What is Venture Capital? Techniques, Private Equity, Factor Affecting

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What is Venture Capital?

Venture capital refers to financial investments made in extremely hazardous projects with the hope of receiving a high rate of return. Although the idea of venture capital is extremely ancient, the government’s current strategy of liberalisation seems to have given the venture capital movement in India a boost.

In reality, one of the newest participants in the Indian capital market is venture capital funding. Because more technocrat entrepreneurs are emerging in our nation but lack the funds to take risks, there is a huge market for venture capital firms.

In the 20th century, venture capital has become a new financial tool for funding. Capital from professional firms that invest alongside management in start-up, evolving or expanding businesses with the potential for significant development is known as Venture Capital. A type of equity financing called venture capital is specifically made for high-risk, high-reward businesses.

The idea that venture money may be used to fund high-tech initiatives is widely held. However, venture capital is a long-term financial investment made in:

  • Ventures advocated by entrepreneurs who lack experience but are technically or professionally prepared
  • Ventures looking to commercialise technologies that haven’t been tested
  • High-risk endeavours

These venture capital firms give entrepreneurs the risk financing they need so they can contribute to what financial institutions want from the promoters. These VCFs (Venture Financing companies) take an active interest in coaching the aided enterprises in addition to giving capital. A fledgling, high-tech business that is still in the early stages of funding and isn’t yet ready to sell securities to the general public may look for venture capital.

To generate a high rate of return, mostly in the form of capital gain, venture capital funds give such high-risk capital in the form of long-term equity financing. In actuality, the venture investor collaborates with the entrepreneur as a partner.

A venture capitalist (VC) can thus give the initial funding for start-up businesses, technologically focused concepts and untested goods. A company that is unable to attract financing through regular channels may potentially receive investment from venture capitalists.

The three attributes of a banker, investor in the stock market and entrepreneur are all present in venture capital.

  • High degrees of risk: Investing money in a project that carries a high degree of risk with the hope of receiving a high rate of return is known as venture capital.

  • Equity participation: Venture capital funding always involves real or potential equity participation, with venture capitalist’s ultimate goal being to earn financially from the sale of the shares once the company is profitable.

  • Long-term investment: Venture capital funding is an investment over the Long Run. The venture capitalists’ investments in securities typically take a long time to be repaid.

  • Participation in management: Venture capital funds actively participate in the management of the aided businesses in addition to giving financing. As a result, venture capital companies have a different strategy than a typical lender or bank.

    Additionally, it differs from a typical stock market investor who only trades a company’s shares without being involved in management. Venture capital, it has been stated, “combines the attributes of a banker, stock market investor and entrepreneur in one.”

  • Achieve Social Objectives: It differs from the development capital offered by several federal and state government agencies in that the financing is driven by a profit goal. However, venture capital ventures indirectly contribute to balanced regional growth, employment and the establishment of new, profitable businesses.

  • Investment is liquid: Unlike an overdraft or a loan payback plan, a venture capital investment is not subject to immediate repayment. Only when the firm is sold or successfully listed on the stock market does the investment become a reality.

Techniques of Venture Capital

Finance provided by venture capital firms to start-up, early-stage and rising businesses with significant development potential is referred to as venture capital finance. In exchange for a share of the company’s ownership or equity, investors put money into risky fledgling businesses. Venture capitalists are those who provide finance for these enterprises. They invest with the hope of profiting more if the business is successful.

The following two key stages are when an investment in a venture might be made, according to venture capital firms.

Let’s discuss them in detail.

Early Stage Financing

This stage includes the following:

  • Seed capital and R&D projects: Venture investors are more frequently drawn to providing seed financing for R&D projects, i.e., making extremely few provisions for the financing required to launch a firm. Before a product is introduced, research and development tasks must be completed. During the product’s development, the entrepreneur frequently needs outside funding.

    Venture capitalists, firms and funds are always willing to take on risks and make investments in these R&D projects because they promise higher returns in the future. As the research phase transitions into the development phase, where a sample of the product is tested before it is finally commercialised, the financial risk increases gradually.

  • Start-ups: The beginning of a new firm after research and development have been finished is the riskiest venture capital undertaking. At this stage, the entrepreneur and his products or services are as yet untested, and the required financing typically falls short of his resources.

