Investment process describes the way in which venture capital assistance is provided to the entrepreneurs. The entrepreneur who has an idea which qualifies for venture capital assistance should contact appropriate and right venture capitalists for assistance.
Selection of investment decision is very important both for the entrepreneur and the capitalists. The proposal for assistance by the entrepreneur to the venture capitalist is the first official step in the investment process.
The venture capital investment process has two aspects, (i) the assessment by the entrepreneur as to whom he should contact for assistance and a comparison of the terms and conditions of various venture capitalists and (ii) assessment of the entrepreneur and his proposal by the investor. Considering the type of industry, nature investment and risk involved in it, the investors generally apply some criteria for investment. Investors consider only those proposals which qualify these stipulations.
The investment process involves the knowledge of the:
(A) Eligibility criteria for evaluating proposals,
(B) Screening of venture capitalist by the entrepreneur,
(C) Screening of entrepreneur and the proposal by the venture capitalists,
(D) Stages of venture capital financing and
(E) Types of finance provided by venture capitalists.
A brief description of these processes is given below:
A. Eligibility Criteria for Proposals:
The minimum eligibility conditions to process an application for venture capital assistance are:
(a) The Venture must be Technically Feasible:
The technology/ idea should have proper technology base and the technology/ idea should have integrity and viability for commercial production. It is to be laboratory proven.
(b) It should be Commercially Viable:
There must be public acceptance for the idea/ technology. If commercial production takes place there should be adequate reason to believe that there will be demand for the item in the market.
(c) The Technical & Managerial Competence and Integrity of the Entrepreneur:
The entrepreneur should have technical competence to apply his idea to production and manage the project to success. The entrepreneur must be reliable and should have consistency in doing.
(d) The Long Run Competitive Advantage of the Units:
The idea should have long run competitive advantage over other existing products/service in the market.
(e) Future Prospects:
The idea should have an excellent future in the coming years. At least the investor should make sure that the product will not become obsolete in the near future.
(f) Availability of Inputs:
Availability of inputs/factors of production is another important factor considered before financing. However good the idea is, if inputs for production are not available in right quantity, it is of no use in commercial applications. Thus the financier prefers only those projects for which inputs are available in right quantity.
(g) Legality of the Proposal:
The financier makes sure that the proposal is legally viable by all respects. That is it satisfies pollution standards, emission standards, government policies, etc.
B. Screening of Venture Capitalist by the Entrepreneur:
There are several venture capital organizations in India both in government sector and in private sector. The lending policies and other terms and conditions of these organizations vary widely. The proposer must be vigilant in selecting the right capitalists.
The following points worth consideration while choosing venture capitalists:
(a) Approach of the Capitalists:
The entrepreneur should assess the approach and attitude of the venture capitalist. Some capitalists show very keen interest and offer all possible value added service (hands on approach) in fields of activity. Hands on approach of capitalist are also called ‘investment nurturing’.
Investment nurturing is the process by which venture capitalists continue to involve themselves in the operations of the concerns assisted by them. It is through personal discussions, plant visits, feedbacks, periodic reports studies etc. that they make it possible. Some capitalists may be very passive in dealing with entrepreneurs (hands off approach). The entrepreneur should approach those who offer very hands on approach.
(b) Terms and Conditions:
The entrepreneurs should assess the implications of each of the terms and conditions laid down in the agreement.
(c) Exit Policy:
The entrepreneur should assess the exit policy of the capitalists. There are several-modes of exit available for the venture capitalist.
(d) Availability of funds:
Financial base and liquidity of the capitalist are other important area to be looked into. It will be easy for one with adequate financial base to provide adequate finance in adequate quantity in times of emergency if it so happens.
(e) Past history of the Capitalists:
Always the past history of the capitalist to be analyzed and to be dealt with only those who have a steady and straight past profile.
(f) Miscellaneous:
Procedural delay, processing charges, rate of interest, duration of advance etc. are other matters of concern.
C. Screening of Entrepreneur and the Proposal by the Venture Capitalists:
As investing in ventures is highly risky the capitalist has to be vigilant in assessing and granting advances to such ventures. The capitalist assess the proposal of entrepreneurs at various stages and apply number of assessment tools to assess the credibility of the proposer, his past history, feasibility of the proposal, amount involved and amount requested by the proposer, future growth prospects of the idea/technology etc.
