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HOW THE VENTURE

CAPITALINDUSTRYWORKS

VENTURE CAPITAL

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VENTURE CAPITALWhat is a venture?

An undertaking that is dangerous, daring or of uncertain out come.A business enterprise involving high risk in expectation of gain.

Something, money or cargo, at hazard, in a risky enterprise.

What is Venture Capital?

Venture capital is the investment of long term equity financewhere the venture capitalist earns his return primarily in the form of

capital gains.(Patient Risk Capital).

VCs provide their own money for seed capitalto research an

idea, referred as Angelscalled Angel Capital.(InformalVenture Capital).

Corporate Venture Capital- dedicated pool of money, refers to

venture capital investments made by large corporations to further

their strategic( Enhancement of financial or market position)

interest.

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VENTURE CAPITAL STATUSVC funds are regulated by SEBI guidiles-2000.

VC funds ,unlike in USA, can be organized only as a company ortrust.

Mostly, VC funds, in India, are organized as limited life trusts,

liquidated when the objectives are met.

US funds are organized as Limited Liability Partnership whileIndian VCs governed mostly by the Indian Trust Act.

Both are created for a limited period with a clearly defined purpose

and liquidated after achieving the objectives.

It is now possible to form LLPs in India under Limited LiabilityPartnership Act-2008 but VCs are majorly organized as trusts due to

1. In sufficient clarity on the taxation aspects.

2. Ambiguity regarding the applicability of SEBI regulation to

LLPs viz lack of clarity about LLPs activities.

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VENTURE CAPITAL SERVICESDo VCs provide only money?

VCs provide Smart Money. They function as guides andmentors and help the entrepreneur in making the business success.

VCs are backers of ideas and potential & provide expertise to

enable a start up business to succeed and grow.

VCs are knowledgeable about their dynamics and the business

landscape. VCs require a sharp nose to smell investment opportunities and

also to keep themselves updatedwith the different markets, business

technology trends etc to arrive at the odds of a business success.

VCs are not only good with numbers but is also very proficient atnetworking and judging people, opportunities and business

dynamics.

VCs do not actually want to run a business . They are only

interested in adding value to the business they invest in so that they

can multiply their investment manifold.

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HOW VC FUNDS ORGANIZED

Like USA, the unique category of business entities called Limited

Liability Partnerships now also legal in India.Protects external investors from direct liability while providing them

of a partnership agreement.

VCs are managed by experienced money managers, called General

Partners(GPs), responsible for managing the affairs of the fund. Investors are called Limited Partners(LPs).Their involvement is

limited , to provide money to create the VC fund.

Passive Investors: Institutions, pension funds, banks, insurance

companies etc .Professional Money Managers, the GPs, providing limited money

& have complete control on the management of the fund with somechecks and balance.

VC may be raising money for one fund, investing/monitoring themoney of another, the earlier fund.

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HOW VC FUNDS ORGANIZED

Limited Partners Ins

com

Pens

fund

Large

corpHNWI

General PartnersVC fund Mgrs

Portfolio Com-A Com-B Com-C Com-D Com-E Com-F

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RAISING VC FUNDS:STEPS

1)Private Placement Memorandum(PPM):

Document contains information such as the fund size, investmentstrategy, returns expected, minimum contribution expected,

expected life of the firm. Investors make commitment & signs

subscription or investment agreement with the VC fund.

2) Closing:

The fund remains open for investment for a defined period , say1 to 2months, after which it is closed. Usually, 10% to 20%of the amount

is collected from the investors at the closing stage.

3) CALLED:

The rest of the commitment is Calledby the fund in accordance withthe call down schedule. Typically, the money is collected from

investors in tranches (around 15% to 25% of the commitment

amount) over the first two years of the fundslife.

In the process, money does not remain idle helping VC to maintain the

targeted return.

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VENTURE CAPITAL PHASESVC fund goes through the following distinct phases: (Year 8-10)

Establishment(Year 0): Creating entity and pooling investors fundfor onward activities

Seeking Investors (Year 0-1): (Three steps)

A. Private Placement Memorandum

B. Called

C. Closed

Investing the Corpus and Calling Commitments (Year 0-3):

Invested in ventures with defined targeted profile.

