A Report On Analysis of Venture Capital as a Source of Finance

Rajasthan Technical University, Kota

Objectives of the Report: To study the concept of Venture Capital as a source of finance. To study the need of Venture Capital in business.

To study the advantages of Venture Capital. To study the disadvantages of Venture Capital.

What is venture capital?

Venture capital provides long-term, committed share capital, to help unquoted companies grow and succeed. If an entrepreneur is looking to start-up, expand, buy-into a business, buy-out a business in which he works, turnaround or revitalise a company, venture capital could help do this. Obtaining venture capital is substantially different from raising debt or a loan from a lender. Lenders have a legal right to interest on a loan and repayment of the capital, irrespective of the success or failure of a business. Venture capital is invested in exchange for an equity stake in the business. As a shareholder, the venture capitalists return is dependent on the growth and profitability of the business. This return is generally earned when the venture capitalist "exits" by selling its shareholding when the business is sold to another owner.

Introduction to venture capital:

Venture Capital is a form of "risk capital". In other words, capital that is invested in a project (in this case - a business) where there is a substantial element of risk relating to the future creation of profits and cash flows. Risk capital is invested as shares (equity) rather than as a loan and the investor requires a higher rate of return" to compensate him for his risk.

The main sources of venture capital in the UK are venture capital firms and "business angels" - private investors. Separate Tutor2u revision notes cover the operation of business angels. In these notes, we principally focus on venture capital firms. However, it should be pointed out the attributes that both venture capital firms and business angels look for in potential investments are often very similar.

Venture Capital' is an important source of finance for those small and medium-sized firms, which have very few avenues for raising funds. Although such a business firm may possess a huge potential for earning large profits in the future and establish itself into a larger enterprise. But the common investors are generally unwilling to invest their funds in them due to risk involved in these types of investments. In order to provide financial support to such entrepreneurial talent and business skills, the concept of venture capital emerged. In a

way, venture capital is a commitment of capital, or shareholdings, for the formation and setting up of small scale enterprises at the early stages of their life cycle.

Venture capital refers to money that is invested in companies during the early stages of their development. Such funds may come from wealthy individuals, government-backed Small Business Investment Companies (SBICs), or professionally managed venture capital firms. Since investing in an unproven business venture is highly speculative, venture capitalists generally target companies that they believe offer significant potential for growth, and therefore an opportunity to earn a high rate of return in a relatively short period of time. In exchange for providing capital, as well as a source of management assistance and industry contacts for growing firms, the investors usually require a percentage of equity ownership in the company, some measure of control over its strategic direction, and payment of assorted fees Like other sources of equity financing, venture capital offers both advantages and disadvantages. The main advantage is that the business is not obligated to repay the money. For a start-up company, this frees up important cash flow that might otherwise be needed to service debt. The involvement of high-profile investors may also help increase the credibility of a new business. The main disadvantage to venture capital financing is that the investors become part owners of the business, and thus gain a say in business decisions. The company's founders face a dilution of their ownership positions and a possible loss of autonomy or control.

Even for business owners willing to make the trade off, venture capital is scarce and often difficult to obtain. Venture capitalists tend to be highly selective in choosing investments. Some will only consider investments in specific technologies, industries, or geographic areas. In fact, the larger venture capital firms typically reject more than 90 percent of the requests for funding that they receive. They evaluate the remaining requests thoroughly, and at considerable expense, before selecting a few that closely match the investors' areas of expertise and offer the best earnings potential. As a result, private equity financing is more likely to be an option for existing businesses with a solid track record and good prospects for future growth than for start-up companies. It is a particularly good choice for fast-growing companies that have few tangible assets to use as collateral for loans.

