• Strategic role of VC
• Angels&CorporateVenturing
• VC Process

Strategic role of a Venture Capitalist

Venture capital is money provided by professionals who invest alongside management in young, rapidly growing companies that have the potential to develop into significant economic contributors. Venture capital is an important source of equity for start-up companies. Venture capital acts as an intermediary between investors looking for high returns and entrepreneurs in need of capital.

Venture capitalists generally have a long-term orientation and take higher risks with the expectation of higher rewards. They add value to the company through active participation by providing management and business skills, contacts and strategy formulation. Their considerations while lending are management term and market potential rather than collateral.

Venture capitalists mitigate the risk of investing by developing a portfolio of young companies in a single venture fund. Many times they co-invest with other professional venture capital firms. In addition, many venture partnerships manage multiple funds simultaneously. For decades, venture capitalists have nurtured the growth of America's high technology and entrepreneurial communities resulting in significant job creation, economic growth and international competitiveness.

In India, these funds are governed by the Securities and Exchange Board of India (SEBI) guidelines. According to this, venture capital fund means a fund established in the form of a company or trust, which raises monies through loans, donations, issue of securities or units as the case may be, and makes or proposes to make investments in accordance with these regulations. (Source: SEBI (Venture Capital Funds) Regulations, 1996)

Difference between a venture capitalist and bankers/money managers

Banker is a manager of other people's money while the venture capitalist is basically an investor.

Venture capitalist generally invests in new ventures started by technocrats who generally are in need of entrepreneurial aid and funds.

Venture capitalists generally invest in companies that are not listed on any stock exchanges. They make profits only after the company obtains listing.

The most important difference between a venture capitalist and conventional investors and mutual funds is that he is a specialist and lends management support and also

• Financial and strategic planning
• Recruitment of key personnel
• Obtain bank and other debt financing
• Access to international markets and technology
• Introduction to strategic partners and acquisition targets in the region
• Regional expansion of manufacturing and marketing operations
• Obtain a public listing

Stages in Venture Financing

• 1. Early stage financing
  • Seed financing for supporting a concept or idea
  • R&D financing for product development
  • Start-up capital for initiating operations and developing prototypes
  • First stage financing for production and marketing
• 2. Expansion financing
  • Second stage financing for working capital and initial expansion
  • Development financing for major expansion
  • Bridge or mezzanine financing for facilitating public issue
• 3. Acquisition/buyout financing
  • Acquisition financing for acquiring another firm for further growth
  • Management buyout financing for enabling operating group to acquire the firm or part of its business
  • Turnaround financing

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Angels

Angels are people with less money orientation, but who play an active role in making an early-stage company work. They are people with enough hands-on experience and are experts in their fields. They understand the field from an operational perspective. An entrepreneur needs this kind of expertise. He also needs money to make things happen. Angels bring both to the table of an entrepreneur.

Angels are important links in the entire process of venture capital funding. This is because they support a fledging enterprise at a very early stage - sometime even before commercialization of the product or service offering. Typically, an angel is an experienced industry-bred individual with high net worth.

Angels provide funding by "first round" financing for risky investments - risky because they are a young /start-up company or because their financial track record is unstable. This venture capital financing is typically used to prepare the company for "second round" financing in the form of an initial public offering (IPO). Example - A company may need "first round" financing to develop a new product line, (viz a new drug which would require significant research & development funding) or make a strategic acquisition to achieve certain levels of growth & stability.

It is important to choose the right Angel because they will sit on your Board of Directors, often for the duration of their investment and will assist in getting "second round" financing. When choosing an 'Angel', it is imperative to consider their experience in a relevant industry, reputation, qualifications and track record.

There are a number of professionally qualified people, especially from IITs who had migrated to USA. Some of them have made their millions riding the IT boom in Silicon Valley. Having witnessed the maturity of the Silicon Valley into the global tech hotspot and thrived in the environment there, these individuals are rich in terms of financial resources and experience. They are the latest angels in the Indian industry.

Corporate Venturing

Even though corporate venturing is an attractive alternative, most companies find it difficult to establish systems, capabilities and cultures that make good venture capital firms. Corporate managers seldom have the same freedom to fund innovative projects or to cancel them midstream. Their skills are honed for managing mature businesses and not nurturing start up companies. If a firm is to apply the venture capital model, it must understand the characteristics of the model and tailor its venture capital program to its own circumstances without losing sight of these essentials.

