Venture Capital
What is Venture Capital/Private
Equity?
• Venture capital is a subset of private equity and
refers to equity investments m...
• Private equity provides equity capital to
enterprises not quoted on a stock market.
Why companies need financing?
• For start-ups or growing companies, as well as those
facing a major change, financing is o...
• During their start-up, growth and expansion
stages, the companies are often faced with
the fact that the incoming cash f...
• A long product development stage and slow
market penetration prolong the negative cash
flow period.
• The company can ha...
Operative financing
• To bridge the deficit in operative financing, the
company has the following choice of available
meas...
External financing
• Should these measures not be sufficient, the
• company has the following alternatives:
• to acquire e...
The Process of acquiring Venture
Capital financing
• The actual venture capital investment made in a
company is preceded b...
• The initial assessment is made relatively
rapidly and therefore the company should pay
attention to two aspects:
• the b...
The Process of acquiring Venture
Capital financing
• The central issues considered by the venture
capital investor at this...
The Process of acquiring Venture
Capital financing
• Besides the company's business plan, the
venture capital investor wil...
• The decisive investment strategy criteria may
be company size, development stage, branch
or geographical location.
• Con...
• Should the investor decide that the
investment request meets his criteria, the
following step is a meeting arranged with...
• The third stage, or the due diligence stage,
involves a thorough study of the target
company by the venture capital inve...
• Other vital issues include the size and
development of the company's target market,
• the competitiveness of the company...
• During the second and third stage of the
assessment process, the investor determines
the value of the company.
• Once th...
• The entry valuation of investor will depend on
factors such as investors return expectations,
and the view of the opport...
• The intention is to liquidate the shareholding in
early phase companies after 4-8 years and in
companies with follow-on ...
Stages of Investments
• Early stage companies may have proprietary
technology or intellectual property that has
the potent...
• Mid-stage companies may have strong
pipeline of technologies and products, which
has been developed by research and
mana...
• Later stage companies have operational and
corporate finance skills ideally positioned and
company may need investments ...
VC’s contribution to entrepreneur
• In addition to money, professional VC as a
shareholder bring strong industry,
operatio...
• Through the VC’s expertise and network the
portfolio companies could gain access to:
• a) follow-on capital through vent...
VC’s contribution to entrepreneur
• VC adds the most value by assisting in the
creation of the best possible team to manag...
Seed stage financing
• The venture is still in the idea formation stage
and its product or service is not fully
developed....
• It's rare for a venture capital firm to fund this
stage.
• In most cases, the money must come from the
founder's own poc...
Start up financing
• The venture at this point has at least one
principal working full time.
• The search is on for the ot...
First -stage financing
• The venture has finally launched and achieved
initial traction.
• Sales are trending upwards.
• A...
• The funding from this stage is used to fuel
sales, reach the breakeven point., increase
productivity, cut unit costs, as...
Second -stage financing
• Sales at this point are starting to snowball.
• The company is also rapidly accumulating account...
Mezzanine or Bridge financing
• At this point the company is a proven winner and
investment bankers have agreed to take it...
• The funding may come from a venture capital
firm or bridge financing specialist.
• They are usually paid back from the p...
Initial Public Offering (IPO)
• The company finally achieves liquidity by
being allowed to have its stock bought and
sold ...
Types of VCs:
• – Angel investors
• – Financial VCs
• – Strategic VCs
Angel Investors
• Typically a wealthy individual
• • Often with a tech industry background, in position to
judge high-risk...
Financial VCs
• Most common type of VC
• • An investment firm, capital raised from
• institutions and individuals
• • Ofte...
Strategic VCs
• Typically a (small) division of a large technology
company
• • Examples: Intel, Cisco, Siemens, AT&T
• • C...
The Funding Process: Single Round
• Company and interested VCs find each other
• • Company makes it pitch to multiple VCs:...
Terms of Investment
• Initially laid out in a term sheet (not binding!)
• • Valuation + investment à VC equity (share)
• •...
Basics of Valuation
• Pre-money valuation V: agreed value of company prior to this
round’s investment (I)
• • Post-money v...
Board Seats and Reserved Matters
• Corporate boards:
• – Not involved in day-to-day operations
• – Hold extreme control in...
So What Do VCs Look For?
• Committed, experienced management
• • Defensible technology
• • Growth market
• • Significant r...
Exits
• Depending on the investment focus and strategy of the
venture firm, it will seek to exit the investment in the
por...
IPO
• The initial public offering is the most glamorous and
visible type of exit for a venture investment.
• In recent yea...
• Once this stock is freely tradable, usually after about
two years, the venture fund will distribute this stock
or cash t...
Mergers and Acquisitions
• Mergers and acquisitions represent the most
common type of successful exit for venture
investme...
48
• Where Does Venture Capital Money Come From?
• How are Venture Capital Funds Organized?
• How do Venture Capitalists m...
49
• Where Does Venture Capital Money Come From?
• Professional Venture Capital Firms raise money from Insurance
Companies...
50
• How are Venture Capital Funds Organized?
• Most Venture Capital Funds are Limited Partnerships:
Venture Capital Fund
...
51
• What Do Venture Capitalists Do?
• Source Deals
• The GPs have to “source” deals- I.e. find investment opportunities. ...
52
• What Do Venture Capitalists Do?
• Manage The Investment
• The GP/VCs have a fiduciary duty to the LPs to “manage” the...
53
• Economics of the Venture Capital Fund - CAPITAL
• Capital Commitments
• The Limited Partners do not actually invest m...
54
• Economics of the Venture Capital Fund – VC Compensation
• Management Fees
• The General Partners receive an annual Ma...
55
• Economics of the Venture Capital Fund – VC Compensation
• Splitting the Returns
• The GP/VCs make investments and the...
