Venture capital (VC) is the type of finance that is endowed by individuals or firms at young or nascent firms that show high growth potential for growth in terms of different evaluation criteria, e.g., revenue generation, market capitalization, wealth creation, etc. As per the fundamental financial principle, these emergent and nascent firms also carry along with them very high risk. Venture Capital Firms (VCFs) put their money in these nascent firms in lieu of ownership stake and assume the high risk as a trade-off. The start-ups usually delve into the realm of unknown, uncharted and untested field mostly based on an innovative idea, innovative technology, innovative use of existing technology, or innovative business model, hence the high risk. The high uncertainty of Venture Capital Funded Firms (VCFFs) transcends to VCFs as well, and they also face high rates of failure. This is the type of professional hazards they have to go through.
Venture Capital is defined as, “financial intermediaries who get capital investment from various institutional investors, high net worth people from the various economic sectors and make investment of these pooled deposits in small and private business which have high technology and have a lot of potential for high growth.”(Cumming and Macintosh, 2003).
Wright and Robbie (1998) defined venture capital as, “the investment for long term by a number of investors in risky equity where their prime aim is eventual going and they are not interested in any periodical income or dividends.”
In true sense, venture capital fund refers to the risk capital supplied to high growth potential ventures and it takes the form of equity capital in the funded firms giving decision making right to VCFs.
In Indian context, the most popular notion of venture capital is the investment in the nascent firms either on the front of creation of innovative technology/innovative use of existing technology or innovative business models. Although very rarely an innovative technological project had been financed by the Indian VCFs. In our country, technologically advanced projects needing financial assistance turn to angel investors or seed capital endowers, which are also forms of venture capital financing, but mostly the venture capital provides finance for high technology projects post-R&D stage, to transform it into commercial production.
In general, venture capital is the way to commit the capital and knowledge both at the onset of companies specializing in Innovative technologies/Innovative use of existing technologies/Innovative business plan/ new ideas. Thus, it does not mean merely the commitment of funds but also deemed a very synchronized input of skill set and competence for setting up the firm, designing its advertising and marketing strategy, organizing and managing it till the time it is ready for a fruitful exit.
In the above sense Indian context is very similar to the western perspective on Venture Capital. There also venture capital concept includes the supply of expertise and skills for providing the impetus to growth and development of financed enterprises along with the supply of funds.
In most of the cases, irrespective of region and economy, a large chunk of this capital goes for already established technology or is utilized to set up new management teams. This mode of twining the utilization of skills and competence of venture capital financer along with the capital has enabled venture capital industry to attain significant success and contribute with its imperative role in the industrial development. Hence the same should be more apt to accept in Indian context.
Characteristics of Venture Capital
Venture capital is a distinct type of financing due to its unique characteristics, as listed below:
i. Mostly, venture capital finances new ventures through the mode of equity participation. In very few cases, the investment may be done in the mode of longterm loans, procurement of redeemable options or convertible securities. The prime intent, as in all cases of investment, is to have high capital gain when the project turns profitable.
ii. Venture capital is a long-term investment in projects having high return potential mostly of techno-savvy entrepreneurs where the probability of exorbitant returns is considered to be high.
iii. Venture Capital Firm (VCF) does not confine itself to the supply of capital rather supplies skills necessary for establishment, growth, management, and development of enterprises. VCFs insist on active role in the running and managing of the business and provide their planning, organizing, staffing, implementation, marketing, technology, and other managerial expertise to the VCFF.
iv. Venture capital financing is an arena that easily straddles the two sides of the financial world: High return along with the high risk. Almost 90% of the Venture Capital Funded Firms fail, 7%yield average return, 2% above market return, and only 1% are having stupendous return, but this one compensates for the heavy losses of the others.
In nut shell, a VCF acts as a financial intermediary between investors looking for projects with a very high prospective returns and the entrepreneurs who have brilliant ideas but need capital as they have no such avenue due to the peculiar nature of their enterprise.
Dimensions of Venture Capital
VCFs are special purpose vehicles that do not limit their contact with the VCFFs only to the extent of providing the finance, rather remain associated with their projects during all the successive stages of the development with very tailor made financing options, appropriately designed for each stage. In theory and practice, four phases of firm‘s development are recognized for each of the enterprise, viz., testing of an idea, start up, fledgling implementation and established growth and development.
