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.
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.
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:
|Financial Stage||Period(Funds locked in yrs.)||Risk Perception||Activity to be financed|
|Seed Money||7-10||Extreme||For supporting a concept or idea or R&D for product development|
|Start-Up||5-9||Very High||Initializing prototypes operations or developing|
|First Stage||3-7||High||Start commercials, marketing and production (Early sales and manufacturing)|
|Second Stage||3-5||Sufficiently high||Expand market and growing working capital need (for a company not yet turning in a profit)|
|Third Stage||1-3||Medium||Market expansion, acquisition & product development for a newly profit-making company|
|Fourth Stage||1-3||Low||Facilitating public issue/ the “going public” process|
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:
To a large extent, the selection of venture capitalists depends upon the approach adopted by VCs.
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.
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.
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.
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.
The venture capitalists usually take the following factors into account when making the investments:
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.
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:
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.
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.
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.
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.
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.