Success of venture capital firms rest on the following characteristics: manage portfolios ruthlessly, abandon losers, and focus on specific industry niches. Although corporate managers have a clear focus in their business, they run into ambiguity with venture programs. Their biggest challenge is to establish clear, prioritized objectives. Simply making a good financial return is not sufficient.

Manage portfolios ruthlessly, abandon losers, whereas abandoning ventures has never been easy for large corporations, whose projects are underpinned by personal relationships, political concerns.

Venture capital firms share several attributes with the start-ups they fund. They tend to be small, flexible and quick to make decisions. They have flat hierarchies and rely heavily on equity and incentive pay.

Apple Computers established a venture fund in 1986 with the dual objectives of earning high financial return and supporting development of Macintosh software. They structured compensation mechanisms, decision criteria and operating procedures on those of top venture capital firms. While they considered Macintosh as an initial screening factor, its funding decisions were aimed at optimizing financial returns. The result was an IRR of 90 per cent but little success in improving the position of Macintosh.

New ventures can be powerful source of revenues, diversification and flexibility in rapidly changing environments. The company should create an environment that encourages venturing. An innovative culture cannot be transplanted but must evolve within the company. Venture investing requires different mindset from typical corporate investors.

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Venture capital Investment process

In generating a deal flow, the venture capital investor creates a pipeline of 'deals' or investment opportunities that he would consider investing in. This is achieved primarily through plugging into an appropriate network. The most popular network obviously is the network of venture capital funds/investors. It is also common for venture capitals to develop working relationships with R&D institutions, academia, etc, which could potentially lead to business opportunities. Understandably the composition of the network would depend on the investment focus of the venture capital funds/company. Thus venture capital funds focussing on early stage technology based deals would develop a network of R&D centers working in those areas. The network is crucial to the success of the venture capital investor. It is almost imperative for the venture capital investor to receive a large number of investment proposals from which he can select a few good investment candidates finally.

First, you need to work out a business plan. The business plan is a document that outlines the management team, product, marketing plan, capital costs and means of financing and profitability statements.

1. Initial Evaluation: This involves the initial process of assessing the feasibility of the project.

2. Due diligence: In this stage an in-depth study is conducted to analyse the feasibility of the project.

3. Deal structuring and negotiation: Having established the feasibility, the instruments that give the required return are structured.

4. Investment valuation

5. Documentation: This is the process of creating and executing legal documents to protect the interest of the venture.

6. Monitoring and Value addition: In this stage, the project is monitored by executives from the venture fund and undesirable variations from the business plan are dealt with.

7. Exit: This is the final stage where the venture capitalist devises a method to come out of the project profitably.

1. Initial Evaluation:

Before any in depth ananlysis is done on a project, an initial screening is carried out to satisfy the venture capitalist of certain aspects of the project. These include

• Competitive aspects of the product or service
• Outlook of the target market and their perception of the new product
• Abilities of the management team
• Availability of other sources of funding
• Expected returns
• Time and resources required from the venture capital firm

Through this screening the venture firm builds an initial overview about the

• Technical skills, experience, business sense, temperament and ethics of the promoters
• The stage of the technology being used, the drivers of the technology and the direction in which it is moving
• Location and size of market and market develpment costs, driving forces of the market, competitors and share, distribution channels and other market related issues
• Financial facts of the deal
• Competitive edge available to the the comany and factors affecting it significantly
• Advantages from the deal for the venture capitalist
• Exit options available

2. Due diligence

Due diligence is term used that includes all the activities that are associated with investigating an investment proposal to assess feasibility. It includes carrying out in-depth reference checks on the proposal related aspects such as management team, products, technology and market. Additional studies and collection of project-based data are done during this stage. The important feature to note is that venture capital due diligence focuses on the qualitative aspects of an investment opportunity.