©2000, Entrepreneurial Finance, Smith and Kiholm Smith Chapter 14
Organizational Structure of
Venture Capital Investment
P...
57
• Economics of the Venture Capital Fund – VC Compensation
• Compensation Drives Behavior
• The Split Formula provides a...
58
• Economics of the Venture Capital Fund – VC Compensation
• Example (continued)
• Assume the average “win” returns to t...
59
• Economics of the Venture Capital Fund – VC Compensation
• Example (continued)
• This is how the Return Splits would w...
60
• Economics of the Venture Capital Fund – VC Compensation
• Sensitivity of Returns
• Notice what happens if the 5 winni...
61
• Fund Investment Cycle
• Fund Life
• Most Funds have a 10 year life. At the end of 10 years they are liquidated.
• Fun...
62
• Follow-On Funds
• Once the initial investments have been made in Fund 1, the VCs are motivated to
raise Fund 2 so the...
63
• Things For the Entrepreneur To Think About
• Does Your Plan Fit the Needs of the Venture Capital Fund?
• As you can s...
64
• Things For the Entrepreneur To Think About
• Are You Prepared to Become a Minority Stockholder?
• As the examples sho...
VENTURE CAPITAL
Myths about Venture Capital
Financing
$ VCs want no less than 50% OwnershipVCs want no less than 50% Owner...
VENTURE CAPITAL
Myths about Venture Capital FinancingMyths about Venture Capital Financing
$ VCs dominate the Private Equi...
VENTURE CAPITAL
Myths about Venture CapitalMyths about Venture Capital
FinancingFinancing
$ VCs expect to Earn a 700% Rate...
The Venture Capital Process
• Find Deals
• Research Deals – A 3-6 Month Process
• Structure and Close Deals
• Manage The I...
Some Statistics
• 99%+ of All Startups Do Not Require
Institutional Venture Capital
• VCs average initial investment is $3...
When Is VC Good
• Heavy R&D Component of the business
– Seminconductors
– Biotech
– Datacomm Equipment
• Very Large Opport...
The Cost of Venture Capital
• Dilution
– Average founder who uses VC owns less than 10%
of the business upon exit
• Liquid...
• Some of the unique features of a VC firm are
Investment in high-risk, high-returns
ventures
• As VCs invest in untested, innovative ideas the
investments entail high r...
Participation in management
• Besides providing finance, venture capitalists
may also provide technical, marketing and
str...
Expertise in managing funds
• VCs generally invest in particular type of
industries or some of them invest in particular
t...
Raises funds from several sources
• A misconception among people is that
venture capitalists are rich individuals who
come...
Diversification of the portfolio
• VCs reduce the risk of venture investing by
developing a portfolio of companies and the...
Exit after specified time
• VCs are generally interested in exiting from a
business after a pre-specified period. This
per...
Venture Capital in India
What specific areas in India interest
VCs?
• Non-data, non-voice mobile phone applications.
• Internet-based technologies....
Setting the stage - Venture Capital in
India
• Phase I - Formation of TDICI in the 80’s and
regional funds as GVFL & APIDC...
The First Stage, 1986–1995
TDICI
• In 1988, the first organization to actually identify
itself as a venture capital operation,
• Technology Developme...
GVFL
• In 1990, Gujarat Venture Finance Limited
(GVFL) began operations with a 240 million
rupee fund with investments fro...
APDIC
• The Andhra Pradesh state government formed
a venture fund subsidiary in its AP Industrial
Development Corporation ...
The Second Stage, 1995–1999
• This stage saw the entrance of foreign
institutional investors.
• This included investment a...
• The formalization of the Indian venture capital
community began in 1993 with the formation
of the Indian Venture Capital...
• Phase III - (2000 onwards). Emergence of
successful India-centric VC firms
• Phase IV – (current) Global VCs and PE firm...
Number Of Investments
Investor 2005 2006 2007 2008 2009 Total
Sequoia Capital India 7 12 13 18 3 53
Ventureast 5 11 4 9 3 ...
Value Of Investments ($ mn)
Investor 2005 2006 2007 2008 2009 Total
Sequoia Capital India 42 184 114 138 26 504
Intel Capi...
Regulatory Framework
Foreign Venture Capital Investor
• An FVCI (or Foreign Venture Capital Investor) is
an investor incorporated or establishe...
• Although foreign private equity players and
offshore VCFs can invest in India directly
under the Foreign Direct Investme...
• The shares acquired by a FVCI in an unlisted company are
not subject to the one year lock-up period upon the Initial
Pub...
Lock-up requirements
• The SEBI, through the DIP Guidelines, has stipulated lock-
up requirements on shares of promoters t...
• While considering an FVCI application, the
SEBI does review the applicant’s track record,
professional competence, finan...
• While registration under the FVCI Regulations
is not compulsory, the Indian Government has
sought to make this registrat...
• Mauritius has traditionally been the most favored
jurisdiction for incorporation to invest in India.
• A company incorpo...
SEBI Venture Capital Funds (VCFs)
Regulations, 1996
• According to these regulations, a VCF means a
fund established in th...
VCU
• A VCU means a domestic company
• Whose shares are not on a recognized stock
exchange in India.
• Which is engaged in...
• All VCFs must be registered with SEBI and pay
Rs 25,000 as application fee and Rs 5,00,000
as registration fee for grant...
Questions for Revision
• What is Venture Capital ? What is Private
Equity?
• What is the process of acquiring Venture
Capi...
Questions for Revision
• Write a short note on exit for Venture Capital
Funds?
• Where Does Venture Capital Money Come
Fro...
Questions for Revision
• Write a short Note on Venture Capital in
India?
• Write a short note on the regulatory
framework ...