To assess the potential of the idea and the proposer the venture capitalists apply the following tests and analysis:
1. Fundamental Analysis:
Here the venture capitalists analyses and assesses the fundamental aspects of the proposed business.
It includes analysis and assessment of the following:
(a) Past history:
It assess the past history of the proposer, its date of incorporation, summary of annual reports, profile of the company for years, etc.,
(b) Management:
Here the company assesses the quality of its management It also assess the quality of board of directors, shareholders etc.,
(c) Products:
The capitalist checks the quality and features of the company’s products.
(d) Markets:
The markets which the company serves, nature of industry, degree of competition etc.
(e) Manufacturing:
Manufacturing and operational aspects of the business is to be checked. That is to say the type of technology used, access to sources of supply, manufacturing capacity and the holdings of premises etc. and
(f) Risks:
The capitalist need to assess the potential risk involved in it.
2. Financial Analysis:
The financial analysis is undertaken to assess the performance of the strategies of the organization. The capitalists assesses the earnings growth of the organization, margin of profit, time lag between investment and return, impact on cash flow, expected value of the company at the time divestment and finally anticipated financial risks and the strategies of the management to tie over it. In the assessment for venture capital, financial performance is very vital.
3. Portfolio Analysis:
Here in portfolio analysis the capitalists assess the present portfolio balance of the proposer at the time of proposal. The capitalist also assesses the feasibility of the future portfolio, if the proposal is accepted and loans granted. The proposal will be considered only if the future portfolio is acceptable. Portfolio analysis involves analysis of the size; stage, location and industry of the investment proposal for all these are closely connected with portfolio.
4. Divestment Analysis:
Here the capitalists analyses the opportunity for divestment (Exit). It assesses the method, timing and valuation of the company upon divestment. There are four common ways in which venture capitalists divest their interests in the venture projects. These are called exit mechanisms.
They are:
(i) Trade Sale:
It is in the form of an unexpected or unsolicited bid. Here the venture capitalists sell its interests/investment to a company in a trade. This usually takes place when there are many interested parties to acquire the interests of the financier. The sales may be for the stake of financier alone or may be of the entire company itself.
(ii) Take-Out:
It is the process of selling capitalist’s interests in the venture project to another venture capitalist or financing/ insurance company or pension fund manager or management holding company by way of private placement.
(iii) Earn Out:
Here the entrepreneur himself buys back the stake of venture capitalists at agreed assessed price and the capitalists realize his money with return. So under this method no third party is involved. The entrepreneur will be given an option for this right at the time of investment.
(iv) Floatation/IPO Method:
This is another exit route for the venture capital investment. It is also called IPO (Initial Public Offer). Here securities are issued through stock market for public subscription. It requires strong management team to make the process a success. If securities are given to pre-arranged buyers it is called ‘placing’. If the company places its shares before the public for subscription at a fixed price, it is called ‘offer for sale’. And if the company calls for tenders from the public quoting name, number of shares and price offered it is called ‘tender’.
(v) Puts and Calls Method:
Under this method, the exit takes place through puts and calls. The put option is the right to sell, while the call option is the right of the entrepreneur to buy. For this purpose the capitalists arrives at an agreed price as per agreed formula. The prices of the assets are arrived at using pre-determined formula. They generally use Book value method or P/E ratio or Percentage of sales method or Multiplier cash flow method or independent valuation or agreed price method to arrive the price of the organization.
(vi) Liquidation:
It is resorted to when the venture becomes and utter failure due to tough competition or technology failure, obsolescence etc. Here exit takes place in involuntary manner. Here the entire organization goes into liquidation and the financier gets his share. In short the venture capitalists assess everything as possible before granting advance. Right from feasibility analysis of the proposal till divestment of its stake, the capitalists assess everything possible before advancing money.
D. Stages of Venture Capital Financing:
Venture capital is provided at two separate stages of venture development. They are the early stage financing and the later stage financing.
I. Early Stage Financing:
(i) Seed Capital:
This is an early stage financing in a project life. It is the amount of capital provided to start the business. This will be comparatively small in value. The European Venture Capital Association defines seed capital as “the financing of the initial product development or the capital provided to an entrepreneur to prove the feasibility of a project and qualify for startup capital”.
