much attention is diversification of many private equity firms
into hedge funds. This may call for some concern in the near future as the activities of hedge
funds are rather non-transparent and may lead to information asymmetries. Hence, there is a
need to clearly define in our regulations as to what a private equity firm is or what a venture
capital firm is and the kind of activities they are allowed to indulge in India.

To encourage this industry, there is a need to relax caps on FDI sectors especially infrastructure
and technology intensive sectors, easing of norms on repatriation of profits, reform of labor laws
and urban land ceiling legislation, rationalization of tax laws to bring transparency and stability in
tax policies and expediting capital market reforms such as developing corporate debt market
and shortening of the IPO process to enable smooth flow of capital to more productive sectors.

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BIBLIOGRAPHY

BOOKS AND RESEARCH PAPERS REFERRED

 Research papers by RMIMRJ Volume 1, issue – 2, September 2014

 Grant Thornton report on startups, private equity and Venture capital

WEBSITES REFERRED:

 www.investmentbank.com
 www.entrepreneur.com
 https://www.draperuniversity.com
 www.forbes.com
 https://economictimes.indiatimes.com/
 https://www.mbaknol.com
 https://www.rbi.org.in
 https://thebusinessprofessor.com
 https://medium.com/
 https://www.scribd.com
 http://www.yourarticlelibrary.com
 http://www.livemint.com/
 http://shodhganga.inflibnet.ac.in/
 https://www.sebi.gov.in/
 www.investopedia.com
 www.slideshare.net


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