The End
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Venture Capital

  1. 1. Venture Capital
  2. 2. What is Venture Capital/Private Equity? • Venture capital is a subset of private equity and refers to equity investments made for the launch, early development, or expansion of a business • Among different countries, there are variations in what is meant by venture capital and private equity • In Europe, these terms are generally used interchangeably and venture capital thus includes management buy-outs and buy-ins (MBO/MBIs). • This is in contrast to the US, where MBO/MBIs are not classified as venture capital.
  3. 3. • Private equity provides equity capital to enterprises not quoted on a stock market.
  4. 4. Why companies need financing? • For start-ups or growing companies, as well as those facing a major change, financing is one of the key business issues. • New capital is needed e.g. for • 1. Financing of product development • 2. Financing of market penetration • 3. Financing of investments • 4. Working capital financing to secure operative continuity • 5. Maintaining liquidity to be able to cover daily payments
  5. 5. • During their start-up, growth and expansion stages, the companies are often faced with the fact that the incoming cash flow is not sufficient for the operations. • The company's cumulative cash flow is negative. • The time needed for turning the company‘s cash flow positive varies considerably
  6. 6. • A long product development stage and slow market penetration prolong the negative cash flow period. • The company can have a negative cash flow for years, a situation that is typical in high- tech branches.
  7. 7. Operative financing • To bridge the deficit in operative financing, the company has the following choice of available measures: • 1. to ensure that the liquidity planning has been appropriate • 2. to make the clients pay their invoices on time by offering, for example, discounts for rapid payments • 3. to intensify the collection of sales receivables • 4. to delay the payments to suppliers within their terms of payment • 5. to maximize the sales margins to cut indirect costs
  8. 8. External financing • Should these measures not be sufficient, the • company has the following alternatives: • to acquire equity capital (e.g. venture capital investors) • to borrow capital
  9. 9. The Process of acquiring Venture Capital financing • The actual venture capital investment made in a company is preceded by a thorough and selective assessment of potential investment targets made by the venture capital investor. • At the first stage, the assessment of the investment request is based on a business plan made by the company. • This is the stage where most of the projects (about 90 %) of all proposed projects are rejected.
  10. 10. • The initial assessment is made relatively rapidly and therefore the company should pay attention to two aspects: • the business plan should be carefully prepared and the contact targeted to the correct investors. • A well-prepared business plan summary is the best means of attracting and convincing the investor.
  11. 11. The Process of acquiring Venture Capital financing • The central issues considered by the venture capital investor at this stage are: – Is the company able to conduct profitable and growing business operations? – Do the company executives have the necessary qualities to manage the business in the various development stages? – Will the investor be able to obtain the desired return through an increase in the company's net worth?
  12. 12. The Process of acquiring Venture Capital financing • Besides the company's business plan, the venture capital investor will assess the compatibility of the investment request against its own investment strategy.
  13. 13. • The decisive investment strategy criteria may be company size, development stage, branch or geographical location. • Contacts directed to the correct investors at an early stage of the process will save time and diminish the probability of negative answers.
  14. 14. • Should the investor decide that the investment request meets his criteria, the following step is a meeting arranged with the company management. • Experience has shown that about half of the remaining companies are discarded at the negotiation stage
  15. 15. • The third stage, or the due diligence stage, involves a thorough study of the target company by the venture capital investor who assesses the company on the basis of his own, weighted investment criteria. • The preparedness of the company management to launch and developed the business in question is generally seen as the most important criterion.
  16. 16. • Other vital issues include the size and development of the company's target market, • the competitiveness of the company‘s product and technology • as well as the capital required by the business at the actual investment stage and the eventual additional investment needs.
  17. 17. • During the second and third stage of the assessment process, the investor determines the value of the company. • Once the entrepreneur and the investor have agreed on the value, the investor's future share of the company is determined.
  18. 18. • The entry valuation of investor will depend on factors such as investors return expectations, and the view of the opportunity for new concept, product or service
  19. 19. • The intention is to liquidate the shareholding in early phase companies after 4-8 years and in companies with follow-on funding after 1-3 years. • In the end, the investment is made in about 3 to 4 % cases of all received investment requests. • The parties finally make a shareholder agreement to establish practical operating rules.
  20. 20. Stages of Investments • Early stage companies may have proprietary technology or intellectual property that has the potential to be exploited on a global scale. • The technology or lead product is usually beyond proof of principle stage
  21. 21. • Mid-stage companies may have strong pipeline of technologies and products, which has been developed by research and management teams with scientific and commercial credibility
  22. 22. • Later stage companies have operational and corporate finance skills ideally positioned and company may need investments to precipitate consolidations. • Companies at this stage are within 12 to 18 months of an IPO.
  23. 23. VC’s contribution to entrepreneur • In addition to money, professional VC as a shareholder bring strong industry, operational, financial and investment banking skills to the partnership with the target company
  24. 24. • Through the VC’s expertise and network the portfolio companies could gain access to: • a) follow-on capital through venture capital ties • b) knowledge of partnership opportunities in multiple markets • c) in-depth operational and management experience’ • d) access to high-quality management teams • e) ties to the investment banking community
  25. 25. VC’s contribution to entrepreneur • VC adds the most value by assisting in the creation of the best possible team to manage and supervise the target company • Management assessment is one of the major tasks to be carried out by the venture capital before deciding to invest
  26. 26. Seed stage financing • The venture is still in the idea formation stage and its product or service is not fully developed. • The usually lone founder/inventor is given a small amount of capital to come up with a working prototype. • Monies may also be spent on marketing research, patent application, incorporation, and legal structuring for investors.
  27. 27. • It's rare for a venture capital firm to fund this stage. • In most cases, the money must come from the founder's own pocket, from the "3 Fs" (Family, Friends, and Fools), and occasionally from angel investors.