For a business owner, the process of obtaining venture capital begins with a formal proposal. The most important element of this proposal is a detailed business plan describing the company's goals and strategies. The proposal should also include recent financial statements, projections of future growth, a brief history of the company, biographies of key managers, the amount of money requested, and a description of how the funds will be used. Experts recommend that companies seeking equity financing evaluate several venture capital firms before entering into a deal. Managers should also hire professionals to help them understand the terms of the agreement to avoid giving away too much control. On receiving a proposal of interest, a venture capital firm usually follows up with a thorough investigation of the company's investment potential. This process might include analyzing financial statements, interviewing customers and suppliers, and meeting with the management team. If the venture capital firm remains interested following the evaluation phase, it usually responds with a proposal of its own, known as a term sheet. The term sheet acts as a blueprint for the investment deal, with provisions covering such issues as the valuation of the investment, voting rights, and liquidation options.

The final terms are decided through negotiations between the business managers and the venture capital firm. One of the most important factors in the negotiation process is agreeing upon the valuation of the business, which determines the amount of equity that is required in exchange for the venture capital (a business with a low valuation must provide a high percentage of equity, and vice versa). As a general rule, venture capital firms seek to control between 30 and 40 percent of equity in the companies in which they invest. This amount allows the venture capital firm to exercise influence without assuming control or eliminating the management team's incentive to grow the business. The venture capital firm usually hopes to achieve a return of three to five times the original investment within five years, by selling its equity either to the company's management or on the public stock markets.

Overall, venture capital can provide a valuable source of financing for growing businesses. Because of its associated risks, however, experts generally suggest that it be viewed as one of a number of potential sources of financing and be used in combination with debt financing whenever possible. "Private equity isn't for the faint of heart," Klein acknowledged. "But then again, entrepreneurs aren't known for being timid."

 It is also a way in which public and private actors can construct an institution that systematically creates networks for the new firms and industries, so that they can progress. This institution helps in identifying and combining pieces of companies, like finance, technical expertise, know-hows of marketing and business models. Once integrated, these enterprises succeed by becoming nodes in the search networks for designing and building products in their domain

SOURCE OF FINANCE
A company would choose from among various sources of finance depending on the amount of capital required and the term for which it is needed. Finance sources can be divided into three categories, namely traditional sources, ownership capital and non-ownership capital. Traditional Sources of Finance

Internal resources have traditionally been the chief source of finance for a company. Internal resources could be a companys assets, factoring or invoice discounting, personal savings and profits that have not been reinvested or distributed among shareholders. Working capital is a short term source of finance and is the money used for a companys day-to-day activities, including salaries, rent, payments for raw materials and electricity bills.

Sources of Finance:

Ownership Capital
Ownership capital is the capital owned by the shareholders of a company. A company can raise substantial funds through an IPO (initial public offering). These funds are usually used

for large

expenses, such as new product development, expansion into a new market and

setting up a new plant. The various types of shares are:

Ordinary shares:
These are also known as equity shares and give the owner the right to share the companys profits and vote at the firms general meetings.

Preference shares:
The owners of these shares may be entitled to a fixed dividend, but usually do not have the right to vote.

Companies that are already listed on a stock exchange can opt for a rights issue, which seeks additional investment from existing shareholders. They could also opt for deferred ordinary shares, wherein the issuing company is not required to pay dividends until a specified date or before the profits reach a certain level.

Unquoted companies (those not listed on stock exchanges) can also issue and trade their shares in over-the-counter (OTC) markets.

Sources of Finance: Non-Ownership Capital

Non-ownership capital includes funds raised from lenders, such as banks and creditors. Companies typically borrow a fixed amount from a bank, at a predetermined interest rate and with a fixed repayment schedule. Certain bank accounts offer overdraft facilities. This is used by companies to meet their short-term fund requirements, as they usually come at a very high interest rate.

Factoring enables a company to raise funds using its outstanding invoices. The company typically receives about 85% of the value of the invoice from the factor. This method is more appropriate for overcoming short-term cash-flow issues.

Hire purchase allows a company to use an asset without immediately paying the complete purchasing price. Trade credit enables a company to obtain products and services from another firm and pay the bill later.