    Start-ups may include new industries/businesses set up by experienced individuals in the field in which they know, others may result from research bodies or large corporations, and still, others may result from research bodies or large corporations.

  • Second round financing: This refers to the period after a product has been introduced to the market but before it has generated sufficient profits to draw in new investors. At this point, additional funding is required to meet the expanding needs of the company.

    Venture Capital Institutions (VCIs) provide larger funds than other early-stage financings in the form of debt at this stage, and the investment period is typically three to seven years.

Later Stage Financing

Businesses that are already established and need extra funding but are unable to do so through a public offering might turn to venture capital firms to help with development funding, buyouts and turnarounds.

  • Development capital: Development capital refers to the financing of an enterprise that has passed through a highly risky stage, has generated profits but is unable to go public and therefore needs financial support.

    Funds are required for the purchase of new equipment and plant, the expansion of marketing and distribution facilities, the launch of products into new regions and other activities. The time frame of investment is typically one to three years and falls under the medium risk category.

  • Expansion finance: The time frame of investment is typically between one and three years, and it represents the final round of funding before a planned exit. Growth implying bigger factories, large warehouse, new factories, new products or new markets or through purchase of existing businesses are both considered low risk by venture capitalists.

  • Buyouts: There are two sorts of buyouts, which refer to the transfer of management control by separating the current firm from its owners.

    • Management Buyouts (MBOs): An essential component of VCIs’ activities, Management Buyouts (MBOs) includes venture capital institutions funding the acquisition of an existing product line or firm by investors or current operational management.

    • Management Buy-ins (MBIs): MBIs involve three parties a management team, a target company and an investor (i.e., venture capital institution). MBIs are riskier than MBOs and are therefore less common because it is challenging for new management to gauge the actual potential of the target company. Typically, MBIs can target weaker or under-performing companies.

  • Replacement Capital: Another aspect of financing entails providing money for the purchase of an owner’s existing shares. This may be done several reasons, such as a personal need for money, a family dispute or the desire to be associated with a recognisable name. The investment period is one to three years and is low risk.

  • Turnarounds: This type of venture capital financing entails medium to high risk and a time frame of three to five years. It involves acquiring control of a sick company, which calls for highly specialised skills. It may also call for rescheduling all of the company’s debts, a change in management or even a change in ownership. During the initial crisis period, venture capitalists may nominate their chairman or appoint one.

To maintain a balance between risk and profitability, venture capital firms finance both early and later-stage investments. When making early-stage investments, venture capitalists assess technology and research potential markets in addition to taking the promoter’s ability to implement the project into account. In later-stage investments, new markets and the track record of the business or entrepreneur are closely scrutinised.

Indian Venture Capital Scenario

The development of financial institutions, like IDBI, ICICI and State Financial Corporations, which supported businesses in the private sector by using debt as a source of finance, are likely responsible for the venture capital activity that took place in the past. For a long time, funds raised from the public were used as a source of Venture Capital, but this source depended a lot on the success of the venture.

The first private VC fund, Credit Capital Venture Fund, was sponsored by Credit Capital Finance Corporation (CFC) and promoted by the Bank of India, Asian Development Bank and the Commonwealth Development Corporation at the same time Gujarat Venture Finance Ltd. and APIDC Venture Capital Ltd. were established by ICICI and UTI. VC financing began in India in 1988 with the formation of Technology Development and Information Company of India Ltd. (TDICI) – promoted by ICICI and UTI.

In the last year or so, almost all the major global VC firms have either established an on-ground presence in India or raised significant India-dedicated funds, and the Indian Venture Capital (VC) market has been growing more and more active. In 2006, VC investment levels increased by more than 300 per cent to almost $7.5 billion from $2.2 billion in 2005, and this quantum leap was not the result of a low base as 2005 was a record year in itself.

Annual growth rates of 7-9% are unheard of in mature western economies, and global investors want high returns. Furthermore, several key sectors of the Indian economy (IT/BPO, telecom, pharma/healthcare, financial services, retail and automotive components) that are investment targets are experiencing even higher growth than what is fuelling this VC investment boom.

