Venture capital is the source of finance that can help an entrepreneur obtain business funds. Venture capital has some unique characteristics that separate them fi-om traditional sources of funds. Their investments which are in startup firms, have, firstly; a higher level of uncertainty, secondly; they have substantial asymmetric information, and thirdly; they typically have higher intangible assets and growth prospects.
Definition of venture capital
As the name suggests, venture capital is the provision of capital for business ventures. It supports entrepreneurial talent with funds and business skills to exploit market opportunities with the aim of obtaining capital gains.
Venture capital is a form of intermediation particularly well suited to support the creation and growth of innovative, entrepreneurial companies (Hellmann & Puri, 2000, 2002; Kortum & Lemer, 2000). It specializes in financing and nurturing companies at an early stage of development (start-ups) that operate in high-tech industries. For such companies, the expertise of the venture capitalist, its knowledge of markets and of the entrepreneurial process, and its network of contacts are most useful to help unfold their growth potential (Bottazzi, Da Rin & Hellmann, 2004; Gompers, 1995; Hellmann & Puri, 2002; Lemer, 1994, 1995; Lindsey, 2003).
There are various consistent definitions of venture capital; Chris (1990) has defined Venture capital as the provision of risk-bearing capital, usually in the form of participation in equity, to companies with high growth potential. In addition, the venture capital company provides some value-added services in the form of management advice and contribution to the overall strategy. The relatively high risk of the venture capitalist is compensated by the possibility of high return, usually through substantial capital gains in the medium term. In India, Pandey (1995) has provided the following definition. Venture capital is an investment in the form of equity, quasi-equity, and sometimes debt, straight or conditional (interest and principal payable when the venture starts generating sales), made in new or untried technology, or high-risk venture, promoted by a technically or professionally qualified entrepreneur, where the venture capitalist.
- Expects the enterprise to have a very high growth rate
- Provides management and business skills to the enterprise
- Expects medium to long-term gains
- Does not expect any collateral to cover the capital provided
Another definition of venture capital is, as per Wright & Robbie (1998), “venture capital is investment by professional investors of long-term, unquoted, risk equity finance in new firms where the primary reward is capital gain supplemented by dividend yield.” Similarly, The United States National Venture Capital Association defines venture capital as “money provided by professionals who invest alongside management in young, rapidly growing companies that have the potential to develop into significant economic contributors” (NVCA, 2002). Gompers & Lemer (1999) define venture capital as the investment activities of professional funds that purchase equity or equity-linked stakes in new, unquoted firms; private equity includes funds devoted to venture capital, leveraged buyouts, consolidations, mezzanine, and distressed debt investments, and a variety of hybrids such as venture leasing and venture factoring.
Process and structure of venture capital
The process of venture capital consists of a number of steps that are undertaken by venture capitalists while investing in a company. They are as follows (Tyebjee & Bruno, 1986; Sagari & Guidotti, 1991).
- Deal origination -referral system is an important source of information for VC regarding potential investors.
- Screening-of proposals -regarding the size of the investment, geographical location, and stage of financing is done for those proposals which are of interest to the VC.
- Evaluation and due diligence– the risk and returns are estimated.
- Deal structuring- terms of deals are decided. These include details such as the amount of funding, the share of the company, and the contracts. VC negotiates deals to ensure returns commensurate with the risk, control the organization, minimize taxes, assure liquidity, and the right to replace management in case of poor performance.
- Post-investment activities and exit- VC involve themselves in major decisions and steer the company towards the exit. Exit can be in four ways, initial public offer, acquisition by another company, and repurchase of the VC’s share by the investee company, or purchase of the VC share by a third party.
Structure of the venture capital market
There are three major players, which dominate the US venture capital industry:
1) The institutional investor (provider of capital)
2) The entrepreneurial firm that receives the fund (use of capital) and
3) The agency or agent who stands between the two and identifies, screens, transacts monitors and raises additional fiinds.
The venture capital business model is based on the selection of young growth companies with a good risk-return profile, financing them with external equity or similar forms of capital and nurturing them with management support before selling them at a higher valuation. The venture capitalist tries to collect money from investors. He has to convince the investors by clearly communicating his investment approach (Silver, 1985; Schroeder, 1992)
As shown in figure 1-2, financial capital flows from limited partners, such as pension funds, individuals, insurance companies, and corporations, into venture capital funds. When sufficient capital is available, the fund is closed, and the venture capitalist makes his first call of capital, i.e., investors actually pay the first share of the capital they have committed (Smith & Smith, 2000). The venture capitalist usually calls on the committed capital when there are immediate attractive opportunities for investment, thereby ensuring the best performance possible of the fund since there are no opportunity costs that need to be earned on capital that has not been called yet.
After that, the venture capitalist starts to make portfolio investments, which typically lasts two or three years (Smith & Smith, 2000). He tries to create deal flow; i.e., he actively seeks to find potential investees on the one hand, and he tries to promote the fund in order to attract entrepreneurs on the other hand (Silver, 1985).