Areas of due diligence would include

General assessment

• business plan analysis
• contract details
• collaborators
• corporate objectives
• SWOT analysis
• Time scale of implementation

People

• Managerial abilities, past performance and credibility of promoters
• Financial background and feedback about promoters from bankers and previous lenders
• Details of Board of Directors and their role in the activities
• Availability of skilled labour
• Recruitment process

Products/services, technology and process

In this category the type of questions asked will depend on the nature of the industry into which the company is planning to enter. Some of the areas generally considered are

• Technical details, manufacturing process and patent rights
• Competing technologies and comparisons
• Raw materials to be used, their availability and major suppliers, reliability of these suppliers
• Machinery to be used and its availability
• Details of various tests conducted regarding the new product
• Product life-cycle
• Environment and pollution related issues
• Secondary data collection on the product and technology, if so available

Market

The questions asked under this head also vary depending on the type of product. Some of the main questions asked are

• main customers
• future demand for the product
• competitors in the market for the same product category and their strategy
• pricing strategy
• potential entrants and barriers to entry
• supplier and buyer bargaining power
• channels of distribution
• marketing plan to be followed
• future sales forecasts

Market survey could be conducted to gather further more accurate and relevant data.

Finance

• Financial forecasts for the next 3-5 years
• Analysis of financial reports and balance sheets of firms already promoted or run by the promoters of the new venture
• Cost of production
• Wage structure details
• Accounting process to be used
• Financial report of critical suppliers
• Returns for the next 3-5 years and thereby the returns to the venture fund
• Budgeting methods to be adopted and budgetary control systems
• External financial audit if required

Sometimes, companies may have experienced operational problems during their early stages of growth or due to bad management. These could result in losses or cash flow drains on the company. Sometimes financing from venture capital may end up being used to finance these losses. They avoid this through due diligence and scrutiny of the business plan.

3. Structuring a deal

Structuring refers to putting together the financial aspects of the deal and negotiating with the entrepreneurs to accept a venture capital's proposal and finally closing the deal. Also the structure should take into consideration the various commercial issues (ie what the entrepreneur wants and what the venture capital would require to protect the investment).

The instruments to be used in structuring deals are many and varied. The objective in selecting the instrument would be to maximize (or optimize) venture capital's returns/protection and yet satisfy the entrepreneur's requirements. The instruments could be as follows:

Instrument	Issues
Equity Shares	new or vendor shares, par value, partially-paid shares
Preference shares	redeemable, participating, par value, nominal shares
Loan	Loan clean vs. Secured, interest bearing vs. Non-interest bearing convertible, 1st charge, 2nd charge, loan vs. Loan stock, maturity
Warrants	exercise price, expiry period
Options	exercise price, expiry period, call, put

In structuring a deal, it is important to listen to what the entrepreneur wants, but the venture capital comes up with his own solution. Even for the proposed investment amount, the venture capital decides whether or not the amount requested, is appropriate and consistent with the risk level of the investment. The risks should be analyzed, taking into consideration the stage at which the company is in and other factors relating to the project. (eg exit problems, etc).

A typical proposal may include a combination of several different instruments listed above. Under normal circumstances, entrepreneurs would prefer venture capitals to invest in equity as this would be the lowest risk option for the company. However from the venture capitals point of view, the safest instrument, but with the least return, would be a secured loan. Hence, ultimately, what you end up with would be some instruments in between which are sold to the entrepreneur. A number of factors affect the choice of instruments, such as -

4. Investment valuation

The investment valuation process is an exercise aimed at arriving at 'an acceptable price' for the deal. Typically in countries where free pricing regimes exist, the valuation process goes through the following steps:

1.Evaluate future revenue and profitability

2.Forecast likely future value of the firm based on experienced market capitalization or expected acquisition proceeds depending upon the anticipated exit from the investment.

3.Target ownership positions in the investee firm so as to achieve desired appreciation on the proposed investment. The appreciation desired should yield a hurdle rate of return on a Discounted Cash Flow basis.

4.Symbolically the valuation exercise may be represented as follows:

NPV = [(Cash)/(Post)] x [(PAT x PER)] x k,

where

a. NPV = Net Present Value of the cash flows relating to the investment comprising outflow by way of investment and inflows by way of interest/dividends (if any) and realization on exit. The rate of return used for discounting is the hurdle rate of return set by the venture capital investor.

b. Cash represents the amount of cash being brought into the particular round of financing by the venture capital investor.

c. 'Pre' is the pre-money valuation of the firm estimated by the investor. While technically it is measured by the intrinsic value of the firm at the time of raising capital. It is more often a matter of negotiation driven by the ownership of the company that the venture capital investor desires and the ownership that founders/management team is prepared to give away for the required amount of capital

d. PAT is the forecast Profit after tax in a year and often agreed upon by the founders and the investors (as opposed to being 'arrived at' unilaterally). It would also be the net of preferred dividends, if any.

e. PER is the Price-Earning multiple that could be expected of a comparable firm in the industry. It is not always possible to find such a 'comparable fit' in venture capital situations. That necessitates, therefore, a significant degree of judgement on the part of the venture capital to arrive at alternate PER scenarios.

f. 'k' is the present value interest factor (corresponding to a discount rate 'r') for the investment horizon.