Venture Capital

Firms in the early stages of development can opt for venture capital. This option gives the financing company some ownership as well as influence over the direction of the enterprise.

Duration
Long-term sources of finance: Long-term financing can be raised from the following sources: Share capital or equity share Preference shares Retained earnings Debentures/Bonds of different types Loans from financial institutions Financial institutions Loans from commercial banks Commercial

Short term sources of finance:

the following sources:

Short-term financing can be raised from

Trade credit Commercial banks

Fixed deposits for a period of 1 year or less Advances received from customers Various short-term provisions

Venture Capital Investment Characteristics:

Illiquid - No easy or short-term path to get out of the investment. An investor will most
likely have to wait until the company is able to attract a buy-out or issue an IPO. A liquidity risk premium is a characteristic of the initial investment.

Long-term commitment required - Given the nature of the investment and the
process of developing a viable business, VC investors must make a long-term commitment at least three to five years; however, the profit potential is huge. This is mostly due to the time lag between starting a company and bringing it to a buy-out or IPO.

Difficulty determining market values - Since these assets do not trade in an

active marketplace it's difficult to determine an objective value for the business and the investment. Limited historical risk and return data - This is due to the fact that there are no active trading markets.

Entrepreneurial/management mismatches - Brilliant entrepreneurs don't

always make the best business executives. Management styles that may have worked perfectly during a business's early stages may be disastrous as the company grows larger.

Lack of knowledge of the competitors - Because some entrepreneurs are

developing new businesses, there is generally little information as to who else is working in their space. As such, competitive valuations are difficult to find in the marketplace.

Vintage cycles - The volume of business start-ups is dependent on the economic

climate - some years offer more and better opportunities than others. It all depends on the market and who and when firms are entering and exiting the marketplace.

The venture capital recognises different stages of financing, namely:Early stage financing - This is the first stage financing when the firm is undertaking
production and need additional funds for selling its products. It involves seed/ initial finance for supporting a concept or idea of an entrepreneur. The capital is provided for product development, R&D and initial marketing.

Start-up - Supports product development and initial marketing. Start-up financing

provides funds to companies for product development and initial marketing. This type of financing is usually provided to companies just organized or to those that have been in business just a short time but have not yet sold their product in the marketplace. Generally, such firms have already assembled key management, prepared a business plan and made market studies. At this stage, the business is seeing its first revenues but has yet to show a profit. This is often where the enterprise brings in its first "outside" investors.

First Stage - Capital is provided to initiate commercial manufacturing and sales. Most
first-stage companies have been in business less than three years and have a product or service in testing or pilot production. In some cases, the product may be commercially available.

Later Stage - Capital provided after commercial manufacturing and sales but before
any initial public offering. The product or service is in production and is commercially available. The company demonstrates significant revenue growth, but may or may not be showing a profit. It has usually been in business for more than three years.

Third Stage - Capital provided for major expansion such as physical plant expansion,
product improvement and marketing.

Expansion financing issue.

This is the second stage financing for working capital and

expansion of a business. It involves development financing so as to facilitate the public

Mezzanine (bridge) - Finances the step of going public and represents the bridge
between expanding the company and the IPO

Balanced stage- financing refers to all the stages, seed through mezzanine.

Structure:
Venture capital firms are typically structured as partnerships, the general partners of which serve as the managers of the firm and will serve as investment advisors to the venture capital funds raised. Venture capital firms in the United States may also be structured as limited liability companies, in which case the firm's managers are known as managing members. Investors in venture capital funds are known as limited partners. This constituency comprises both high net worth individuals and institutions with large amounts of available capital, such as state and private pension funds, university financial endowments, foundations, insurance companies, and pooled investment vehicles, called funds of funds

What is involved in the investment process?