Research and development projects means the amount required to conduct researches to study the market feasibility other needs before the business starts commercial production. The past history of the entrepreneur and the quality of the project are the major determinants at this stage of financing.
(ii) Startup Capital:
Startup capital is defined as the “capital needed to finance the product development, initial marketing and the establishment of product facilities”.
The word start up signifies the stage where a new activity is launched.
(iii) Second Round Finance:
It means the finance provided to capture more and more markets and to increase production and sales. At this stage venture capitalists advance more debt finance to organizations.
II. Later Stage Financing:
1. Development Capital:
This is provided for purchasing new machineries, plants or expansion of business or to set up new marketing and distribution set up etc. The duration of such finance may be one to three years.
2. Expansion Finance:
This is provided for expansion projects such as bigger factory, larger warehouse, new factories, new products etc. The duration of such loans ranges from one to three years.
3. Replacement Capital:
It is provided to purchase shares of other owners. This may be due to family problems or personal need of funds or so. This type of finance has duration of one to three years.
4. Turnarounds:
This means financing for acquisition of a sick company which requires much specialized skills. It requires rescheduling of all the company’s borrowings, management and ownership. It is a highly risky financing and its duration is for three to five years. In such cases the financing company sometimes nominates its chairman and appoints its nominees in the director board of the company.
5. Management Buy Outs (MBOs):
It refers to the transfer of management control by creating a separate business by separating it from their existing owners. This takes place in two forms, namely MBOs and MBIs. Financing the existing client to acquire another existing product line/business is called Management Buyouts (MBO). The European Venture Capital Association defines MBOs as “the acquisition of a company (or the shares in that company) from the existing owners by a team of existing management/employees.
The vending shareholders may or may not have been actively involved in the running of the company, the acquiring groups are presumed to be actively involved in the day-to-day running of the company and are making the acquisition with a view towards becoming active owner-managers.” Deals pertaining to the purchase of management holding of an enterprise are called ‘buy -out-deals’.
6. Management Buy In (MBIs):
Financing an outsider group to acquire an existing company is called Management Buy In (MBIs). The European Venture Capital Association defines MBIs as “funds provided to enable a manager or group of managers from outside the company to buy-in the company with the support of venture capital investors”. It is highly risky than buy-outs.
7. Mezzanine Finance:
It is the last stage in equity related financing to venture projects. It is finance given to private companies in the final run up to a trade sale or a public issue. It is a type of secured credit provided as bridge finance with a maturity of less than two years. Sometimes it is given as high-raking equity (preference shares).
It is to be noted that venture capital is provided at all stages of the project life cycle. The financier is there with the entrepreneur at all wakes of his business. It provides finance when in need; it provides skill and knowledge if needed and facilitates easy launching and marketing of products. Before investment the proposals have to be analyzed in detail for its credibility and feasibility. Following methods are popularly used in the assessment of VC proposals.
E. Types of Finance Provided by Venture Capitalists:
Venture capitalists provide funds for feasible ventures only. Feasibility of the projects is assessed by the financier. Moreover financiers specialize in some areas of investment. Some financiers provide finance for seed capital requirements, some for early expansion schemes and some for exit financing. Apart from the above some financiers concentrate on software industry, some on health care and some on agri-based units.
Whatever be the area of finance, financiers provide finance in any of the following ways:
a. Equity:
One of the most common forms of venture capital financing is by way of purchasing equity of the venture. Financiers purchase a maximum of 49% of the total equity of the venture. Thus the ownership and management always rests with entrepreneur. This is the safest form of financing for entrepreneur as it involves no periodical or annual payments.
b. Conditional Loan:
It is another form of venture financing. It is a debt and the borrower needs to pay financier. It is provided sometimes at no interest and sometimes at a nominal interest. This is fixed considering the project and the borrower. In addition the borrower is to pay a royalty to the lender. The royalty is fixed as a percentage of the turnover. As it is set as a percentage of turnovers, this will not affect the entrepreneur badly. Later on when the venture picks up in business the rates of interest will be increased and royalty decreased.
c. Convertible Loans:
These are loans but have an option to convert to equity shares if the venture fails to make interest payments in time.
d. Income Notes:
It is another form of investment. It is a compromise between conventional loans and conditional loans. The assisted firms are to pay both interest and royally on sales but at substantially lower rate.