Matters Concerning the Investment Decisions of Venture Capital

Ruchi Gandhi

22 Jul, 2020

Venture capitalists (VCs) are known to make major bets on new start-ups conceiving a business idea, hoping to score a run in the future on a potential billion-dollar company. With so many investment opportunities and start-up pitches being presented to them, venture capitalists often have a set of pre-determined criteria that they look for, assess, and evaluate before making an investment. In this article, we shall have a look at the expectations of both, the VCs and the investee company, while entering into venture capital transactions.

What does venture capital mean?

Venture capital is the capital provided by professional firms that alongside management, invest in young, fast-growing, or evolving businesses which have the potential for high growth. It is a form of equity financing designed specifically to finance high risk and high reward projects.

Here, an investment firm is usually at the center stage, pooling money from high net worth individuals or big businesses thinking of investing their capital in new ventures. Venture capitalists take care of pooled money from many other investors and place them into a strategically managed fund, from where start-up projects are financed.

After a few years, when the assisted company has reached a certain stage of profitability, the VC sells its shares at a high premium in the stock market, thereby earning profits as well as releasing locked-up funds for redeployment in some other venture and this cycle continues.

For instance, a young, unproven, high-tech company which is in the early stage of financing, and is not yet prepared to make a public offer of its securities may seek venture capital. Venture capital funds provide such high-risk capital in the form of long-term equity finance with the hope of securing a high rate of return primarily in the form of capital gain. The venture capitalist also has a network of connections that can bring value to the company in many ways.

Features of Venture Capital

Venture capital subsumes the characteristics of a banker, investor in the stock market, and entrepreneur into one. The main features of venture capital are as follows:

• Venture capital is a financial investment in a highly risky project with the aim of achieving a high rate of return.
• Venture capital is, invariably, actual or potential equity participation, whereby the objective of VC is to make a capital gain by selling the shares once the firm becomes profitable.
• Venture capital firms have a different approach to that of a traditional lender or banker. In addition to the provision of capital, venture capital funds also take an active interest in the management of investee firms.
• The funding of venture capital is a long-term commitment. It usually takes a longtime to encash the investments made by the VCs in securities.
• Venture capital is not subject to repayment on-demand as with an overdraft or a loan repayment schedule. The investment is realized once the company is sold or achieves a stock market listing. And, it is lost when the company goes into liquidation.
• Based on previous experience with other firms in similar circumstances, the venture capitalist is able to offer practical advice and assistance to the company.

Stages of Financing through VCs

Selection of Venture Capitalists (Investee’s viewpoint)

Over the last ten years, the venture capital industry has seen tremendous growth. Therefore, when selecting the venture capitalists, it is important for entrepreneurs to be cautious. The following factors need to be taken into account:

The approach adopted by VCs:

To a large extent, the selection of venture capitalists depends upon the approach adopted by VCs.

• The hands-on approach of VCs seeks to provide value-added services in an advisory position or active participation with strategic partners in marketing, recruiting and financing. VCs show a keen interest in management affairs and interact actively with the entrepreneurs on different issues.
• Contrary to this, a hands-off approach refers to the venture capitalists being passively involved in management affairs. VCs just receive periodic financial statements. Here, VCs enjoy the right to appoint a director, but this right is seldom exercised by them. Their approach is passive, barring some major decisions like change in top management or a substantial acquisition.

Flexibility in deals

The fund-seeking businessmen usually want to reach an agreement with those venture capitalists who are versatile and generous in their attitude. They provide them with a package that best suits the entrepreneur’s needs. Venture capital firms having a rigid attitude may not be preferred.

Exit policy

The entrepreneurs should question the venture capitalists specifically about their preference for exit plans, whether it is buy-back or quotation or trade sale. In order to prevent disputes, clarifications should be obtained in the beginning, and the exit policy should not be against business interests. Selection will be made by the businessmen, based on the exit strategy of the VCs.

The VC will ask the investor or organization at the time of investment to lay down the exit strategy in detail. Normally, exit happens in two ways: one way is ‘sell to the third party’. This sale can be in the form of IPO or Private Placement to other VCs. In case the exit is not happening in the form of IPO or third-party sale, the promoter/company would buy-back.

Fund Viability and Liquidity

The entrepreneurs must ensure that the VCs have ample liquid resources and can provide funding at a later stage also if the need arises. Moreover, the VC has dedicated investors and is not just interested in accelerating quick financial gains.

Track record of the Venture Capital & its team

The entrepreneur should undertake the scrutiny of past performance, time since it has been operational, a list of successful projects funded earlier, etc. The team of VCs, their experience, engagement, commitment, and guidance during bad times are the other considerations affecting the selection of VCs.

Factors influencing venture capital investment (VC’s viewpoint)

The venture capitalists usually take the following factors into account when making the investments:

Strong Management Team

Venture capital firms assess the strength of the management team with regard to the adequacy of skill level. They are keen to determine the level of team’s engagement and motivation that strikes a balance between members in the fields of marketing, finance and operations, research and development, general management, personal management, and legal and tax issues. Promoters’ track record is also taken into account.

A Viable Idea

Before making investment decisions, venture capital firms consider project viability or the idea of the investee company. This is so because only a viable idea sets the market for the product or service. Venture capital firms look for answers to questions like:

• Why would consumers purchase the product?
• Who are the ultimate users?
• Who is the competition for the investee company?
• What is the industry’s projected growth?

Business Plan

The business plan should explain in a succinct manner the nature of the company, the credentials of members of the management team, how well the company has performed so far, and business estimates or forecasts. Another important consideration is the promoters’ experience in the proposed or related business. A business plan should be such that it meets the investment objective of the venture capitalist.

Project Cost and Returns

A venture capitalist would only want to invest in a venture if its potential cash inflows are likely to be more than the existing cash outflows. While computing the Internal Rate of Return (IRR), factors such as risk associated with the business proposal, the length of time his money will be tied up, etc. are taken into account. Moreover, costs of the project, financing scheme, sources of finance, and cash inflows for the next five years are also examined closely.

Future Market Prospects

It is pertinent to know if the new business venture of the investee company has enough market opportunities or not. The marketing policies implemented so far, competitor-related marketing strategies, market research conducted, market size, market share and potential future market prospects are some of the factors that influence the decision of a venture capitalist.

Existing Technology

The existing technology used and any technical collaboration agreements executed by the promoters also affect the investment decision of venture capitalists to a large extent.

Miscellaneous Factors

Some other factors that indirectly affect the VC’s investment decisions include the availability of raw materials and labor, the measures taken to control pollution, government policies, rules and regulations applicable to business/ industry, a reasonable cash burn rate, company’s technical collaboration agreements, industry location, etc.

Conclusion