  28. 28. Start up financing • The venture at this point has at least one principal working full time. • The search is on for the other key management team members and work is being done on testing and finalizing the prototype for production
  29. 29. First -stage financing • The venture has finally launched and achieved initial traction. • Sales are trending upwards. • A management team is in place along with employees
  30. 30. • The funding from this stage is used to fuel sales, reach the breakeven point., increase productivity, cut unit costs, as well as build the corporate infrastructure and distribution system. • At this point the company is two to three years old
  31. 31. Second -stage financing • Sales at this point are starting to snowball. • The company is also rapidly accumulating accounts receivable and inventory. • Capital from this stage is used for funding expansion in all its forms from meeting increasing marketing expenses to entering new markets to financing rapidly increasing accounts receivable • Venture capital firms specializing in later stage funding enter the picture at this point
  32. 32. Mezzanine or Bridge financing • At this point the company is a proven winner and investment bankers have agreed to take it public within 6 months. • Mezzanine or bridge financing is a short term form of financing used to prepare a company for its IPO. • This includes cleaning up the balance sheet to remove debt that may have accumulated, buy out early investors and founders deemed not strong enough to run a public company, and pay for various other costs stemming from going public.
  33. 33. • The funding may come from a venture capital firm or bridge financing specialist. • They are usually paid back from the proceeds of the IPO.
  34. 34. Initial Public Offering (IPO) • The company finally achieves liquidity by being allowed to have its stock bought and sold by the public. • Founders sell off stock and often go back to square one with another startup.
  35. 35. Types of VCs: • – Angel investors • – Financial VCs • – Strategic VCs
  36. 36. Angel Investors • Typically a wealthy individual • • Often with a tech industry background, in position to judge high-risk investments • • Usually a small investment (< $1M) in a very early stage company. • • Motivation: • – Dramatic return on investment via exit or liquidity event: • • Initial Public Offering (IPO) of company • • Subsequent financing rounds • – Interest in technology and industry
  37. 37. Financial VCs • Most common type of VC • • An investment firm, capital raised from • institutions and individuals • • Often organized as formal VC funds, • • Sometimes organized as a holding company • • Fund compensation: carried interest • • Holding company compensation: IPO • • Fund sizes: ~$25M to 10’s of billions • • Motivation: • – Purely financial: maximize return on investment • – IPOs, Mergers and Acquisitions (M&A)
  38. 38. Strategic VCs • Typically a (small) division of a large technology company • • Examples: Intel, Cisco, Siemens, AT&T • • Corporate funding for strategic investment • • Help companies whose success may spur revenue growth of VC corporation • • Not exclusively or primarily concerned with return on investment • • May provide investees with valuable connections and partnerships • • Typically take a “back seat” role in funding
  39. 39. The Funding Process: Single Round • Company and interested VCs find each other • • Company makes it pitch to multiple VCs: • – Business plan, executive summary, financial projections with assumptions, competitive analysis • • Interested VCs engage in due diligence: • – Technological, market, competitive, business development • – Legal and accounting • • A lead investor is identified, rest are follow-on • • The following are negotiated: • – Company valuation • – Size of round • – Lead investor share of round • – Terms of investment • • Process repeats several times, builds on previous rounds
  40. 40. Terms of Investment • Initially laid out in a term sheet (not binding!) • • Valuation + investment à VC equity (share) • • Other important elements: • – Board seats and reserved matters • – Liquidation and dividend preferences • These days, VCs extract a huge amount of control over their portfolio companies.
  41. 41. Basics of Valuation • Pre-money valuation V: agreed value of company prior to this round’s investment (I) • • Post-money valuation V’ = V + I • • VC equity in company: I/V’ = I/(V+I), not I/V • • Example: $5M invested on $10M pre-money gives VC 1/3 of the shares, • • I and V are items of negotiation • • Generally company wants large V, VC small V, but there are many subtleties… • • This round’s V will have an impact on future rounds • • Possible elements of valuation: • – Multiple of revenue or earnings • – Projected percentage of market share
  42. 42. Board Seats and Reserved Matters • Corporate boards: • – Not involved in day-to-day operations • – Hold extreme control in major corporate events (sale, mergers, acquisitions, IPOs, bankruptcy) • • Lead VC in each round takes seat(s) • • Reserved matters (veto or approval): • – Any sale, acquisition, merger, liquidation • – Budget approval • – Executive removal/appointment • – Strategic or business plan changes • • During difficult times, companies are often controlled by their VCs
  43. 43. So What Do VCs Look For? • Committed, experienced management • • Defensible technology • • Growth market • • Significant revenues • • Realistic sales and marketing plan
  44. 44. Exits • Depending on the investment focus and strategy of the venture firm, it will seek to exit the investment in the portfolio company within three to five years of the initial investment. • While the initial public offering may be the most glamourous and heralded type of exit for the venture capitalist and owners of the company, • most successful exits of venture investments occur through a merger or acquisition of the company by either the original founders or another company.
  45. 45. IPO • The initial public offering is the most glamorous and visible type of exit for a venture investment. • In recent years technology IPOs have been in the limelight during the IPO boom of the last six years. • At public offering, the venture firm is considered an insider and will receive stock in the company, • but the firm is regulated and restricted in how that stock can be sold or liquidated for several years.
  46. 46. • Once this stock is freely tradable, usually after about two years, the venture fund will distribute this stock or cash to its limited partner investor • who may then manage the public stock as a regular stock holding or may liquidate it upon receipt. • Over the last twenty-five years, almost 3000 companies financed by venture funds have gone public.
  47. 47. Mergers and Acquisitions • Mergers and acquisitions represent the most common type of successful exit for venture investments. • In the case of a merger or acquisition, the venture firm will receive stock or cash from the acquiring company and the • venture investor will distribute the proceeds from the sale to its limited partners.
