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What is Venture Capital? Research Team | Posted On Wednesday, October 28,2009, 07:50 PM

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What is Venture Capital?



Venture capital

If a person wants to become an entrepreneur then he must start a new business and for starting up the business he needs to have a business plan. It is not necessary that the plan has to be a new idea for which he will need capital. The amount of capital depends upon the type of business that the entrepreneur is starting. He can get the required capital from many sources. The required capital, be it less or more depends upon the business plan. Some of the sources from which the entrepreneur can raise the required capital are

  • Own funds
  • Venture capitalists
  • Angel investors
  • Partnership
  • Banks
  • From friends and relatives
  • Institutional investors

In this article we will be concentrating on the venture capitalists.

Who is Venture Capitalist?

Venture capitalists (VC) are those businessmen who are interested in startup companies and who provide capital for such companies. It is not necessary that venture capitalist must be a businessman. The investment can be done by the individuals who have a high net worth or investable assets. The VC’s invest in a startup company and usually they ask for a share of partnership or ask for particular percentage of shares from that company.

History of venture capital

Venture capital investment was called as the development capital. This was applicable to the people who were very rich or the families who had lot of wealth which could be used for investing. After the Second World War there was establishment of two firms named as American Research and Development Corporation (ARDC) & J.H.Whitney and Company.

The phenomenon of venture capitalism entered India in the late 19th century that is around 1980’s. It began with the set up of Risk Capital Foundation by All India Financial Institutions. The venture capital industry was promoted by the government when it promoted venture capital during 1986 when it created a venture capital fund. The Indian venture capital industry is very young (just about 30 years) when compared to the venture capital industry in America and Europe. Till today it has nurtured thousands of business firms which are in different stages of business cycle.

See Also: Features of Capital Market

How does venture capital work?

You may be wondering as to what is the need for a person to become a venture capitalist when he can earn money if he invests the same amount of money in his business, share market, in banks etc. There are many things which play a very important role in converting a person into a venture capitalist.

The VC’s does not invest in each and every business opportunity that they come across. They invest in only those projects which they feel can definitely work and are capable of bringing them good returns. A study has shown that some of the VC’s invest in one project or business opportunity among the 400 or 500 projects that they have seen, it again depends upon the perception of the venture capitalist because some of them will be looking out for projects which are there in specific fields such as healthcare, fast-foods, medicines, technology oriented etc. Once the entrepreneur or the businessman who needs the capital approaches the VC there are certain conditions put forward by them. Some of them are

  • Social responsibility: A person who aims at becoming a venture capitalist is giving a contribution to the society by helping the young entrepreneurs to start their business and indirectly it means that they are helping in the improvement of the economy.
  • They can get good returns if they invest in the stock market or in their own business but the returns that they get by investing in new business are far more and it comes very easily.
  • They can dictate their terms in some matters when they are investing in a startup company whereas it cannot happen even if they are a managing director of a public company
  • It involves a lot of risk to invest in startup companies and no doubt the venture capitalist is ready to take up that risk
  • The main advantage is the capital gains. When VC puts money in the business the one thing he asks for is percentage of shares and when the company is doing extremely well and its share prices are very high, VC sells of the shares of that company to make a lot of money. It again depends upon VC whether he wants to sell or keep the shares.
  • A place in Board of Directors
  • Percentage of shares
  • Business partnership
  • Reporting the progress of business
  • The targets to be met

I am not saying that these will be the only demands by venture capitalist; there may be other conditions or any two or three of above conditions. It solely depends upon the venture capitalist as to what are the conditions he has to place. The three prominent things demanded are place in Board of directors, percentage of shares, progress report. The venture capitalist does not stay in the same venture for many years. Once they feel that the venture has grown up they sell the shares and move on to the next venture.

How to get capital?

The first step is that a business proposal is submitted to VC. Venture capitalist reviews the business proposal and if he feels that the business is worth investing then he calls the entrepreneur or the management team of that particular company for a discussion.