The investment process, from reviewing the business plan to actually investing in a proposition, can take a venture capitalist anything from one month to one year but typically it takes between 3 and 6 months. There are always exceptions to the rule and deals can be done in extremely short time frames. Much depends on the quality of information provided and made available.

The key stage of the investment process is the initial evaluation of a business plan. Most approaches to venture capitalists are rejected at this stage. In considering the business plan, the venture capitalist will consider several principal aspects:

- Is the product or service commercially viable? - Does the company have potential for sustained growth? - Does management have the ability to exploit this potential and control the company through the growth phases? - Does the possible reward justify the risk? - Does the potential financial return on the investment meet their investment criteria?

In structuring its investment, the venture capitalist may use one or more of the following types of share capital:

Ordinary shares
These are equity shares that are entitled to all income and capital after the rights of all other classes of capital and creditors have been satisfied. Ordinary shares have votes. In a venture capital deal these are the shares typically held by the management and family shareholders rather than the venture capital firm.

Preferred ordinary shares These are equity shares with special rights.For example, they may be entitled to a fixed dividend or share of the profits. Preferred ordinary shares have votes.

Preference shares
These are non-equity shares. They rank ahead of all classes of ordinary shares for both income and capital. Their income rights are defined and they are usually entitled to a fixed dividend (eg. 10% fixed). The shares may be redeemable on fixed dates or they may be irredeemable. Sometimes they may be redeemable at a fixed premium (eg. at 120% of cost). They may be convertible into a class of ordinary shares.

Loan capital
Venture capital loans typically are entitled to interest and are usually, though not necessarily repayable. Loans may be secured on the company's assets or may be unsecured. A secured loan will rank ahead of unsecured loans and certain other creditors of the company. A loan may be convertible into equity shares. Alternatively, it may have a warrant attached which gives the loan holder the option to subscribe for new equity shares on terms fixed in the warrant. They typically carry a higher rate of interest than bank term loans and rank behind the bank for payment of interest and repayment of capital.

Venture capital investments are often accompanied by additional financing at the point of investment. This is nearly always the case where the business in which the investment is being made is relatively mature or well-established. In this case, it is appropriate for a business to have a financing structure that includes both equity and debt.

Other forms of finance provided in addition to venture capitalist equity include:

Clearing banks -

principally provide overdrafts and short to medium-term loans at

fixed or, more usually, variable rates of interest.

Merchant banks - organise the provision of medium to longer-term loans, usually for
larger amounts than clearing banks. Later they can play an important role in the process of "going public" by advising on the terms and price of public issues and by arranging underwriting when necessary.

Finance houses -

provide various forms of instalment credit, ranging from hire

purchase to leasing often asset based and usually for a fixed term and at fixed interest rates.

Factoring companies - provide finance by buying trade debts at a discount, either

on a recourse basis (you retain the credit risk on the debts) or on a non-recourse basis (the factoring company takes over the credit risk).

Government and European Commission sources to enterprise loans in selective areas.

provide financial

aid to UK companies, ranging from project grants (related to jobs created and safeguarded)

Mezzanine firms - provide loan finance that is halfway between equity and secured
debt. These facilities require either a second charge on the company's assets or are unsecured. Because the risk is consequently higher than senior debt, the interest charged by the mezzanine debt provider will be higher than that from the principal lenders and sometimes a modest equity "up-side" will be required through options or warrants. It is generally most appropriate for larger transactions.

The Advantages of Venture Capital

The primary advantage of venture capital is that they allow entrepreneurs to build their company with OPM (other people's money). If you need financing to build your technology or product and don't have the money to do it yourself, the idea is that the venture capitalists provides the capital to allow you to build. In exchange, the venture capitalist takes some ownership in your company. The venture capitalist then hopes that your company increases in value and ultimately has a liquidity event (e.g. IPO or sells to another company) so that they can get a return on their invested capital. In addition to capital, venture capitalist can be an invaluable source of information, resources and contacts to help you be successful. More times than not, venture capitalists have experience building companies themselves so they can really help you think strategically about how to grow and be successful. There are some benefits to venture capital funding. In many cases, the company able to secure venture capital funds can receive services that may include:

Business Consultations -

Many venture capital firms have consultants on their

staff that is well versed in specific markets. This can help a start up firm avoid many of the pitfalls that are often associated with start-up business ventures.