Substantially Invested and Monitoring Portfolio (Year 4-7):

Monitored and to ensure that the requisite value is created.

Exit through IPOs and Strategic Sales (Year 5-7): Monies realized

will be propotionately distributed to the investors of the fund.

Distributions (Year 7-9):Liquidation and distribution to investors in

the ratio, invested.

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HOW VC MAKES MONEYVC fund makes money in two ways:

A. Management Fees1. Charged (Between 1% to 3% documented in Private Placement

Memorandum- PPM) to investors on the committed or invested capital.

2. VC charge at the higher end of the scale say 3%,if he has a past

track record of providing superior return.

3. Fees are to be paid on quarterly basis

B. Share of Profits:

1. Carried Interest(Carry) : It is usually about 20% of the funds

profit. It is defined at the initial stages of the funds formation and is

usually dependent on excess returns to investors over and above thenormal return from other investment.

2. Hurdle Rate: VC is not entitled to share in the profits below the

above threshold. VC fund Manager gets his 20% carry only if he can

produce return higher than the hurdle rate.

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VC RETURN METRICS

Internal Rate of Return:

A. The internal rate of return is an annualized rate of return over theperiod between investment and final return and expressed as a

percentage.

B. VC fund having a fixed life of 10 years earns returns at an IRR

30% per annum, means that the corpus has grown at a compoundedrate of 30% per annum over the entire period of 10 years.

Exception in VC fund:

A. VC funds, investments are made in stages and also returned in

stagesB. IRR measures the time value of money by taking into account the

timing of cash flows, in and out, of the fund.

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VC RETURN METRICS

Investment Multiple:

1. It is a simple cash-oncash return.2. Calculated by the monies received divided by the monies invested.

3. Simple measure and does not take into account the number of years

the monies remain invested.

4. IRR falls if the money remains invested for a longer period but

return the same investment multiple.Example: INR 100 reached at INR176 after 5 years of investment in

Bank , at an IRR of 12%.If same amount of money received after 8

years, IRR reduced to 7.5%.The main reasons why VCs are constantly

looking for a good exit at the earliest.IRR% for Different Multiples of X

Year 2x 3x 4x 5x 6x 7x 8x 9x 10x

3 26.0 44.2 58.7 71.0 81.7 91.3 100.0 108.0 115.4

5 14.9 24.6 32.0 38.0 43.1 47.6 51.6 55.2 58.5

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RISK VCs TAKE

Venture Capital Backed Companies Known for Innovative Business

Models, Technology and Products, Employment at IPO and Now.

Company As of IPO Year Current Change

Microsoft 1,153 March1986 100,500 99,347

Intel 460 Oct1971 100,100 99,640

Medtronic 1,287 Year 1977 45,000 43,713

Apple Inc 1.015 Jan1981 76,100 75,085

Google 3,021 April2004 53,861 50,840

JetBlue 4,011 April2002 12,070 8,059

The Home Depot 650 Year 1981 331,000 330,350

Starbucks Corpn 2,521 June1992 160,000 157,479

Staples 1,693 April1989 89,019 87,326

eBay 138 Sept1998 31,500 31,362

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TRANSLATING VC RISK INTO VC TARGET RETURN

A. VCs target is much higher than the expected return as they take

higher risk by investing in unlisted , risky & even new business.

B. Relationship between risk and the buildup of return as

compensation for assuming greater risks.

Risk Free rate of 8%:

Usually reflected by the yield on the 10 year Government Bonds.Investors always aim, at least to make an average around 8%, in tune

with the Govt bonds yield.

Equity Premium of Another 8% for Market Risk

Additional return over and above the risk free return , compensating the

risks taken due to investing money in the equity, of unlisted company.VC Risk Premium of Another 8%(Investors expectation)

Investors like another 50% return over and above they could make by

investing in listed securities ,considering average equity return of 16%

for longer term.

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TRANSLATING VC RISK INTO VC TARGET RETURN

VC Fund Managers Fees and Fund: (Expeted overall 8%)

VC fund manager will take 2% to 3% as annual management fees andabout 20% (Carried Interest) of the return the fund makes on its

operation.