The second step is the Pre-liminary screening wherein the management team/ entrepreneur of the business sit and review the business plan or proposal. It is the one important stage where the management team/entrepreneur has to prepare well and convince the venture capitalist that the business plan will work out and for doing that they need to know even the minute details about the project because they can never anticipate the kind of questions that will be asked by venture capitalist.

The next step is Negotiating the investment. In this stage the amount that is needed for the proposal is discussed and both parties come to an understanding called as Memorandum of Understanding (MoU). The venture capitalist reviews the market study and market potential which has been carried out by the respective firm or by people who are specialized in this particular work. The venture capitalist also studies the industry carefully to obtain information about competitors, entry barriers, potential to exploit substantial niches, product life cycles, and distribution channels which will help in convincing him that the business plan is worth investing.

The final step is getting the approvals and the capital. In this step all the terms are negotiated and the investment proposal is submitted to venture capital board of directors and if it’s approved the legal documents are prepared. Then the VC provides the capital that they have decided in the MoU. The capital can be given in a lump sum or in installments depending upon what was decided during the meeting.

What do venture capitalists look for?

Although the final decision of investing the money in a business lies in the hands of a Venture capitalist, the selection of a VC is definitely in the hands of an entrepreneur. It should not be mis-understood that the power lies in the hands of the entrepreneur because they need capital for setting up the business and they are in no condition to dictate the terms. The mistake that they do is to decide upon one VC and approach him for funding without knowing if that particular VC has got any preferences. It has been seen that venture capitalists have preferences regarding particular stages of investment, amount of investment, industry sectors and geographical location. It’s not only these things what an entrepreneur will look for in an Venture Capitalist, but other important things as to what will be the value addition that the VC brings in, what will be his style of doing business, the expertise and experience that he brings along with him.

Stages of financing

Let’s have a look at the general stages of financing. The steps given here are not universal because the modes and stages of financing depend upon the negotiations that have taken place between the VC and the entrepreneur/management. But these are the steps in which the financing happens most of the times

Step 1: seed financing or seed capital or concept stage financing

The entrepreneur or the main management is provided with a small amount of capital. In this stage the products or services are not being sold to the customers. In most of the cases it is seen that the entrepreneurs get the capital from the angel investors rather than the venture capitalists.

Step 2: startup financing

In this step a prototype of the product is built and is tested for the market viability. The search for the other team members and the technical specialists is on. There are very few venture capitalists that fund during this stage and again it’s the angel investors who come to the rescue of the entrepreneurs.

Step 3: First stage financing

This is the step where the VC’s will be looking to get involved with a company. For a company to reach this stage it requires at least a year and the management team is in place and is working in co-ordination. The sales may or may not be that great but if the product is accepted well in the market, the sales will definitely be on the rise

Step 4: second stage financing

The sales in this stage are rising and the company is looking to reduce the costs and increase the productivity and enter new markets. The funds in this phase are used for opening into new markets; increase the productivity, expansions etc.

Step 5: Third stage financing

The customer’s happiness, the sales figures are taking an exponential phase and the business is going on very well, these are some of the things which happen in this phase if everything goes as planned. The finance that the firm gets during this stage is used for increasing plant capacity, marketing, working capital and expansion.

Step 6: Bridge or Mezzanine financing

The company has successfully passed through the rough patches that arise during the initial years and is doing well now. The bridge financing is done to prepare the company for an Initial Public Offering (IPO) which includes clearing the debts and buying out the investors who are not strong enough to run a public company.

The next step is that the company or the firm goes for the IPO and raises the funds or capital.

Venture capital -  Present scenario in India

There are number of Venture capital firms and individual VC’s in India. Some of the top VC firms are Sequoia Capital India, Ventureast, Intel Capital, Helion Venture Partners, DFJ India, Nexus India Capital etc. Apart from the firms there are individual VC’s such as one of the Infosys founder Mr. N.S.Raghavan, Vinod Khosla. They have been providing the capital for the budding entrepreneurs. The next addition to the list is Mr. Narayana Murthy who recently sold shares of worth Rs 180 crores to start a venture capital firm.

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