Management Consultations -

Unfortunately, not all entrepreneurs are good

business managers. Since venture capital firms almost always require a percentage of equity in the start-up firm, they likely will have a say in how the firm is managed. For the nonmanagement expert, this can be a significant benefit.

Human Resources - In terms of finding the best talent for start up firms, venture
capital firms often provide consultants who are specialists in hiring. This can help a start up firm avoid the pitfalls of hiring the wrong people for their company.

Additional Resources -

Starting a new business is fraught with concerns about

legal matters, payroll matters, and tax issues. It is not unusual for a venture capital firm to take an interest in providing these resources since they have a vested interest in the success of the company.

In general, business resources that are provided by venture capital firms who have taken an equity position in a start up company can be invaluable to the success of the company. Many starts up firms securing venture capital are able to thrive and become giants in their industries.

Conclusion

If considering venture capital, the advantages and disadvantages are many. This type of funding is not right for everyone. Those companies who have high growth potential such as electronics manufacturers, green technologies, and other high tech ventures are usually the

ones who fare best with venture capital funding. Before you decide that venture capital is right for you, make sure that you know all of the pros and cons and do your research.

Cons of Venture Capital:

Securing venture capital typically means that you have to give up something in exchange for the funding. Most venture capital firms are not interested in merely receiving the capital that they have invested along with a standard interest rate. In fact, there are some things that venture capital firms may ask for that may surprise you. These include:

Management Position - In many cases, a venture capital firm will want to add a
member of their team to the start up company's management team. This is generally to ensure that the company can be successful, though this can also create internal problems.

Equity Position -

Most venture capital firms require that the company give up an

equity position to them in return for their funding. This amount is not small, in many cases it

can be as much as 60 percent of the equity in the company. In effect, this means that the entrepreneur is not controlling their business; it is being controlled by the venture capital firm.

Decision Making - One of the biggest problems that many entrepreneurs face when
they agree to accept venture capital is they often are giving up many key decisions in how their company will operate. Venture capital firms that have taken an equity position want a "seat at the table" when any major decision is made and they often have the power to override decisions.

Business Plans -

When a business plan is written and submitted for financing

considerations, most finance companies will agree to sign a non-disclosure agreement. This is not the case in most venture capital firms. Venture capital firms will nearly always refuse to sign a non-disclosure agreement due to the legal ramifications of doing so. This can put ideas from an entrepreneur at risk.

Funding Plan -

If an entrepreneur writes their business plan and determines they

need $500,000 to get the business launched, they may be lulled into thinking that these funds will come up front. This is simply not the case. Venture capital firms almost always set goals and milestones for releasing funds. Funding from venture capital firms is typically done in stages with an eye on the expansion of the business.

These are only a few of the possible problems an entrepreneur could face when they secure venture capital funding. It is important that they carefully review all agreements and have them reviewed by an attorney as well.

Need of Venture Capital:

There are entrepreneurs and many other people who come up with bright ideas but lack the capital for the investment. What these venture capitals do are to facilitate and enable the start up phase. When there is an owner relation between the venture capital providers and receivers, their mutual interest for returns will increase the firms motivation to increase profits. Venture capitalists have invested in similar firms and projects before and, therefore, have more knowledge and experience. This knowledge and experience are the outcomes of the experiments through the successes and failures from previous ventures, so they know what works and what does not, and how it works. Therefore, through venture capital involvement, a portfolio firm can initiate growth, identify problems, and find recipes to overcome them.

Limitations: Time Constraint As we have use secondary data so reliability of data is not confirm As our topic is current appropriate data will not be available on our issue