The next step is the analysis of potential portfolio companies. In this staged process, the ventures are first screened to check whether they fit into the strategy of the VC. If so, they then are compared to a number of explicit and implicit criteria, and finally, formal and costly due diligence is conducted. If both parties are then still interested in the deal, the conditions of the investment are negotiated, and the investment is made.
Also, he monitors the portfolio company to ensure efficient use of the funds provided (Gorman& Sahlman, 1989; Sapienza, 1992; Duffner, 2003).
Finally, Venture capitalists seek to exit portfolio companies within approximately ten years after the first closing of the fund.
The VC process involves transaction charges such as the annual fee, a 2-3 percent management fee, and 15-20 percent interest carried on the capital gain. These are built-in incentives for the agent to carry out his role because it is not easy for institutions to make the connection to the entrepreneurial company directly and effectively conclude deals with them.
This, however, leads to a constant tug-of-war between the Limited Partners and the General Partners. Limited Partners are always suggesting that General Partners are making too much money or that management fees are too high. The General Partners retort with arguments to the contrary. While these terms have stabilized somewhat, there is constant pressure on both sides.
Why entrepreneurs opt for venture capital
The most common source of funds for entrepreneurs the personal savings, credit cards, loans from friends and family, and loans against property. Even though entrepreneurs typically are not able to invest sufficient amounts of money, some may be. But even for them, there are high costs involved with it. The entrepreneur’s personal fate will be closely tied in with the company. This is because the capital paid in by the entrepreneur is fully liable. If the entrepreneur finances with equity, the money is fully lost in the case of insolvency. If he finances with debt, many legal environments are very restrictive. Self finance by an entrepreneur who is not wealthy and uses all cash he can get is called bootstrapping.
The high uncertainties concerning the development of young growth companies, their missing track record concerning the repayment of credits, and their inability to provide a collateral are factors that, in combination with a conservative strategy of the banking industry, lead to a situation in which debt capital for young growth companies, at least in the early stages of their development is virtually not available.
An entrepreneur faces problems in raising funds from capital markets and lending institutions because:
- Many start-up firms require considerable capital. A firm’s founder may not have adequate funds to finance these projects single-handedly and might therefore seek outside financing. Entrepreneurial firms are characterized by significant intangible assets, expect years of negative earnings and have uncertain prospects. Such firms are usually unlikely to receive bank loans or other debt financings. (Gompers & Lemers, 1999). This problem is further compounded when the lending institutions are in the public sector and open to wide public scrutiny; thus, they tend to be risk averse. (Planning Commission New Delhi, 2006).
- Early-stage ventures cannot depend on the conventional modes of raising equity finance because these are not designed to handle substantial informational asymmetries or to cater to the need for mentoring. Moreover, the standard mode of market flotation may not be a viable option for such ventures, which often start on a small scale. The major issue in the funding of early-stage technology ventures is the asymmetry in the information available to the three partners – the technologist, the entrepreneur, and the financier. Because of this, they may have widely varying perceptions of the prospects for the enterprise. The role of the VC funding system is to devise financing and management agreements that accommodate these variations in information and perceptions. The informational asymmetries make it difficult to raise debt-type financing for early-stage ventures. Early-stage ventures often have a low equity base and lack a cash flow that can sustain debt finance. Hence the classical route of loan financing fi-om a development finance institution will not work.
- Capital markets overlook small business opportunities because of high information and transaction costs (Premus, 1985; Smith & Smith, 2002).
4. Risk measured in terms of the default rate is high for new enterprises (Rangarajan, 1980). In developing countries the default rate has been found to vary between 10 to 60 percent (Anderson, 1982). Due to the high-risk lenders is reluctant to fund such enterprises).
5. Lenders require collateral for giving loans, and most entrepreneurs of new enterprises are unable or unwilling to provide adequate security (Pandey, 2003). 6. The literature on capital constraints documents that an inability to obtain external financing limits many forms of business investment. (Glenn, 1996). These show that capital constraints appear to limit research-and-development expenditures, especially in smaller firms. (Hall, 1992; Hao & Jaffe 1993; Himmelberg & Petersen 1994).
Inadequate supply and high costs of SMEs funding, the so-called ‘SME finance gap’, often leads to a shortage of firms between the smallest micro-enterprises and larger firms. The problem of the ‘missing middle’ is often worsened by government policies that favor larger firms for financial access, for example, through collateral requirements imposed on the banking sector.
Given the fact that lack of financing is typically most prominent at the early stages of enterprise development, measures, either directly through subsidies or indirectly through participation in private sector projects, are crucial at this stage. As figure 1-4 below demonstrates, this early stage represents the so-called ‘Valley of Death’, which can be bridged by venture capital funds.
On the other hand, the problems in financing new start-ups prove beneficial to VC. In light of empirical data, Amit et al. (1998) concluded that venture capitalists exist because the market for entrepreneurial finance is characterized by informational asymmetries and moral hazard. Because venture capitalists can reduce these market failures, they have an advantage over other investors in providing funds for new ventures.
For citing this article use:
- Mohd, A. (2009). Venture capital in Uttar Pradesh problems and prospects.
