VENTURE CAPITAL FINANCING

INTRODUCTION
Venture capital institutions, which emerged the world over to fill gaps in the conventional
financial mechanism, focused on new entrepreneurs, commercialization of new technologies and
support to small and medium enterprises in the manufacturing and the service sectors. Over the
years, the concept of venture capital has undergone significant changes . They also maintain a
close rapport and a hands-on approach in nurturing investments during their association with
the assisted/investee companies as active partners rather than as passive investors.

THEORETICAL FRAMEWORK
Venture capital financing is emerging as a new institutional mechanism post-1990 in the country.
As a new technique of financing to inject long-term capital into the small and medium sectors, it
has made notable contribution to growth in the developed countries, particularly in the USA and
the UK .The theoretical aspects of the venture capital institutions, based largely on these
experiences, are briefly described in this section. The aspects covered below include features,
selection of investment monitoring/nurturing, portfolio valuation, structure and legal framework
and existing form of investments.
Features
Venture capital has, somehow, come to acquire various connotations. It is defined as an equity/
equity-related investment in a growth-oriented small/medium business to enable investees to
accomplish corporate objectives, in return for minority shareholding in the business or the
irrevocable right to acquire it.
Venture capital is a way in which investors support entrepreneurial talent with finance and
business skills to exploit market opportunities and, thus, to obtain long-term capital gains. It is
the provision of risk-bearing capital, usually in the form of participation in equity, to companies
with high-growth potential.
In addition, it provides some value addition in the form of management advice and contribution
to over-all strategy. The relatively high risks are compensated by the possibility of high return,
usually through substantial capital gains in the medium term.
According to a very widely-accepted definition, venture capital is described as a separate asset
class, often labelled as private equity. Private equity investment sits at the furthest end of the
risk-reward spectrum from government bonds and can broadly describe equity investment in
private companies not quoted on the stock market.
Based on the above description of venture capital, then, some of its distinguishing features as
against other capital investments are:
1) Venture capital is basically equity finance in relatively new companies when it is too early to
go to the capital market to raise funds. However, such investment is not exclusively equity
investment. It can also be made in the form of loan finance/convertible debt to ensure a running
yield on the portfolio of venture capitalists. Nonetheless, the basic objective of venture capital
financing is to earn capital gain on equity investment at the time of exist and debt financing is
only supplementary.
2) It is a long-term investment in growth-oriented small/medium firms. The acquisition of out
standing shares from other shareholders cannot be considered venture capital investment. It is
new, long-term capital that is injected to enable the business to grow rapidly.

3) There is a substantial degree of active involvement of the venture capital institutions with the
promoters of the venture capital undertakings. It means such finance also provides business skills
to the investee firms which is termed as hands-on approach/management. However, venture
capitalists do not seek/acquire a majority/controlling interest in the investees, though under
special circumstances and for a limited period, they might have a controlling interest. But the
objective is to provide business/managerial skill only and not interfere in management.
4) Venture capital financing involves high risk-return spectrum. Some of the ventures yield very
high returns to more than compensate for heavy losses on others which also may have had
potential of profitable returns. The returns in such financing are essentially through capital gains
at the time of exits from disinvestments in the capital market.
5) Venture capital is not technology finance though technology finance may form a sub-set of
venture capital financing. The concept of venture capital embraces much more than financing
new, high technology-oriented companies. It essentially involves the financing of small and
medium-sized firms through early stages of their development until they are established and are
able to raise finance from the conventional, industrial finance market. The scope of venture
capital activity is fairly wide. In brief, a venture capital institution is a financial intermediary
between investors looking for high potential returns and entrepreneurs who need institutional
capital as they are yet not ready/able to go to the public.
FUNCTIONS OF VENTURE CAPITAL FINANCING:
Selection of Investment
The first step in the venture capital financing decision is the selection of investment. The starting
point of the evaluation process by the venture capital institution (VCI) is the business plan of the
venture capital undertaking (promoter). The appraisal is akin to the feasibility studies of the
development finance institutions for grant of term loans and other financial assistance.
The selection of the investment proposal includes, stages of financing, methods to evaluate deals
and the financial instruments to structure a deal.
Stages of Financing The selection of investment by a VCI is closely related to the stages and
type of investment. From analytical angle, the different stages of investments are recognised and
vary as regards the time-scale, risk perceptions and other related characteristics of the investment
decision process of the VCIs. The stages of financing, as differentiated in the venture capital
industry, broadly fall into two categories:
(a) early stage, and (b) later stage.

