Venture Capital

What Does Venture Capital Mean? Money provided by investors to startup firms and small businesses with perceived long-term growth potential. This is a very important source of funding for startups that do not have access to capital markets. It typically entails high risk for the investor, but it has the potential for above-average returns.

Investopedia explains Venture Capital Venture capital can also include managerial and technical expertise. Most venture capital comes from a group of wealthy investors, investment banks and other financial institutions that pool such investments or partnerships. This form of raising capital is popular among new companies or ventures with limited operating history, which cannot raise funds by issuing debt. The downside for entrepreneurs is that venture capitalists usually get a say in company decisions, in addition to a portion of the equity. Filed Under: Entrepreneur, Small Business, Venture Capital Related Terms Adventure Capitalist Death Valley Curve Diluted Founders Down Round Initial Public Offering - IPO Pre-Money Valuation Risk Capital Seed Capital Series A (Preferred Stock) Venture Capitalist

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Venture capital financing From Wikipedia, the free encyclopedia Jump to: navigation, search Venture capital financing is a type of financing by venture capital: the type of private equity capital is provided as seed funding to early-stage, high-potential, growth companies and more often after the seed funding round as growth funding round (also referred as series A round) in the interest of generating a return through an eventual realization event such as an IPO or trade sale of the company.

Contents

1 Overview 2 Venture Capital Financing Process o 2.1 The Seed Stage o 2.2 The Start-up Stage o 2.3 The Second Stage o 2.4 The Third Stage o 2.5 The Bridge/Pre-public Stage 3 At Last 4 See also 5 References 6 Further reading

[edit] Overview To start a new startup company or to bring a new product to the market, the venture may need to attract financial funding. There are several categories of financing possibilities. If it is a small venture, then perhaps the venture can rely on family funding, loans from friends, personal bank loans or crowd funding. For more ambitious projects, some companies need more than what mentioned above, some ventures have access to rare funding resources called angel investors. These are private investors who are using their own capital to finance a ventures need. The Harvard report [1] by William R. Kerr, Josh Lerner, and Antoinette Schoar tables evidence that angel-funded startup companies are less likely to fail than companies that rely on other forms of initial financing. Apart from these investors, there are also venture capitalist firms (VC-firms) who are specialized in financing new ventures against a lucrative[citation needed] return. When a venture approaches the last one, the venture is going to do more than negotiating about the financial terms. Apart from the financial resources these firms are offering; the VC-firm also provides potential expertise the venture is lacking, such as legal or marketing knowledge. This is also known as "smart money". [edit] Venture Capital Financing Process As written in the previous paragraph, there are several ways to attract funding. However in general, the venture capital financing process can be distinguished into five stages; 1. 2. 3. 4. 5. The Seed stage The Start-up stage The Second stage The Third stage The Bridge/Pre-public stage

Of course the stages can be extended by as many stages as the VC-firm thinks it should be needed, which is done in practice all the time. This is done when the venture did not perform as the VC-firm expected. This is generally caused by bad management or because the market collapsed or a bit of both (see: Dot com boom). The next paragraphs will go into more details about each stage.

The following schematics shown here are called the process data models. All activities that find place in the venture capital financing process are displayed at the left side of the model. Each box stands for a stage of the process and each stage has a number of activities. At the right side, there are concepts. Concepts are visible products/data gathered at each activity. This diagram is according to the modeling technique founded by Professor Sjaak Brinkkemper of the University of Utrecht in the Netherlands. [edit] The Seed Stage

