Venture Financing: Support Needed

April 25, 2020

Venture Capital Financing: Support Needed to Promote Start-ups Financing

(Published in the Financial Express in 2018)  

Dr. Shah Md Ahsan Habib[1]

Start-ups of Venture capital is a support to entrepreneurial talents and appetite by turning ideas and basic science into products and services which is able to build companies from the simplest form to mature organizations.  The rationale for venture capital is commonly viewed in addressing the gap between ‘a significant potential demand for funding by new or high risk ventures with prospects for high growth and profitability’ and ‘an inadequate supply of capital on appropriate terms from existing financial institutions’. A market for desirable specialized venture capital institutions depends on the regulatory and policy support; readiness of commercial and investment banks or capital markets to finance new or small businesses; and the ability of venture capitalists to identify and add value to promising business propositions.

Venture capital fund is one of the key categories of Alternative Investment Funds from the view point of regulations which are not like the highly regulated financial institutions. Alternative Investment Funds are the investments which do not happen via the traditional modes of finance and investment such as bank finance, stocks, bonds, cash, property etc.; and these funds commonly include hedge funds, angel funds, venture capital funds, private equity funds, commodity funds, debt funds, and infrastructure funds. These generally refer to any privately pooled investment fund – a trust or a company or a body corporate or a limited liability partnership which are not covered the regulations for traditional financial institutions. In the global context, most of these investment entities are owned by big corporate houses or wealthy individuals; several multinational banks have also alternative investment funds. Of the alternative investment funds, venture capital is particularly distinguishable by the involvement of very high risk, and potentials/expectations of very high returns. At the initial stage of business plan, it might be possible to get or collect sufficient amount of money from relatives, friends or other informal sources to run the business. As business grows and size expands, institutional sources of funds at a reasonable cost become crucial. Offering an institutional sources or creating markets for such funds are crucial for ensuring continuous development and innovation in any economy.

Venture capital investors generally actively engage with management of the company typically by taking seat on the board; and through the due diligence process the venture capital firms concentrate on the founders, the management team, the concept, the marketplace, the revenue model, the value-added potential of the firm, the amount of capital needed to heal the business and whether all these fit to the fund’s objectives. Over the three to eight years (many very from sector to sector or case to case in global context), the venture capital firm works with the founding entrepreneur/s to grow the company. Once a company funded by venture capital matures and becomes successful, venture funds generally exit by taking it public through an initial public offering (IPO) or by selling it to big companies. An ‘exit strategy’ is the point when the investment reaps the rewards of initial and subsequent investments and for taking on the risks of said investment. This allows the venture funds to be free from the previous investment and invest in the next generation of companies. Venture capital investments are generally made as cash in exchange for shares and an active role in the invested company which differs from traditional financing sources on certain grounds.

Venture capital for new and emerging businesses typically comes from high net worth individuals (angel investors) and venture capital firms. These investors usually provide capital to young, private companies with the potential for rapid growth. This type of investing inherently carries a high degree of risk. But venture capital is long-term or ‘patient capital’ that allows companies the time to mature into profitable organizations. Venture capital is also an active rather than passive form of financing. These investors seek to add value, in addition to capital, to the companies in which they invest in an effort to help them grow and achieve a greater return on the investment. This requires active involvement; almost all venture capitalists want a seat on the board of directors. Although investors are committed to a company for the long haul, that does not mean indefinitely. The primary objective of equity investors is to achieve a superior rate of return through the eventual and timely disposal of investments. A good investor considers potential exit strategies from the time of the investment.

The people who invest this money are called venture capitalists. A venture capitalist is not a lender, but an equity partner. The venture capital investment is made when a venture capitalist buys shares of such a company and becomes a financial partner in the business. Venture capitalists are part riverboat gambler, part security analyst, and part entrepreneurial voyeur. This is a business of ambiguity and adversity- ambiguity in that often the venture capitalist must read between the lines, based on his general knowledge and experience, to derive the real state of affairs for an investment, ambiguity in that the investments are often highly illiquid and must be held through good times and bad-ambiguity in that most entrepreneurs have a love/hate relationship with the venture capitalists. For entrepreneurs the attractions of venture capital inevitably go beyond the money. More than finance, the venture capitalist gives his marketing and management skills for the development of the new firm.

In connection with the actors, the main actors are investors (fund providers), venture capitalists, and entrepreneurs. Investors and venture capitalists represent the supply side of venture capital, while the entrepreneur represents the demand side. Venture capitalists serve as intermediaries (e.g. brokers) between investors and entrepreneurial firms in need of growth capital, i.e., they act both as a supplier of capital (financial and non-financial) to entrepreneurs and a seeker of capital from investors. The relationships are both contractual and reciprocal and build on considerable trust. To avoid any potential conflict, the relationship with investors is considered almost as important as relationships with portfolio firms.

From the demand perspective, certain steps are commonly followed in the process of getting involved by the venture fund/capitalist. The initial step in generating idea and approaching a Venture Capital is to submit a business plan commonly covering a summary proposal; description of the opportunity and the market potential; reviewing the existing and expected competitive scenario; detailed financial projection and management. Once the preliminary study is done by the VC, then the next step is a one-to-one meeting that is called for discussing the project in detail. After the meeting the VC finally decides whether or not to move forward to the due diligence stage of the process. This process involves solving of queries related to customer references, product and business strategy evaluations, management interviews, and other such exchanges of information during this time period. If the due diligence phase is satisfactory, the VC offers a term sheet, which is a non-binding document explaining the basic terms and conditions of the investment agreement. The term sheet is generally negotiable and must be agreed upon by all parties, after which on completion of legal documents and legal due diligence, funds are made available.

[1] Professor and Director (Training), BIBM ([email protected]).

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