  48. 48. 48 • Where Does Venture Capital Money Come From? • How are Venture Capital Funds Organized? • How do Venture Capitalists make money Personally?
  49. 49. 49 • Where Does Venture Capital Money Come From? • Professional Venture Capital Firms raise money from Insurance Companies, Educational Endowments, Pension Funds and Wealthy Individuals. • These organizations have an investment portfolio which they allocate to various asset classes such as stocks (equities), bonds, real estate etc. • One of the assets classes is called “Alternative Investments”- venture capital is such an investment. Perhaps 5% to 10% of the portfolio might be allocated to Alternative Investments. • The portfolio owners seek to obtain high returns from these more risky Alternative Investments.
  50. 50. 50 • How are Venture Capital Funds Organized? • Most Venture Capital Funds are Limited Partnerships: Venture Capital Fund Limited Partners Pension Funds, Educational Endowments, Foundations, Insurance Companies, Wealthy Individuals General Partners The General Partners use an Offering Memorandum to raise a fund of a given size from the Limited Partners by convincing them that the GPs have a unique strategy or expertise in a particular sector or sectors of the market. Fund raising can take a year or more. If the GPs are successful they will convince enough Limited Partners to invest enough money to achieve the size fund offered. When this happens there is a first “close” of the fund.
  51. 51. 51 • What Do Venture Capitalists Do? • Source Deals • The GPs have to “source” deals- I.e. find investment opportunities. This is done in a variety of ways- referrals from trusted sources (other funds, entrepreneurs they have invested in before, lawyers, accountants etc.) • Make Investment Decisions • From the opportunities identified the GPs pick the ones they think will be the “winners”. They might look at 50 or 100 opportunities for each one they invest in.
  52. 52. 52 • What Do Venture Capitalists Do? • Manage The Investment • The GP/VCs have a fiduciary duty to the LPs to “manage” the investment. This means they usually sit on the Board of Directors. Given this time commitment a VC might only be able to handle 6 to 10 portfolio investment companies at a time. • Harvest The Investment • The GP/VCs win only if they can get their money out of the investment (“harvest the investment”). This usually takes the form of an acquisition of the portfolio company or taking the portfolio company public in an Initial Public Offering (IPO). Note: even the most successful funds rarely have even 1/3 of their portfolio investments become successful – i.e even with careful vetting 2 out of 3 investments are not “wins”.
  53. 53. 53 • Economics of the Venture Capital Fund - CAPITAL • Capital Commitments • The Limited Partners do not actually invest money in the Fund at the closing. They legally commit to provide a certain amount of capital when they are called upon. This is called a Limited Partner’s Capital Commitment. • Capital Calls • When the General Partners find what they think is a good investment opportunity they make a “Capital Call” on the Limited Partners. Example: a Fund has $500M of capital and the GP/VCs want to make an investment of $10M. A Limited Partner with a Capital Commitment of $50M will be required to send $1M to the General Partners: 50M/500M = 10% times 10M = $1M
  54. 54. 54 • Economics of the Venture Capital Fund – VC Compensation • Management Fees • The General Partners receive an annual Management Fee, which is usually a percentage of the Capital Commitments to the Fund. • A typical fee is 2.5%. On a $400M fund this $10M per year. • The Management Fee is used by the General Partners to run the Fund business – e.g. it pays the salaries of the General Partners, the Associates, the Support Staff and the office rent.
  55. 55. 55 • Economics of the Venture Capital Fund – VC Compensation • Splitting the Returns • The GP/VCs make investments and they hopefully harvest some of those. • The returns from the investment are split between the Limited Partners and the General Partners. A typical arrangement is as follows: • The Limited Partners receive 99% of all the returns and the GP/VCs receive 1% of all returns until the Limited Partners receive back 100% of their Capital (plus in some cases “interest” on that Capital). • Thereafter the splits go 80% to the Limited Partners and 20% to the GP/VCs. This 20% part is called the GP’s “Carried Interest” • Venture Capitalists with a great track record will receive a higher Carried Interest- e.g. 30%
  56. 56. ©2000, Entrepreneurial Finance, Smith and Kiholm Smith Chapter 14 Organizational Structure of Venture Capital Investment Portfolio Companies –Value creation – Generate deal flow – Screen opportunities – Harvest investments – Negotiate deals – Monitor and advise General Partners Venture Capital Fund – Pension plan – Endowments – Life insurance companies – Corporations – Individuals Limited Partners Effort and 1% of capital Annual Management Fee 2-3% Carried Interest 20- 30% of Gain 99% of Investment Capital Capital Appreciation 70-80% of Gain Investment Capital and Effort Financial Claims
  57. 57. 57 • Economics of the Venture Capital Fund – VC Compensation • Compensation Drives Behavior • The Split Formula provides a heavy incentive for the GP/VCs to invest in situations that can be Big Hits. Reason: They don’t make money unless they return Big Returns to the Limited Partners. • Examples • Assume the Fund has invested $400M in 20 companies ($20M per company on average). • Assume that each of the Fund’s investment provides it with a 50% ownership interest in a portfolio company. • Assume that 25% of the companies are successful and the Fund can harvest those investments – i.e. 5 of the 20 companies are successful.