VC overall target return of 32%:

1. VC funds target an IRR of around 32% as arrived above.2. However it varies depending upon the market condition like

inflation, risk free interest rate, capital market situation, money

availability from investors etc.Most VC investors is satisfied with about 30% return on an average for all their

investments as a whole.

Reality: VC Industry- One third Principle: (1/3rdmultiple return, 1/3rd just investment

amt, 1/3rd write off)

VC Portfolio of investments: 2/3rdwritten off or return of original

investment amount.

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PORTFOLIO PERFORMANCE

Overview of VCs portfolio return amounting to INR100Million (INR in M)

A. The fund has earned an IRR32% over 5 years in spite of the fact that

30% of its investment were total loses.

B. Conclude that in general, every three of VCs investments could

able to succeed to generate return multiple.

Investment

Type

Sunk Average Superior Solid Super

Stars

Total

Portfolio

No of Companies 3 3 2 1 1 10

Total Invested 30 30 20 10 10 100

Value after 5 Yrs 0 120 100 80 100 400

Stages Seed Start up Early Stage Later Stage Turnaround

Industry Electro

nics

Computer

Software

Consumer

related

Industrial

Products

Medical

Return Multiple 0X 4X 5X 8X 10X 4X

IRR% 0% 32% 38% 52% 58% 32%

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VENTURE CAPITAL STRATEGYThe strategies VCs adopt in order to achieve their objectives

varies with their:1. Experience

2. View on the need in the market

3. Estimate of what the future in various industries is likely

to be

4. Risk they can take

5. Sources and cost of funds

6. Style of investment i.e. how much involvement in themanagement, monitoring and control of the business they

consider necessary to ensure a profitable exit.

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VENTURE CAPITAL RISK STRATEGYSeed Stage(Very High Risk)

Turnaround Stage

(Medium to High Start up Stage

Risk) (High Risk) (High Risk)

Mature Stage

(Medium to

Low Risk)

Early Growth

Expansion Stage Stage

(Medium Risk) (Medium to High

Risk)

VC RISK

STRATEGY

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VENTURE FUNDING STAGES PURPOSEA. Seed Stage(VH): (Drawing Board Status)

Research, Prototype development, Business Plan Development

B. Start Up Stage(H): (Validated Status)

Product & Basic Infrastructure Development , Market survey etc

C. Early Growth Stage(MH): (Full Scale Operation Status)

Creating Market, Process Creation, Market Development ,

Working Capital (First Round Funding by VC)D. Expansion Stage(M): ( Product Refinement Status)

Market Development , Geographical Expansion, Incremental

Working Capital. ( 2nd& 3rdRound Funding by VC)

E. Mature Stage(ML): (New Market & Product Dev Status) Acquisition, Global Marketing, Increased Capacity

(Mezzanine or Bridge for IPO by VC)

F. Turnaround Stage(MH): (Special Situation Stage)

Reorganization of Business, Surviving till disinvestment and

positive cash flow (Restructuring : Reduction of debt by specialized VC)

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VENTURE FUNDING STAGESSEED STAGE FINANCING( 5 years to 8 years , expected return100%)

This stage is a relatively small amount of capital provided to an

inventor or entrepreneur to prove a concept.

This involves product development and market research as well as

building a management team and developing a business plan, if the

initial steps are successful, is a pre-marketing stage.

EARLY STAGE FINANCING ( 4 to 7 years , expected return 50%-80%)

This stage provides financing to companies completing development

where products are mostly in testing or pilot production. In some

cases, product may have just been made commercially available.

Companies may be in the process of organizing or they may already

be in business for three years or less.

Usually such firms will have made market studies, assembled the

key management, developed a business plan, and are ready or have

already started conducting business.

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VENTURE FUNDING STAGESEXPANSION STAGE (3 years to 6 years, expected return 40% -70%)

This stage involves working capital for the initial expansion of a

company. It may or may not be showing a profit.

Some of the uses of capital may include further plant expansion,

marketing, working capital, or development of an improved product.

More institutional investors are more likely to be included.

VCsrole evolves from a supportive role to a more strategic role.

LATER STAGE ( 3 years to 5 years, expected return 30% to 50%)

Capital in this stage is provided for companies reached at a fairly

stable growth rate , may not be growing as fast as the earlier stage. These companies may or may not be profitable, but are more likely to

be better than in previous stages of development.