It is quite apparent that PER time PAT represents the value of the firm at that time and the complete expression really represents the investor's share of the value of the investee firm. The following example illustrates this framework:

Example: Best Mousetrap Limited (BML) has developed a prototype that needs to be commercialized. BML needs cash of Rs2mn to establish production facilities and set up a marketing program. BML expects the company will go public in the third year and have revenues of Rs70mn and a PAT margin of 10% on sales. Assume, for the sake of convenience that there would be no further addition to the equity capital of the company.

Prudent Fund Managers (PFM) propose to lead a syndicate of like minded investors with a hurdle rate of return of 75% (discounted) over a five year period based on BML's sales and profitability expectations. Firms with comparable sales and profitability and risk profiles trade at 12 times earnings on the stock exchange. The following would be the sequence of computations:

In order to get a 75% return p.a. the initial investment of Rs2 million must yield an accumulation of 2 x (1.75)5 = Rs32.8mn on disinvestment in year 5.

BML's market capitalization in five years is likely to be Rs (70 x 0.1 x 12) million = Rs84mn.

Percentage ownership in BML that is required to yield the desired accumulation will be (32.8/84) x 100 = 39%

Therefore the post money valuation of BML At the time of raising capital will be equal to Rs(2/0.39) million = Rs5.1 million which implies that a pre-money valuation of Rs3.1 million for BML

Another popular variant of the above method is the First Chicago Method (FCM) developed by Stanley Golder, a leading professional venture capital manager. FCM assumes three possible scenarios - 'success', 'sideways survival' and 'failure'. Outcomes under these three scenarios are probability weighted to arrive at an expected rate of return:

In reality the valuation of the firm is driven by a number of factors. The more significant among these are:

• Overall economic conditions: A buoyant economy produces an optimistic long- term outlook for new products/services and therefore results in more liberal pre-money valuations.
• Demand and supply of capital: when there is a surplus of venture capital of venture capital chasing a relatively limited number of venture capital deals, valuations go up. This can result in unhealthy levels of low returns for venture capital investors.
• Specific rates of deals: such as the founder's/management team's track record, innovation/ unique selling propositions (USPs), the product/service size of the potential market, etc affects valuations in an obvious manner.
• The degree of popularity of the industry/technology in question also influences the pre-money. Computer Aided Skills Software Engineering (CASE) tools and Artificial Intelligence were one time darlings of the venture capital community that have now given place to biotech and retailing.
• The standing of the individual venture capital Well established venture capitals who are sought after by entrepreneurs for a number of reasons could get away with tighter valuations than their less known counterparts.
• Investor's considerations could vary significantly. A study by an American venture capital, VentureOne, revealed the following trend. Large corporations who invest for strategic advantages such as access to technologies, products or markets pay twice as much as a professional venture capital investor, for a given ownership position in a company but only half as much as investors in a public offering.
• Valuation offered on comparable deals around the time of investing in the deal.

Quite obviously, valuation is one of the most critical activities in the investment process. It would not be improper to say that the success for a fund will be determined by its ability to value/price the investments correctly.

Sometimes the valuation process is broadly based on thumb rule metrics such as multiple of revenue. Though such methods would appear rough and ready, they are often based on fairly well established industry averages of operating profitability and assets/capital turnover ratios

Such valuation as outlined above is possible only where complete freedom of pricing is available. In the Indian context, where until recently, the pricing of equity issues was heavily regulated, unfortunately valuation was heavily constrained.

5. Documentation

It is the process of creating and executing legal agreements that are needed by the venture fund for guarding of investment.

Based on the type of instrument used the different types of agreements are

• Equity Agreement
• Income Note Agreement
• Conditional Loan Agreement
• Optionally Convertible Debenture Agreement etc.