  58. 58. 58 • Economics of the Venture Capital Fund – VC Compensation • Example (continued) • Assume the average “win” returns to the Fund 5 times the amount invested. In our example, the $20M becomes $100M. • Note: If the Fund owns 50% of a company then the value of the company at harvest has to be $200M in order for the Fund to receive 5 times its investment. Venture Partners Fund 1 Capital Commitments: 400 Winning Investments: Company Amount Invested % Ownership Return Multiple Investment Value at Harvest Value of Company 1 20 50% 5 100 200 2 20 50% 5 100 200 3 20 50% 5 100 200 4 20 50% 5 100 200 5 20 50% 5 100 200 100 500
  59. 59. 59 • Economics of the Venture Capital Fund – VC Compensation • Example (continued) • This is how the Return Splits would work: • Recall: 99% of the returns go to the Limited Partners until they receive back their invested Capital then the upside is split with the General Partners • In this case the LPs are probably somewhat happy - they get a 19% return - and the GPs make $23M. (note: this example ignores the time value of money). Venture Partners Fund 1 Capital Commitments: 400 Winning Investments: Company Amount Invested % Ownership Return Multiple Investment Value at Harvest 1 20 50% 5 100 2 20 50% 5 100 3 20 50% 5 100 4 20 50% 5 100 5 20 50% 5 100 100 500 Return Splits Returns $ % $ % Return of Capital: 404 400 99% 4 1% Upside, if any: 96 77 80% 19 20% 500 477 23 LP % Return: 19% Limited Partners General Partners
  60. 60. 60 • Economics of the Venture Capital Fund – VC Compensation • Sensitivity of Returns • Notice what happens if the 5 winning investments pay out at lower multiples: • The reward system makes the VCs “swing for the fences” – they need to find companies that can be really big. Venture Partners Fund 1 Capital Commitments: 400 Winning Investments: Company Amount Invested % Ownership Return Multiple Investment Value at Harvest Value of Company 1 20 50% 5 100 200 2 20 50% 4 80 160 3 20 50% 4 80 160 4 20 50% 3 60 120 5 20 50% 3 60 120 100 380 Return Splits Returns $ % $ % Return of Capital: 380 376.2 99% 4 1% Upside, if any: 0 0 80% 0 20% 380 376 4 LP % Return: -6% Limited Partners General Partners Venture Partners Fund 1 Capital Commitments: 400 Winning Investments: Company Amount Invested % Ownership Return Multiple Investment Value at Harvest Value of Company 1 20 50% 4 80 160 2 20 50% 4 80 160 3 20 50% 3 60 120 4 20 50% 3 60 120 5 20 50% 3 60 120 100 340 Return Splits Returns $ % $ % Return of Capital: 340 336.6 99% 3 1% Upside, if any: 0 0 80% 0 20% 340 337 3 LP % Return: -16% Limited Partners General Partners
  61. 61. 61 • Fund Investment Cycle • Fund Life • Most Funds have a 10 year life. At the end of 10 years they are liquidated. • Funds plan to harvest winners in 5 to 7 years or less. • Initial Portfolio Investments • For Early Stage Funds it is typical for the Fund to reserve $2-$3 for every $1 invested. For example if the Fund invests $2m in Round 1 they will reserve another $4m -$6m for follow-on rounds. So a $400M Fund might invest $100M in the first rounds of portfolio companies and $300M in follow on rounds. • Timing of Initial Investments • A Fund usually makes its initial investments in the first 3 years of the Fund life cycle. During the remaining life of the Fund follow-on investments are made and the portfolio companies are positioned for “harvest”
  62. 62. 62 • Follow-On Funds • Once the initial investments have been made in Fund 1, the VCs are motivated to raise Fund 2 so they can make investments in new opportunities and get additional Management Fees. • Hopefully there are some early successes in Fund 1 so they can go to their LPs and get them to invest in Fund 2. • Through this layering of Funds the GPs build up their total Capital Under Management. Year Year Year Year Year Year Year Year Year Year 1 2 3 4 5 6 7 8 9 10 Totals Fund 1 Initial Investments 30 30 30 90 Fund 1 Follow On 50 110 150 310 Fund 2 Initial Investments 30 30 30 90 Fund 2 Follow On 50 110 150 310 Fund 3 Initial Investments 30 30 30 90 Fund 3 Follow On 50 110 150 310
  63. 63. 63 • Things For the Entrepreneur To Think About • Does Your Plan Fit the Needs of the Venture Capital Fund? • As you can see they need to see Big Returns. If your Plan can justify this and you need lots of capital to achieve your Plan then VC may be the way to go. • You may be able to grow a successful company and make a lot of money without having to scale to the size that will interest Venture Capital. • Are You Ready For Venture Capital? • As you can see VCs have a relatively short time fuse to success- a 10 year Fund and the need to show some “Winners” early in order to raise the Next Fund. • Result: You have to be ready to move quickly, there will not be much time to recover from errors in the plan or execution.
  64. 64. 64 • Things For the Entrepreneur To Think About • Are You Prepared to Become a Minority Stockholder? • As the examples show, in order to generate returns for their Limited Partners the GP/VCs have to invest a large amount and this usually means they will obtain a significant percentage of the company over time. • Having a small piece of a Big Pie can make you rich but you have to be mentally prepared to become a Minority Stockholder. • Make Sure the VC You Work With Can Add Value • Experienced Venture Capitalists can provide valuable advice and guidance, saving you time and preventing mistakes. They also have contacts with potential customers, Wall Street and acquirers.