Other financial characteristics include positive cash flow.

This also includes companies considering IPO.

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VENTURE FUNDING STAGESACQUISITION FINANCING (1 to 3 years ,expected return 20% -35%)

An acquisition of 49% stake or less. Firm acquires minority sharesof a company.

ACQUISITION: EXPANSION ( 2 to 5 years, expected return 30-50%)

Funds provided to a company to finance its acquisition of other

companies or assets. A consolidatorof companies in specific industries.

MANAGEMENT/LEVERAGED BUYOUT (Depends on the situation)

These funds enable an operating management group to acquire a

product line or business, at any stage of development , from either apublic or private company , may be closely held or family owned.

Management/leveraged buyouts usually involve revitalizing an

operation,with entrepreneurial management acquiring a significant

equity interest.

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VENTURE FUNDING STAGES

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VENTURE FUNDING STAGES

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VC INVESTMENT PROCESS

A. Deal Sourcing:

Identification of attractive investment opportunities

B. Evaluation of business aspects: ( 85% to 90% rejection)

Management: (Composition,motivation,commitment,vision,partner)

Growth Potential (Product/Market Dynamics), (Scalability, industry)

Profitability:( Economies, infrastructure, capital intensity,WC Reqr)

Investment Requirements:(size, Rounds of finance, portfolio size)

Exit Opportunities, timing & Return:( Risks & Reward, exit time)

C. Deal Structuring and Negotiation:

Creating Documents on accepted agreements-called Term SheetD. Due Diligence Review: (Scrubbing the Deal)

Detailed examinationby VC on the business plan & representation.

E. Legal Documentation:

Finally, Legal vetting of term sheet

O C

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NEED FOR VENTURE CAPITAL FUNDFunding Gap:

1. Arises at the initial stages of venture, when the venture can neither

attract debt finance nor can it get venture capital funding.

2. Founder/Entrepreneur finance the required amount through

personal savings or avail credit on the strength of their own credit

history.

3. Sources: Family/ friends , Leasing , Bank,Angel,Venture Capital

4. The initial gap is managed by the Entrepreneur with his own efforts

and resources-referred as Bootstrapping skills

Really venture need Money?

1. Money invested in venture has always a cost

2. Adoption of Prudent Money Management Style

3. Optimal use of all the available sources of financing.

4. Avoid getting money in exchange of Equity at the early life cycle ofthe venture, cost heavily.

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CREATIVE FINANCING IDEAS

1. Find ways sharing expenses with others.

2. Carry minimum head count on your payroll3. Structureperformance linked compensation for

employees

4. Do not block your money in fixed asset

5. Minimum inventory carrying cost6. Suppliers can be a cheap source of funds

7. Ways to receive advance from buyers against future

services

8. Sales commission to sales staff, on receipt of cash.9. Create Cash is King perception in the organization.

10 Strategic alliances/JVswith suppliers and customers.

11. Ideal capacity forbartering services.

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ENTREPRENEURS ANXIETY

Myth 1: Take over of Business:

VCs primary business is money management. Objectives are

protection and harvesting their investment for huge profit.

Myth 2: Looking control of Business by Vc.

VCs have control over the crucial decision making process, not on

day to day operational affairs.

Myth 3: Selling of Business to enable the VC to Exit.VCs look clear path to realize their profit, selling is the last resort

Myth 4: Need to change the way of working.

Founder is more responsible than VCs- to recognize all time

Myth 5: Open up of Business secret causing detrimental tobusiness.

VC is a partner of your business having same footing like you.

Myth 6: VCs unreasonable demand for high return.

VC funding carries high risk. High return is the only alternative.

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BUSINESS WHERE VCs PROVIDE MONEY

1. Ventures which can become big business rapidly.

2. Businesses have better odds of reaching an IPO.

3. Business achieving a strategic sale within 3 to 5 years for VCs exit.

Business, majorly two types :

A. Limited Opportunity Business:

Provides regular income to its owners/investors.

Geographically confined and serve the local community. Retail/ consulting/service/ transportation/ restaurants firms.

Do not sell equity to VC to retain overall control.

It is very difficult to have aprofitable exit by VC.

Investors here received dividend, interest payments & do not relyon the IPO market, strategic merger or sale for their return.

