VENTURE CAPITAL
Venture capital is money provided by professionals who invest alongside management, in young, rapidly growing companies that have the potential to develop into economic powerhouse. Venture capital firms are generally private partnerships, or closely held private companies funded by private and public pension funds. It is also referred as Risk capital.
Venture capitalists:
- Finance new rapidly growing companies
- Purchase equity shares
- Assists in the development of new products or services
- Add value to the enterprise through active participation in management
Venture capitalists invest in
- First generation businesses promoted by first generation entrepreneurs
- Untried and untested products and technology
- High risk projects that have high risk of failures but with enormous possible rewards
Stages of Venture capital assistance:
- Seed money
- Start-up capital
- Second and third stage assistance
- Mezzanine financing
Seed Money
It refers to financing the project at the development stage of product or service. At this stage risk is highest. There is no guarantee that the prototype will evolve successfully and later turn out to be viable commercially. Very few venture capitalist firms specialize in seed-capital financing.
Start-up capital
At this stage funds, which are adequate to generate initial sales sufficient in volume to yield, are provided. In most of the cases it is provided in the form of private placement in equity of the venturer-entity. The funding is for the period of 3 to 5 years at the end of which the entity is expected to achieve a stable growth.
Second and third stage assistance
In case the initial start-up funding may prove to be inadequate because of inefficiency of management or unexpected changes in operating environment, further funds are infused by the venture capitalist.
Mezzanine financing
Sometimes company needs money to fund expansion programs, which would help it to make public offering at a later stage. Finance provided for such expansion is known as Mezzanine financing. Its duration is very short.
Modes of financing:
- Pure equity financing
- Conditional loans, repayable in the form of royalties on sales
- Income notes, a hybrid instrument which carries returns both in form of interest and contingent payment linked to sales or profit levels
- Participating debentures carrying returns ranging from zero initially, to nominal market rates for an interim period and profit sharing arrangement over and above nominal market rate of interest at the end.
Before investing, venture capitalists look at three areas, namely, the proposed product or service, the potential market and the management team.
VC’s evaluate the project by determining the following
- Possible gains from capital infusion
- Capability of management
- Financial projections and its variability
- Possible exit strategy
Expectation of returns
The business in this case are highly risky hence the expectation of returns are high. The returns expected might range from 60 to 80% for seed money financing and 20 to 25% for second and third stage financing
The Pay Day
For a venture capitalist, an Initial Public Offering (IPO) is the ‘Pay-Day’. That’s when they get the return on their investment. Most venture investors consider IPO as the best type of “exit” point. A successful exit is also seen by many market-watcher as a barometer to measure the expertise of the venture investor, and the success of the fonder-owners themselves.