  65. 65. VENTURE CAPITAL Myths about Venture Capital Financing $ VCs want no less than 50% OwnershipVCs want no less than 50% Ownership Fact:Fact: VC Funds customarily hold 47% to 53% Voting Interest $ VCs have the Right to Fire the Founder/CEOVCs have the Right to Fire the Founder/CEO Fact:Fact: Customary Condition is Employment ContractCustomary Condition is Employment Contract authorizing Majority of Directors toauthorizing Majority of Directors to firefire Founder/CEOFounder/CEO ““with or without causewith or without cause.”.” Performance Issues vs.Performance Issues vs. Company Needs:Company Needs: Administrator or InspirationalAdministrator or Inspirational LeaderLeader
  66. 66. VENTURE CAPITAL Myths about Venture Capital FinancingMyths about Venture Capital Financing $ VCs dominate the Private Equity MarketVCs dominate the Private Equity Market Fact:Fact: VCs account for less than 1% of the PrivateVCs account for less than 1% of the Private Equity MarketEquity Market $ VCs finance a Broad Range of Industry Types on aVCs finance a Broad Range of Industry Types on a Nationwide BasisNationwide Basis Fact:Fact: Most VC investments are in High-Technology orMost VC investments are in High-Technology or Bio-science Industries in California’s SiliconBio-science Industries in California’s Silicon Valley orValley or Boston areaBoston area
  67. 67. VENTURE CAPITAL Myths about Venture CapitalMyths about Venture Capital FinancingFinancing $ VCs expect to Earn a 700% Rate of Return within Two toVCs expect to Earn a 700% Rate of Return within Two to Three YearsThree Years Fact:Fact: VCs aim to “harvest” their Investments within 7VCs aim to “harvest” their Investments within 7 to 10 Years (and try to earn no less than 700%)to 10 Years (and try to earn no less than 700%) $ Governments invest in VC Funds because they are aGovernments invest in VC Funds because they are a “Win-Win” Situation: Eye-Popping Rates of Return and“Win-Win” Situation: Eye-Popping Rates of Return and High-Paying JobsHigh-Paying Jobs Fact:Fact: Probable Returns will be around 25% with less thanProbable Returns will be around 25% with less than half of Firms surviving more than 3 yearshalf of Firms surviving more than 3 years
  68. 68. The Venture Capital Process • Find Deals • Research Deals – A 3-6 Month Process • Structure and Close Deals • Manage The Investment • Exit The Investment
  69. 69. Some Statistics • 99%+ of All Startups Do Not Require Institutional Venture Capital • VCs average initial investment is $3M+ • Average Dilution from Initial VC Investment is 40%+ • VCs look at over 100 business plans for every one they finance
  70. 70. When Is VC Good • Heavy R&D Component of the business – Seminconductors – Biotech – Datacomm Equipment • Very Large Opportunity Requiring A Lot of Working Capital – Federal Express – Amazon.com
  71. 71. The Cost of Venture Capital • Dilution – Average founder who uses VC owns less than 10% of the business upon exit • Liquidation Preference – The VCs will want to take their money out first
  72. 72. • Some of the unique features of a VC firm are
  73. 73. Investment in high-risk, high-returns ventures • As VCs invest in untested, innovative ideas the investments entail high risks. • In return, they expect a much higher return than usual. (Internal Rate of return expected is generally in the range of 25 per cent to 40 per cent).
  74. 74. Participation in management • Besides providing finance, venture capitalists may also provide technical, marketing and strategic support. • To safeguard their investment, they may also at times expect participation in management.
  75. 75. Expertise in managing funds • VCs generally invest in particular type of industries or some of them invest in particular type of businesses and hence have a prior experience and contacts in the specific industry which gives them an expertise in better management of the funds deployed.
  76. 76. Raises funds from several sources • A misconception among people is that venture capitalists are rich individuals who come together in a partnership. In fact, VCs are not necessarily rich and almost always deal with funds raised mainly from others. The various sources of funds are rich individuals, other investment funds, pension funds, endowment funds, et cetera, in addition to their own funds, if any.
  77. 77. Diversification of the portfolio • VCs reduce the risk of venture investing by developing a portfolio of companies and the norm followed by them is same as the portfolio managers, that is, not to put all the eggs in the same basket.
  78. 78. Exit after specified time • VCs are generally interested in exiting from a business after a pre-specified period. This period may usually range from 3 to 7 years.
  79. 79. Venture Capital in India
  80. 80. What specific areas in India interest VCs? • Non-data, non-voice mobile phone applications. • Internet-based technologies. • Growth-stage businesses in real estate, and especially entertainment and media, which will see many emerging technologies. Late-stage businesses that interest investors are in the retailing sector. • Language-based Internet applications, like text-to- voice conversion into vernacular. • Pharma sector, which is attracting many private equity funds. • Sports and wellness/healthcare.
  81. 81. Setting the stage - Venture Capital in India • Phase I - Formation of TDICI in the 80’s and regional funds as GVFL & APIDC in the early 90s. • Phase II - Entry of Foreign Venture Capital funds (VCF) between 1995-1999 • Phase III - (2000 onwards). Emergence of successful India-centric VC firms • Phase IV – (current) Global VCs and PE firms actively investing in India • 150 Funds active in the last 3 years (Government, Overseas, Corporate, Domestic)
  82. 82. The First Stage, 1986–1995
  83. 83. TDICI • In 1988, the first organization to actually identify itself as a venture capital operation, • Technology Development & Information Company of India Ltd. (TDICI), • was established in Bangalore as a subsidiary of the Industrial Credit & Investment Corporation of India, Ltd.(ICICI), • India’s second-largest development financial institution (at the time, it was state owned and managed).
  84. 84. GVFL • In 1990, Gujarat Venture Finance Limited (GVFL) began operations with a 240 million rupee fund with investments from the World Bank, the U.K. Commonwealth Development Fund, the Gujarat Industrial Investment Corporation, Industrial Development Bank of India, various banks, state corporations, and private firms
  85. 85. APDIC • The Andhra Pradesh state government formed a venture fund subsidiary in its AP Industrial Development Corporation (APDIC).
  86. 86. The Second Stage, 1995–1999 • This stage saw the entrance of foreign institutional investors. • This included investment arms of foreign banks, but particularly important were venture capital funds raised abroad. • Very often, NRIs were important investors in these funds. • The overseas private sector • investors became a dominant force in the Indian venture capital industry.
  87. 87. • The formalization of the Indian venture capital community began in 1993 with the formation of the Indian Venture Capital Association (IVCA) headquartered in Bangalore.