Early Stage Financing This stage includes (i ) seed capital/pre-start-up, (ii) start-up and (ill)
second-round financing.
Seed Capital This stage is essentially an applied research phase where the concepts and
ideas of the promoters constitute the basis of a pre-commercialisation research project
usually expected to end in a prototype which may or may not lead to a business launch
Start-Up This is the stage when commercial manufacturing has to commence. Venture
capital financing here is provided for product development and initial marketing. The essence
of this stage is that the product/service is being commercialised for the first time in
association with the VCIs. It includes several types of new projects such as (i) greenfield
based on a relatively new or high technology, (ii) new business in which the entrepreneur has
good knowledge and working experience, (iii) new projects by established companies and
(iv) a new company promoted by an existing company with limited finance to commercialise
new technology.
Second Round Financing This represents the stage at which the product has already been
launched in the market but the business has not, yet, become profitable enough for public
offering to attract new investors. The promoter has invested his own funds but further
infusion of funds by the VCIs is necessary. The time-scale for the investment is shorter than
in the case of start-ups.
Financial Analysis
Financial Analysis Venture capital investments are generally idea-based and growth-based in
contrast to the conventional investments which are asset-based. While the latter type are
generally valued on the basis of tangible assets/future earnings streams, the former have to be
in the nature of things valued differently in order to decide the required venture capital
percentage ownership of the VCIs in venture capital undertaking. Some of the valuation
methods which illustrate the approach that VCIs can adopt are: (i) conventional venture
capitalist valuation method, (ii) the first Chicago method and (iii) the revenue multiplier
method.
Investment Nurturing/Aftercare
Unlike the conventional financial institutions, which normally keep aloof from the
management and operations of the assisted concerns, VCIs have an active, intimate and
constant ongoing involvement during the entire life of the investment in VCUs. The enduring
relationship between the VCIs and VCUs and the active role by the former in the
management of the latter is termed as investment nurturing/after care.

Styles The styles of nurturing refer to the extent of participation by VCIs in the affairs of
VCUs. The style depends upon a variety of factors such as the specialisation of the VCI,
stage of investment, financing plan, the stage of the development of the venture capital
industry itself and so on. It broadly falls into three categories: (i) hands-on, (ii) hands-off and
(iii) hand-holding.
Objectives of Aftercare:
1)To ensure the proper utilisation of assistance provided. Any deviation from the
programme/appraisal should be within the prior approval of the VCI;
(ii) To ensure the implementation of the project/venture within the time and costs envisaged;
(iii) In case of time and cost overruns beyond the control of the VCU, to assist in finding
additional/supplementary finance;
(iv) To provide strategic inputs in technology production, finance, marketing, personnel and
so on;
(v) To anticipate likely problems and advise preventive/remedial actions;

Valuation of Portfolio
The venture capital portfolio has to be valued from time to time to monitor and evaluate the
performance of the venture capital investment, that is, whether there has been an appreciation
in the value of the investment or otherwise. The portfolio valuation approaches/techniques
depend on the type of investments, namely, equity and debt instruments. These, in turn,
depend on the stage of investment: seed, start-up, early and later stages of the venture.

Equity Investments The valuation methods for equity instruments of VCUs are: (i) cost method,
and (ii) market value-based methods.
Cost Method According to this method, the value of equity holding is computed/recorded at the
historical cost of acquisition until it is disposed of. Although simple, objective, and easy to
understand, it does not indicate a fair value of investment, does not reflect management
performance and may result in two values for equity acquired at two different points in time. It
does not provide a satisfactory basis of valuation of venture capital investments.
Market Value-based Methods Such methods can be divided into: (i) quoted market value, (ii)
fair market value and (iii) others. They are conceptually superior to the cost method.

Debt Instruments VCIs provide, in addition to equity capital, debt finance. From the point of
view of their valuation as a part of the overall portfolio (fund), they are divided into (i)
convertible, (ii) non-convertible and (iii) leveraged
Convertible Debt Debt instruments are generally valued at cost. But convertible debts are
converted into equity at a specified price and time. They should, therefore, be valued in the case
of VCIs on the same basis as equity investments.
Non-convertible Debt This debt supplied by VCIs can be of two types: fixed interest bearing
such as bonds/debentures and mortgages and non-interest bearing such as zexo interest bonds
and secured premium notes.
Structural Aspects
The structuring of VCIs is important from the viewpoint of the profitability of such organisations
and their contributors and participants. While deciding upon a structure, the objectives generally
sought are:
Limited liability of investors;
Simple operation of funds;
Tax transparency of the fund in the sense that double taxation is avoided;
Tax exemption of the carried interest defined as the extra incentive/profit to the managers over
and above the share attributed to their capital contribution and the management fee;
Maximum tax benefits to investors.
The alternative forms in which VCIs can be structured are: (i) limited partnership, (ii)
investment company, (iii) investment trust, (iv) offshore funds and (v) small business investment
company.
Exit:
The last stage in venture capital financing is the exit to realise the investment so as to make a
profit/minimise losses. In fact, the potential exit in terms of the realisation horizon (exit timing)
has to be planned at the time of the initial investment itself. The precise timing of exit depends
on several factors such as nature of the venture, the extent and type of financial stake, the state of
actual and potential competition, market conditions, the style of functioning as well as perception
of VCIs and so on.
Disinvestments of Equity/Quasi-Equity Investments There are five disinvestment channels for
realization of such investments: (i) going public, (ii) sale of shares to entrepreneurs/employees,
(iii) trade sales/sale to another company, (iv) selling to a new investor and (v)

liquidation/receivership. The first four alternative routes are voluntary while the last one is
involuntary.
Exit of Debt Instruments Exit in case of debt component of venture capital financing, in
contrast with equity/quasi-equity component, has to normally follow the pre-determined route. In
case of a normal loan, the exit is possible only at the end of the period of loan. If the loan
agreement permits,whole or part can be converted into equity prior to that.