The Seed Stage This is where the seed funding takes place. It is considered as the setup stage where a person or a venture approaches an angel investor or an investor in a VC-firm for funding for their idea/product. During this stage, the person or venture has to convince the investor why the idea/product is worthwhile. The investor will investigate into the technical and the economical feasibility (Feasibility Study) of the idea. In some cases, there is some sort of prototype of the idea/product that is not fully developed or tested. If the idea is not feasible at this stage, and the investor does not see any potential in the idea/product, the investor will not consider financing the idea. However if the idea/product is not directly feasible, but part of the idea is worth for more investigation, the investor may invest some time and money in it for further investigation. Example A Dutch venture named High 5 Business Solution V.O.F. wants to develop a portal which allows companies to order lunch. To open this portal, the venture needs some financial resources, they also need marketeers and market researchers to investigate whether there is a market for their idea. To attract these financial and nonfinancial resources, the executives of the venture decide to approach ABN AMRO Bank to see if the bank is interested in their idea. After a few meetings, the executives are successful in convincing the bank to take a look in the feasibility of the idea. ABN AMRO decides to put a few experts for investigation. After two weeks time, the bank decides to invest. They come to an agreement of invest a small amount of money into the venture. The bank also decides to provide a small team of marketeers and market researchers and a supervisor. This is done to help the venture with the realization of their idea and to monitor the activities in the venture. Risk

At this stage, the risk of losing the investment is tremendously high, because there are so many uncertain factors. From research, we know that the risk of losing the investment for the VC-firm is around the 66.2% and the causation of major risk by stage of development is 72%. These percentages are based on the research done by Ruhnka, J.C. and Young, J.E. [edit] The Start-up Stage

The Start-up Stage If the idea/product/process is qualified for further investigation and/or investment, the process will go to the second stage; this is also called the start-up stage. At this point many exciting things happen. A business plan is presented by the attendant of the venture to the VC-firm. A management team is being formed to run the venture. If the company has a board of directors, a person from the VC-firms will take seats at the board of directors. While the organisation is being set up, the idea/product gets its form. The prototype is being developed and fully tested. In some cases, clients are being attracted for initial sales. The management-team establishes a feasible production line to produce the product. The VC-firm monitors the feasibility of the product and the capability of the management-team from the Board of directors. To prove that the assumptions of the investors are correct about the investment, the VC-firm wants to see result of market research to see whether the market size is big enough, if there are enough consumers to buy their product. They also want to create a realistic forecast of the investment needed to push the venture into the next stage. If at this stage, the VC-firm is not satisfied about the progress or result from market research, the VC-firm may stop their funding and the venture will have to search for another investor(s). When the cause relies on handling of the management in charge, they will recommend replacing (parts of) the management team. Example Now the venture has attracted an investor, the venture need to satisfy the investor for further investment. To do that, the venture needs to provide the investor a clear business plan how to realise their idea and how the venture is planning to earn back the investment that is put into the venture, of course with a lucrative return. Together with the market researchers, provided by the investor, the venture has to determine how big the market is in their region. They have to find out who are the potential clients and if the market is big enough to realise the idea.

From market research, the venture comes to know that there are enough potential clients for their portal site. But there are no providers of lunches yet. To convince these providers, the venture decided to do interviews with providers and try to convince them to join. With this knowledge, the venture can finish their business plan and determine a pretty good forecast of the revenue, the cost of developing and maintaining the site and the profit the venture will earn in the following five years. After reading the business plan and consulting the person who monitors the venture activities, the investor decides that the idea is worth for further development. Risk At this stage, the risk of losing the investment is shrinking, because the uncertainty is becoming clearer. The risk of losing the investment for the VC-firm is dropped to 53.0%, but the causation of major risk by stage of development becomes higher, which is 75.8%. This can be explained by the fact because the prototype was not fully developed and tested at the seed stage. And the VC-firm has underestimated the risk involved. Or it could be that the product and the purpose of the product have been changed during the development.[2] [edit] The Second Stage

The Second Stage At this stage, we presume that the idea has been transformed into a product and is being produced and sold. This is the first encounter with the rest of the market, the competitors. The venture is trying to squeeze between the rest and it tries to get some market share from the competitors. This is one of the main goals at this stage. Another important point is the cost. The venture is trying to minimize their losses in order to reach the break-even. The management-team has to handle very decisively. The VC-firm monitors the management capability of the team. This consists of how the management-team manages the development process of the product and how they react to competition. If at this stage the management-team is proven their capability of standing hold against the competition, the VC-firm will probably give a go for the next stage. However, if the management team lacks in managing the company or does not succeed in competing with the competitors, the VC-firm may suggest for restructuring of the management team and extend the stage by redoing the stage again. In case the venture is doing tremendously bad whether it is caused by the management team or from competition, the venture will cut the funding.