Sourced funds from individuals, strategic partners, lenders etc

Positive, high cash flow early in business development.

Initial losses are funded through founder, angel, Strategic Investors.

Return to investors through annual dividends or interest payments.

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BUSINESS WHERE VCs PROVIDE MONEY

B. Scalable Growth Business:

1. Ability for a rapid business growth due to the combination of

The marketin which they operate

Their differentiated product offerings

Managementcapability of the founding team.

2. Sufficiently large and growing industrial segments.

3. Opportunity of a new segment in a matured market.4. New method of solvingindustrysexisting problem.

5. Rationalization in regulatory environment due to changes in social

attitudes or structural changes in the market.

6. New technology enlarge the existing market & create new market.7. Create entry barriers for potential competitors under IPRs.

8. Business having strong competitive positioning.

9. Deregulationof market creates huge opportunity to entrepreneur.

10.Management capability: Core Mgt Team, Teams internal roles,

responsibilities, rewards. Creative,Dynamic,business acumen of Team.

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VC FINANCE :YES LIST

Founder and his team arepassionateabout their business.

Definite need of ventures product and service in the market besides

to address any existing pain in the targeted customers.

Offering any unique and differentiated products than competitors.

Having huge market size & growing rapidly.

Existence of entry barriers.

Expected revenue to grow over 50% pa over the next five years. Motivated management team, aiming to grow the business.

Roles, responsibilities, rewards of the Leaders are clearly defined.

No legal violation, compliance of all regulatory requirements.

Policy, procedures & process should promote efficiency/scalability.

Ready to sell off a part to VC.

Willing to be accountablefor performance to the VC.

Willing to change working style to accommodate VCs monitoring.

Have a clear exit strategy.

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PROCESS OF RAISING VC BY ENTREPRENEURS

Step 1: Preparation of Documents.

Detailed Business PlanExecutive Summary

Elevator Pitch

Presentation

Step 2: Selection of Target VCs (Short Listing). Industry

Stage of Business

Investment Amount

Target Return

Post Investment monitoring Requirement

Geographical Area

Step 3: Meeting the VC

Present, business case.

Impress the VC and aim at to receive term sheet

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PROCESS OF RAISING VC

Step 4: Term Sheet Negotiation

Awareness of VC terms sheet , transformed to be a legal documentSound negotiating strategy prior to start of the funding by VC.

Step 5: Due Diligence.

Investigation of ventures business by VC

VCs validation of historical and operational information, submittedby ventures

Prior competency to know expected issues that lead VCs, saying no.

Step 6: Legal Documentation

Investment Agreement Share holders Agreement

Confidentiality and non disclosure agreement

Service Contracts for Key employees and Directors

Non negotiable key clauses from the VCsstand point , awareness.

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WHEN ENTREPRENEURS SHOULD RAISE FUND

Initiate VC funding activities, when venture has least need of

the money . Have a financially good year, move to VC at the end of the

fiscal year with audited balance sheet and with current year

forecast besides updated achievements.

Major event ( Products trial run , acquisition of newcustomer or big order etc) , having positive impact on the

future growth of your business lead to be a positive point to

consider by VC.

External environment like booming of capital market willhelp the ventures to get a higher valuation of their business.

VCs are also able to raise more money and keen to invest into

the best opportunities

Wh C G W R i i VC

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What Can Go Wrong, Raising VC

1.General:

Underestimating the length of time taken to obtain funding Underestimating Management time taken to prepare

Not having a scalable growth business

Not using experienced advisers

Inappropriate timing of fund raising

2. Targeting Stage:

Inexperienced advisers or incorrect advice

Badly made business plan, executive summary and elevator pitch

Selecting wrong VC(Industry focus, Investment size/amount, return)

Portfolio needs of the VC preclude investment

IRR not good enough

Timing and mode of exit is unsuitable

Wh C G W R i i VC

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What Can Go Wrong , Raising VC

3. Screening Stage:

Business Plan not well drafted

Management Lacking in Creditability

Lack of integrity (selective disclosure, false/partial statement.

Lack of chemistry between the founder and VC.

High equity stake by VC

Funding amount is too high or too lowNo syndicate VCs available.