There are also different agreements based on whether the agreement is with the promoters or the company. The different legal documents that are to be created and executed by the venture firm are

Shareholders agreement - This agreement is made between the venture capitalist, the company and the promoters. The agreement takes into account

1. Capital structure

2. Transfer of shares: This lays the condition for transfer of equity between the equity holders. The promoters cannot sell theri shares without the prior permission of the venture capitalist.

3. Appointment of Board of Directors

4. Provisions regarding suspension/cancellation of the investment. The issues under which such cancellation or suspension takes place are default of covenants and conditions, supply of misleading information, inability ot pay debts, disposal and removal of assets, refusal of disbursal by other financial institutions, proceedings against the company, and liquidation or dissolution of the company.

l Equity subscription agreement - This is the agreement between the venture capitalist and the company on:

1. Number of shares to be subscribed by the venture capitalist

2. Purpose of the subscription

3. Predisbursement conditions that need to be met

4. Submission of reports to the venture capitalist

5. Currency of the agreement

• Deed of Undertaking - The agreement is signed between the promoters and the venture capitalist wherein the promoter agrees not to withdraw, transfer, assign, pledge, hypothecate etc their investment without prior permission of the venture capitalist. The promoters shall not diversify, expand or change product mix without permission.
• Income Note Agreement - It contains details of repayment, interest, royalty, conversion, dividend etc.
• Conditional Loan Agreement - It contains details on the terms and conditions of the loan, security of loan, appointment of nominee directors etc.
• Deed of Hypothecation, Shortfall Undertaking, Joint and Several Personal Guarantee, Power of Attorney etc.

Whenever there is a modification in any of the agreements, then a Supplementary Agreement is created for the same.

6. Monitoring and follow up

The role of the venture capitalist does not stop after the investment is made in the project. The skills of the venture capitalist are most required once the investment is made. The venture capitalist gives ongoing advice to the promoters and monitors the project continuously.

It is to be understood that the providers of venture capital are not just financiers or subscribers to the equity of the project they fund. They function as a dual capacity, as a financial partner and strategic advisor.

Venture capitalists monitor and evaluate projects regularly. They are actively involved in the management of the of the investee unit and provide expert business counsel, to ensure its survival and growth. Deviations or causes of worry may alert them to potential problems and they can suggest remedial actions or measures to avoid these problems. As professional in this unique method of financing, they may have innovative solutions to maximize the chances of success of the project. After all, the ultimate aim of the venture capitalist is the same as that of the promoters - the long term profitability and viability of the investee company. The various styles are

Hands-on Style suggests supportive and direct involvement of the venture capitalist in the assisted firm through Board representation and regularly advising the entrepreneur on matters of technology, marketing and general management. Indian venture capitalists do not generally involve themselves on a hands-on basis bit they do have board representations.

Hands-off Style involves occasional assessment of the assisted firms management and its performance with no direct management assistance being provided. Indian venture funds generally follow this approach.

Intermediate Style venture capital funds awe entitled to obtain on a regular basis information about the assisted projects.

7. Exit

One of the most crucial issues is the exit from the investment. After all, the return to the venture capitalist can be realized only at the time of exit. Exit from the investment varies from the investment to investment and from venture capital to venture capital. There are several exit routes, buy-buck by the promoters, sale to another venture capitalist or sale at the time of Initial Public Offering, to name a few. In all cases specialists will work out the method of exit and decide on what is most profitable and suitable to both the venture capitalist and the investee unit and the promoters of the project.

At present many investments of venture capitalists in India remain on paper as they do not have any means of exit. Appropriate changes have to be made to the existing systems in order that venture capitalists find it easier to realize their investments after holding on to them for a certain period of time. This factor is even more critical to smaller and mid sized companies, which are unable to get listed on any stock exchange, as they do not meet the minimum requirements for such listings. Stock exchanges could consider how they could assist in this matter for listing of companies keeping in mind the requirement of the venture capital industry.

To provide the lenders with additional security, a Special Purpose Vehicle (SPV) can be created, which would hold the shares bought back from the venture capitalist firm in a trust until the firm achieves a certain targeted rate of return. Meanwhile a certain proportion of the firm's sale proceeds can be funneled directly to the SPV t amortize the debt.

An exit via the capital market is certainly less expensive but this option is open only to the more established firms. A listing on a stock exchange, which would enable the venture capitalist to easily off-load his stake, is obviously a far more feasible proposition for a firm already in existence for a few years than for a new venture.

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