Example The portal site needs to be developed. (If possible, the development should be taken place in house. If not, the venture needs to find a reliable designer to develop the site.) Developing the site in house is not possible; the venture does not have this knowledge in house. The venture decides to consult this with the investor. After a few meetings, the investor decides to provide the venture a small team of web-designers. The investor also has given the venture a deadline when the portal should be operational. The deadline is in 3 months. In the meantime, the venture needs to produce a client-portfolio, who will provide their menu at the launch of the portal site. The venture also needs to come to an agreement how these providers are being promoted at the portal site and against what price. After 3 months, the investor requests the status of development. Unfortunately for the venture, the development did not go as planned. The venture did not make the deadline. According to the one who is monitoring the activities, this is caused by the lack of decisiveness by the venture and the lack of skills of the designers. The investor decides to cut back their financial investment after a long meeting. The venture is given another 3 months to come up with an operational portal site. Three designers are being replaced by a new designer and a consultant is attracted to support the executives decisions. If the venture does not make this deadline in time, they have to find another investor. Luckily for the venture, with the come of the new designer and the consultant, the venture succeeds in making the deadline. They even have 2 weeks left before the second deadline ends. Risk At this stage, the risk of losing the investment still drops, because the venture is capable to estimate the risk. The risk of losing the investment for the VC-firm drops from 53.0% to 33.7%, and the causation of major risk by stage of development also drops at this stage, from 75.8% to 53.0%. This can be explained by the fact that there is not much developing going on at this stage. The venture is concentrated in promoting and selling the product. That is why the risk decreases.[3] [edit] The Third Stage

The Third Stage

This stage is seen as the expansion/maturity phase of the previous stage. The venture tries to expand the market share they gained in the previous stage. This can be done by selling more amount of the product and having a good marketing campaign. Also, the venture will have to see whether it is possible to cut down their production cost or restructure the internal process. This can become more visible by doing a SWOT analysis. It is used to figure out the strength, weakness, opportunity and the threat the venture is facing and how to deal with it. Except that the venture is expanding, the venture also starts to investigate follow-up products and services. In some cases, the venture also investigates how to expand the life-cycle of the existing product/service. At this stage the VC-firm monitors the objectives already mentioned in the second stage and also the new objective mentioned at this stage. The VC-firm will evaluate if the management-team has made the expected reduction cost. They also want to know how the venture competes against the competitors. The new developed follow-up product will be evaluated to see if there is any potential. Example Finally the portal site is operational. The portal is getting more orders from the working class every day. To keep this going, the venture needs to promote their portal site. The venture decides to advertise by distributing flyers at each office in their region to attract new clients. In the meanwhile, a small team is being assembled for sales, which will be responsible for getting new lunchrooms/bakeries, any eating-places in other cities/region to join the portal site. This way the venture also works on expanding their market. Because of the delay at the previous stage, the venture did not fulfil the expected target. From a new forecast, requested by the investor, the venture expects to fulfil the target in the next quarter or the next half year. This is caused by external issues the venture does not have control of it. The venture has already suggested to stabilise the existing market the venture already owns and to decrease the promotion by 20% of what the venture is spending at the moment. This is approved by the investor. Risk At this stage, the risk of losing the investment for the VC-firm drops with 13.6% to 20.1%, and the causation of major risk by stage of development drops almost by half from 53.0% to 37.0%. However at this stage it happens often that new follow-up products are being developed. The risk of losing the investment is still decreasing. This may because the venture rely its income on the existing product. That is why the percentage continuous drop.[4]

[edit] The Bridge/Pre-public Stage

The Bridge/Pre-public Stage In general this stage is the last stage of the venture capital financing process. The main goal of this stage is to achieve an exit vehicle for the investors and for the venture to go public. At this stage the venture achieves a certain amount of the market share. This gives the venture some opportunities like for example:

Hostile take over Merger with other companies; Keeping away new competitors from approaching the market; Eliminate competitors.