  88. 88. • Phase III - (2000 onwards). Emergence of successful India-centric VC firms • Phase IV – (current) Global VCs and PE firms actively investing in India
  89. 89. Number Of Investments Investor 2005 2006 2007 2008 2009 Total Sequoia Capital India 7 12 13 18 3 53 Ventureast 5 11 4 9 3 32 Intel Capital 3 7 4 8 1 23 Helion Venture Partners 0 4 8 8 2 22 DFJ India 0 3 3 9 2 17 Nexus India Capital 0 1 4 9 2 16 NEA IndoUS Ventures 0 0 5 9 0 14 IDG India Ventures 0 0 6 5 0 11 Kleiner Perkins 1 3 0 6 0 10 Norwest Venture Partners 1 3 1 2 3 10 Canaan Partners 0 1 4 4 1 10 Inventus Capital Partners - - - - 3 3
  90. 90. Value Of Investments ($ mn) Investor 2005 2006 2007 2008 2009 Total Sequoia Capital India 42 184 114 138 26 504 Intel Capital 19 37 15 53 7 131 Norwest Venture Partners 13.9 8.1 24.1 17.7 92.8 156.6 Helion Venture Partners - 30 30 30 10 100 Nexus India Capital - 7.5 16 45 7 75.5 DFJ India - 13.75 4 33 10 61 Ventureast 7 19 2 17 9 54 NEA IndoUS Ventures - - 24 26 - 50 Canaan Partners - 4 10 12 4 30 Kleiner Perkins 2 8 - 19 - 29 IDG India Ventures - - 14 8 - 22 Inventus Capital Partners - - - - - -
  91. 91. Regulatory Framework
  92. 92. Foreign Venture Capital Investor • An FVCI (or Foreign Venture Capital Investor) is an investor incorporated or established outside India • which proposes to make investments either in domestic Venture Capital Funds (‘VCFs’) or Venture Capital Undertakings10 (‘VCUs’) in India (defined to mean a domestic unlisted Indian Company) • and which is registered under the Foreign Venture Capital Investor Regulations, 2000 (‘FVCI Regulations’).
  93. 93. • Although foreign private equity players and offshore VCFs can invest in India directly under the Foreign Direct Investment Scheme (the ‘FDI Scheme’), • the SEBI grants certain benefits to those investors who register themselves under the FVCI Regulations
  94. 94. • The shares acquired by a FVCI in an unlisted company are not subject to the one year lock-up period upon the Initial Public Offering (‘IPO’) of the shares of the company. Thus, the FVCI would be able to exit its investment in such a company after the listing of the shares without having to wait for the completion of the lock-up period. • FVCIs registered with the SEBI are ‘Qualified Institutional Buyers’ in the SEBI (Disclosure and Investor Protection) Guidelines, 2000 (‘DIP Guidelines’). • As a result, they are eligible to participate in the primary issuance process, meaning that they would be able to subscribe for the securities in an IPO under the typical book-building process.
  95. 95. Lock-up requirements • The SEBI, through the DIP Guidelines, has stipulated lock- up requirements on shares of promoters to ensure that the promoters or persons who are controlling the company continue to hold some minimum percentage in the company after the public offering. • A promoter is defined as being a person (or persons) who is in over-all control of the company or who is instrumental in the formulation of a plan or program pursuant to which the securities are offered to the public, and those named in the prospectus as promoters(s). • This definition, however, is an inclusive one and it would really depend upon the manner in which the SEBI would interpret the actions of a company and the key individuals/ entities associated with it.
  96. 96. • While considering an FVCI application, the SEBI does review the applicant’s track record, professional competence, financial soundness, experience, general reputation, whether the applicant is regulated by an appropriate foreign regulatory authority or is an income tax payer, amongst other factors. • The SEBI then forwards its approval to the RBI, which then grants its approval.
  97. 97. • While registration under the FVCI Regulations is not compulsory, the Indian Government has sought to make this registration attractive by conferring certain benefits upon those institutions that have registered. • An FVCI is entitled to various benefits under securities and taxation laws in India.
  98. 98. • Mauritius has traditionally been the most favored jurisdiction for incorporation to invest in India. • A company incorporated in Mauritius becomes a tax resident of Mauritius, and thus is subject to the DTAA between India and Mauritius. • Under the India-Mauritius DTAA, any capital gains earned by a resident of Mauritius are exempt from tax in India. • Further, the business profits of a Mauritius offshore company are taxable at an effective tax rate of only 3%25 . • Most investors who come into India via Mauritius do not have any substantive business in Mauritius and are incorporated there only to take advantage of the DTAA
  99. 99. SEBI Venture Capital Funds (VCFs) Regulations, 1996 • According to these regulations, a VCF means a fund established in the form of a trust / company and registered with SEBI which has – A dedicated pool of capital raised in a manner specified in the regulations and – Invests in Venture Capital Undertakings (VCUs) in accordance with these regulations.
  100. 100. VCU • A VCU means a domestic company • Whose shares are not on a recognized stock exchange in India. • Which is engaged in the business of providing services/production/manufacture of articles/things excluding a negative list.
  101. 101. • All VCFs must be registered with SEBI and pay Rs 25,000 as application fee and Rs 5,00,000 as registration fee for grant of certificate. • They cannot invest more than 25% corpus of the fund in one VCU.
  102. 102. Questions for Revision • What is Venture Capital ? What is Private Equity? • What is the process of acquiring Venture Capital Financing? • Explain the different stages of Venture Capital Investment? • Write a short note on the different types of Venture Capitalists?
  103. 103. Questions for Revision • Write a short note on exit for Venture Capital Funds? • Where Does Venture Capital Money Come From? • How are Venture Capital Funds Organized? • How do Venture Capitalists make money?
  104. 104. Questions for Revision • Write a short Note on Venture Capital in India? • Write a short note on the regulatory framework for Venture Capital in India?
  105. 105. The End
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