The introduction of FBT on stock options and the most recent information regarding preference share capital necessitating compliance with ECB guidelines on interest/dividend coupon caps and end-use restrictions (that is, compliance with external debt) are two examples of recent regulations that many investors fear have not been well thought through and would like to see the government use the current momentum to push forward with further deregulation.

This is in stark contrast to many western markets, where an even higher and ever-increasing percentage of VC investments are structured with a layer of preference share capital also referred to as “hybrid capital.” At present, it is estimated that about 30% of the Indian VC/PE investments are structured as preference share capital; however, unless this estimate is revised, the percentage may well come down.

Private Equity in Venture Capital

As implied by the name, private equity funds invest in assets that are either not owned publicly or that are publicly owned but that the private equity buyer plans to take private. Private equity firms invest in both privately and publicly held companies, even though the money used to fund these investments comes from private markets.

Private equity, which includes venture, buyout and mezzanine investing, has become a more common asset for sophisticated investors. Private equity assets are often purchased by investors through either a fund of funds, which involves commitments to several private equity funds or through individual funds, which are typically limited partnerships with a particular investing stage and geographic concentration.

An investor makes an initial financial commitment when investing in private equity through funds or funds of funds and that cash is subsequently “called” or taken down as the investment managers of the underlying funds identify investment possibilities. Capital is primarily returned to investors through secondary investment, which is the acquisition of an interest in a private equity fund from the original investor before the end of the fund’s fixed life.

Contrary to stocks, mutual funds and bonds, private equity funds typically invest in more illiquid assets, such as companies. By buying companies, the firms gain access to those companies’ assets and revenue sources, which can result in extremely high returns on investments.

If a private equity fund’s return on assets (ROA) is higher than this cost, the fund’s return on equity (ROE) is higher than if it hadn’t borrowed money. However, the same principle applies in reverse, making these leveraged buyouts potentially very risky; if the acquired company’s ROA is lower than the cost of the debt used in buyouts, the acquired company’s ROA is lower than the cost of the debt.

Factors Affecting Private Equity

The following are the main factors that have an impact on private equity’s growth:

Raising capital

The company may need a significant infusion of capital for long-term productivity investments, such as research and development. Rather than waiting several quarters (or years) to gather sufficient capital, the company may choose to sell part of its interests in exchange for the ability to pursue development projects earlier.

Increasing regulation of public markets

Given the increased regulation and scrutiny in the public markets over the past few years, some companies may wish to avoid having their fates controlled—or at least heavily influenced—by public shareholders. In a private equity transaction, such rights are typically absent. As a result, some companies may wish to avoid having their fates controlled—or at least heavily influenced—by public shareholders.

Effect on public markets

For stock market investors, the real question is how the private equity market has affected public markets and what its likely future effects will be. Many analysts contend that the rise in private equity deals has benefited some aspects of the stock market because it’s harder for public investors to access sectors where private equity has been particularly active.

Rising stock prices

Given recent trends in the private equity industry, investors frequently feel safe in assuming that private equity firms will pay a hefty premium over a company’s market value. Companies that are perceived as likely targets of private equity buyouts have seen their stock prices rise in anticipation of the transaction.

Private Equity in India

Private equity houses have been involved in an unprecedented number of investment deals as a result of the recent boom in the Indian economy, which has seen sustained growth of around 8% a year. In sharp contrast to the past, when private equity funds were invested in India from a base overseas (for example, Singapore), many private equity firms have now established a presence in the nation.

The average deal size in India is significantly lower than in China or South Korea, for example, but 8,000 companies are listed on Indian exchanges, a huge number by any standard and the rising performance of the stock market since 2004 has resulted in a higher level of investment opportunities than in either of those other two regions.

However, there are signs that private equity firms are willing to play a more active advisory role in parallel with their ability to raise growth capital — a prospect that owners and promoters are starting to find appealing. In addition to providing capital and financial expertise, private equity firms are in a unique position to introduce new disciplines and techniques.

With an increasing local market and new opportunities brought on by globalisation, the value of private equity investment in India has grown tremendously over the past ten years. The effect of private equity on Indian businesses is projected to increase further in the future years.

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