4. Due Diligence Stage:

Shareholder issues, Employee issues

Legal cases or contingent liabilities Post due diligence valuation adjustment not agreed by entrepreneur

5. Legal Agreement Stage:

Control issue

Anti dilution issues

Share transfer issues


VC METHODS OF FINANCING(INDIA)

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VC: METHODS OF FINANCING(INDIA)

EQUITY:

I. Provides VC in the form of equity and acts as co-owner.II. Generally less than the promoters contribution ,not exceeding 49%

III. Effective control retains by the promoters

CONDITIONAL LOANS:

I. Not repayable and does not carry interest.

II. Repayment is linked to the sales of the company in the form of

loyalty

III. Royalty(2% to 15%) usually collected from the third to fifth year.

IV. Repayment terms being decided keeping in view the gestation

period & the repayment ability.

CONVENTIONAL LOANS:

I. Long term loan , 10-12 years ,at a concessional rate of interest with

a clause to raise when the project is commercially successful.


VC: METHODS OF FINANCING(INDIA)

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VC: METHODS OF FINANCING(INDIA)INCOME NOTES:

I. Hybrid security combining the features of both conventional &

conditional loans.

II. A floor rate of interest (Say10%) and a royalty on sales are charged.

III. Funds are made available in the form of unsecured loan.

IV. Higher interest rate during the development phases.

OTHER INSTRUMENTS: (Innovative Financial Instrument)

A. Participating Debentures stipulating a three phase system charges;

I. Interest Holiday till the project is implemented successfully.

II. Lower rate of interest till the project operates at a particular level of

capacity utilization.

III. Increased rate of interest and a small royalty on sales once the project

takes off.

B. Partially convertible debentures, Cumulative convertible preference Shares,

C. Hire purchase, lease finance & even overdraft in selected cases.

VC: CASE STUDY 4

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VC: CASE STUDY-4 PDQ plc is a software company and Internet provider that was

established in the dot-com boom of the year 2000.

The three funding shareholders who are still directors andmanagers of the company own 30% of PDQ plc. Employees, friends

and relatives of the founders own a further 15%. The majority 55%

shareholding is owned by a venture capital company that bought

a stake in PDQ plc four years ago for INR12M. The venture capitalcompany now wishes to dispose of the holding. The 45% minority

shareholders and non-shareholding employees are considering a

management buyout.

PDQ plc has sustained losses for the past three years but believesit is now moving into profit. Because of this losses, no liability to

tax will arise in AY 2014 but the company will begin to pay tax at

30% per annum from AY 2015. It has not declared or paid a

dividend since the company was formed.

KEY FINANCIAL INFORMATION

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KEY FINANCIAL INFORMATIONIncome statement for the years ended (INR M)

Particulars 31/3/2014(Est) 31/3/2013

Sales Revenue 15.25 14.52Direct Costs & Expenses 12.50 16.97

Profit/(Loss) before tax 2.75 (2.45)

BALANCESHEET FOR THE YEAR ENDED

Fixed Asset(NV) 0.50 0.50

Inventory 1.25 1.25Receivables 4.25 3.25

Cash & Marketable Securities 0.50 00

Current Assets 6.00 4.50

Less Current Liabilities

Trade Payables 2.80 3.20

Bank Overdraft 00 2.80 0.85 4.05

Total Net Asset 3.70 0.95

Ordinary Share capital of INR1 0.25 0.25

Total Reserve 3.45 0.70

Net Worth 3.70 0.95

VC: CASE STUDY-4

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VC: CASE STUDY 4 The Directors expect growth of 20% each year for the three years

2015-2017 inclusive, falling to 5% each year after that. The

average P/E ratio for established listed companies in the industryis currently 28.4 but there is a wide range of between 7.5 and 51.5.

The average post tax cost of equity capital for the industry,

according to a recent study, is 15%.

Requirements

Advise the founders/employees on the following:

The price they might have to offer the venture capitalist to

succeed with a management buyout. You should include in your

discussion the various methods of share valuation that might besuitable in the circumstances. Make and state whatever

assumptions you feel are necessary and appropriate.

The Advantages and disadvantages of pursuing a management

buyout at the present time compared with the possibility of a sale

of the venture capitalists shareholding to another investor.

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VENTURE CAPITAL

GOOD WISHES

TO ALL