The Venture Capital
Investment Process
The venture capital investment
activity is a sequential process involving five steps
1. Deal origination
2. Screening
3. Evaluation or due diligence
4. Deal structuring
5. Post-investment activities
and exit
1. Deal origination
A continuous flow of deals
is essential for the venture capital business. Deals may originate in various
ways.
Referral system is an important source of deals. Deals may
be referred to the VCs through their parent organizations, trade partners,
industry associations, friends etc. The venture capital industry in India
has become quite proactive in its approach to generating the deal flow
by encouraging individuals to come up with their business plans. Consultancy
firms like Mckinsey and Arthur Anderson have come up with business plan
competitions on an all India basis through the popular press as well
as direct interaction with premier educational and research institutions
to source new and innovative ideas. The short listed plans are provided
with necessary expertise through people who have experience in the industry.
2. Screening
VCFs carry out initial screening
of all projects on the basis of some broad criteria. For example the screening
process may limit projects to areas in which the venture capitalist is
familiar in terms of technology, or product, or market scope. The size
of investment, geographical location and stage of financing could also
be used as the broad screening criteria.
3. Evaluation or due diligence
Once a proposal has passed
through initial screening, it is subjected to a detailed evaluation or
due diligence process. Most ventures are new and the entrepreneurs may
lack operating experience. Hence a sophisticated, formal evaluation is
neither possible nor desirable. The VCs thus rely on a subjective but comprehensive,
evaluation. VCFs evaluate the quality of the entrepreneur before appraising
the characteristics of the product, market or technology. Most venture
capitalists ask for a business plan to make an assessment
of the possible risk and expected return on the venture.
According to a study conducted
by Professor IM Pandey of Indian Institute of Management, Ahmedabad a venture
capital fund places most importance on the following eleven parameters
in the same order of importance while evaluating a venture for possible
funding.
Integrity
Urge to grow
Long-term vision
Commercial orientation
Critical competence vis-à-vis
venture
Ability to evaluate and
react to risk
Well-thought out strategy
to remain ahead of competition
High market growth rate
Expected return over 25%
p.a. in five years
Managerial skills
Marketing skills
Investment Valuation
The investment valuation process
is aimed at ascertaining an acceptable price for the deal. The valuation
process goes through the following steps:
Projections on future revenue
and profitability
Expected market capitalization
Deciding on the ownership
stake based on the return expected on the proposed investment
The pricing thus calculated
is rationalized after taking in to consideration various economic scenarios,
demand and supply of capital, founder’s/management team’s track record,
innovation/ unique selling propositions (USPs), the product/service size
of the potential market, etc
4. Deal Structuring
Once the venture has been
evaluated as viable, the venture capitalist and the investment company
negotiate the terms of the deal, i.e. the amount, form and price of the
investment. This process is termed as deal structuring. The agreement also
includes the protective covenants and earn-out arrangements. Covenants
include the venture capitalists right to control the investee company and
to change its management if needed, buy back arrangements, acquisition,
making initial public offerings (IPOs) etc, Earn-out arrangements specify
the entrepreneur’s equity share and the objectives to be achieved.
Venture capitalists generally
negotiate deals to ensure protection of their interests. They would like
a deal to provide for
A return commensurate with
the risk
Influence over the firm
through board membership
Minimizing taxes
Assuring investment liquidity
The right to replace management
in case of consistent poor managerial performance.
The investee companies would
like the deal to be structured in such a way that their interests are protected.
They would like to earn reasonable return, minimize taxes, have enough
liquidity to operate their business and remain in commanding position of
their business.
There are a number of common
concerns shared by both the venture capitalists and the investee companies.
They should be flexible, and have a structure, which protects their mutual
interests and provides enough incentives to both to cooperate with each
other.
The instruments to be used
in structuring deals are many and varied. The objective in selecting the
instrument would be to maximize (or optimize) venture capital’s returns/protection
and yet satisfy the entrepreneur’s requirements. The different instruments
through which a Venture Capitalist could invest a company include: Equity
shares, preference shares, loans, warrants and options.
In India, straight equity and
convertibles are popular and commonly used. Nowadays, warrants are issued
as a tool to bring down pricing.
5. Post-investment Activities
and Exit
Once the deal has been structured
and agreement finalized, the venture capitalist generally assumes the role
of a partner and collaborator. He also gets involved in shaping of the
direction of the venture. This may be done via a formal representation
of the board of directors, or informal influence in improving the quality
of marketing, finance and other managerial functions. The degree of the
venture capitalists involvement depends on his policy. It may not, however,
be desirable for a venture capitalist to get involved in the day-to-day
operation of the venture. If a financial or managerial crisis occurs, the
venture capitalist may intervene, and even install a new management team.
Venture capitalists typically
aim at making medium-to long-term capital gains. They generally want to
cash-out their gains in five to ten years after the initial investment.
They play a positive role in directing the company towards particular exit
routes. A venture capitalist can exit in four ways
Initial Public Offerings
(IPOs)
Acquisition by another company
Repurchase of the venture
capitalist’s share by the investee company
Purchase of the VC’s share
by a third party.
Introduction
to Venture Capital
Venture Capital
in India
Accessing
Venture Capital
Current Scenario
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