At first, VCFF is engrossed in the testing and development of a notion which has just came out of a research lab. At this stage, delineating the precise specification, designing the new product/service and subsequently establishing the related businessplan is the prime task. The need at this stage is of Seed Finance. VCFs find this stage as the riskiest one as the probability of failure is highest at this stage and majority of the nascent projects fail at this stage.
The next stage of the development of firm is start-up. In this stage, after carrying out the testing of his product/service/idea/business plan entrepreneur sets the start-up to carry out his business plan to produce a product/service practically. At this stage of progress, VCFs supply the start-up finance.
In the next stage, when the VCFF has already achieved a little progress, having a ready product and well-designed service in its bag, but is struggling with teething problems and incessant hurdles. It may fail to generate adequate funds internally, hence struggling to achieve the self-sustainability. And it may also face difficulty in its efforts to raise the finances from external sources. To overcome all these problems at this stage, the enterprise needs the infusion of a big trench of funds. This finance is provided by the venture capitalist to the fledgling enterprise.
In many cases, at the ultimate stage of development of the enterprise, when it has already stabilized its working and operations, but further needs a dose of resources to exploit opportunities of scale. Most probably it comes as the final concoction of funds from venture capitalists. This whole cycle of infusion of funds at various stages and making the VCFFs ready for IPO may take five to ten years.
Aims & Objectives of Venture Capital
- i. It satisfies the ambition of entrepreneurs.
- ii. It creates future business enterprises.
- iii. It provides avenue to the investors willing to earn high profit in trade-off assuming high risk.
Functions of Venture Capital
Due to the new economic world order, where the rapid changes are normal and the rate of obsolescence is very high the popularity of venture capital has increased manifold. Rapid changes need fast and daring forage in to the world of unknown that needs the financial assistance that enthusiastically supports such endeavours merely at a promise of high future rewards. This is exactly the function of venture capital. It carries out this very crucial function of fostering the innovative development by exploiting untapped potential resources and overreaching the gap left by the traditional financial resources available.
Venture capital firms (VCFs) play this role adeptly by carrying out the following major functions:
Venture capital provides finance along with necessary competence and sets of skills to nascent enterprises that are fledgling their wings and still trying to make sense of the newly developed idea or innovation. Very frequently if it sees potential in an idea or technology it provides funding in the form of seed capital for further research and development even when the marketing potential of the final product or service are still unknown. Any new ventures or the existing ones, based on innovative technology/innovative use of existing technology/ innovative idea/ innovative business plan attracts the attention of venture capital.
Subsequent to the conceptual stage the development stage starts. At this stage, VCFs, in partnership with the entrepreneur, design the business plan, research the market opportunity, test the product, and take care of the financial needs.
At each of these crucial stages, VCF has to assess the intrinsic value, merits and potential risk-return profile of the newly developed idea/product/service, ensure that the newly developed idea/product/service is channelized towards a very well defined market opportunity and stay alert to any disruption that may arise due to the environmental factors on one end and the internal inexperience of the management team on the other end.
The venture capitalist provides all-round support to the entrepreneurial team to make the maximum of the exploitation opportunity and at the same time he tries to safeguard his own interest by setting out certain terms and conditions. While entrepreneur will be busy to make the idea/product/service adaptable to the given market conditions, venture capitalist will establish rules of the game, standardize the procedure of organizing the resources, planning the production, setting up the conditions of monitoring and controlling and measuring the outcomes to reach the success, in terms of predetermined profit targets.
Hence in every project the venture capitalist takes up he plays a dual role, supplier of funds as well as an active partner to assist the entrepreneur as and when the need arises. He assumes absolute risk and while trying to mitigate this risk he becomes a multifaceted provider of a whole gamut of support – technical, commercial, managerial, financial and entrepreneurial.
Venture capitalist compensates for the deficit of owner‘s funds in lieu of the equity position he assumes on the board of the project and he also compensates for any simultaneous deficit in any of the expertise that the new business require to reach the optimum scale of operations. All his efforts are directed towards the successful implementation of the business plans in order to achieve optimum performance.
Venture capitalists aid in the process of staffing to equip the project with the professionals required to compensate for any missing skill set. He carries out liaisoning work with the outsiders, brings the benefit of own network, prior experience from previous projects, and even other critical resource procurement. Venture capitalist further ensures adequate commercial banking and receivable financing for any scaling up of the business plan.
For citing this article use:
- Bushra, S. (2019). A Critical Evaluation of Venture Capital Financing of Information Technology Firms in India.