Internally, the venture has to reposition the product and see where the product is positioned and if it is possible to attract new Market segmentation. This is also the phase to introduce the follow-up product/services to attract new clients and markets. As we already mentioned, this is the final stage of the process. But most of the time, there will be an additional continuation stage involved between the third stage and the Bridge/pre-public stage. However there are limited circumstances known where investors made a very successful initial market impact might be able to move from the third stage directly to the exit stage. Most of the time the venture fails to achieves some of the important benchmarks the VC-firms aimed. Example

Now the site is running smoothly, the venture is thinking about taking over the competitors website happen.nl. The site is promoting restaurants and is also doing business in online ordering food. This proposal is being protested by the investor, because it may cost a lot of the ventures capital. The investor suggests a merge instead. To settle down their differences, the venture requested an external party to investigate into the case. The result of the investigation was a take-over. After reading the investigation, the investor agrees to it and happen.nl is being taken over by the venture. With the take-over of a competitor, the venture has expanded its services. Seeing the ventures result, the investor comes to the conclusion that the venture still have not reach the target that was expected, but seeing how the business is progressing, the investor decides to extend its investment for another year. Risk At this final stage, the risk of losing the investment still exists. However, compared with the numbers mentioned at the seed-stage it is far lower. The risk of losing the investment the final stage is a little higher at 20.9%. This is caused by the number of times the VC-firms may want to expand the financing cycle, not to mention that the VC-firm is faced with the dilemma of whether to continuously invest or not. The causation of major risk by this stage of development is 33%. This is caused by the follow-up product that is introduced.[5] [edit] At Last As mentioned in the first paragraph, a VC-firm is not only about funding and lucrative returns, but it offers also the non-funding issues like knowledge as well as for internal as for external issues. Also what we see here the further the process goes, the less risk of losing investment the VC-firm is risking. Stage at which investment made Risk of loss Causation of major risk by stage of development The Seed-stage The Start-up Stage The Second Stage The Third Stage The Bridge/Pre-public Stage [edit] See also

66.2% 53.0% 33.7% 20.1% 20.9%

72.0% 75.8% 53.0% 37.0% 33.0%

Market research Market segmentation Pricing SWORD-financing Corporate Venture Capital

Venture Capital

[edit] References 1. 2. 3. 4. 5. ^ The Consequences of Entrepreneurial Finance: A Regression Discontinuity Analysis ^ See Reference: Authors:Ruhnka, J.C., Young, J.E. ^ Ruhnka, J.C., Young, J.E. ^ Ruhnka, J.C., Young, J.E. ^ Ruhnka, J.C., Young, J.E. (1987). "A venture capital model of the development process for new ventures". In: Journal of business venturing. Volume: 2, Issue: 2 (Spring 1987), pp: 167-184 This article needs additional citations for verification. Please help improve this article by adding citations to reliable sources. Unsourced material may be challenged and removed.(May 2009) [edit] Further reading

Ruhnka, J.C., Young, J.E. (1987). "A venture capital model of the development process for new ventures". In: Journal of business venturing. Volume: 2, Issue: 2 (Spring 1987), pp: 167-184 Ruhnka, Tyzoon T. Tyebjee, Albert V. Bruno (1984). "A Model of Venture Capitalist Investment Activity". In: Management science. Volume: 30, Issue: 9 (September 1984), pp: 1051-1066 Frederick D. Lipman (1998). "Financing Your Business with Venture Capital: Strategies to Grow Your Enterprise with Outside Investors". In: Prima Lifestyles; 1st edition (November 15, 1998)

These are venture capital companies in India. Accel Partners India Artheon Ventures Artiman Ventures BlueRun Ventures Canaan Partners DFJ India Epiphany Ventures Helion Venture Partners IFCI Venture Capital Funds India Innovation Investors Intel Capital Inventus (India) Advisory Company JAFCO Asia Lightspeed Venture Partners Netz Capital Nexus India Capital

Norwest Venture Partners Ojas Venture Partners Reliance Venture SAIF Partners Trident Capital VentureEast Apax Partners

How venture capital funding works

It is popularly believed that venture capitalists fund only established players and proven products. There is a lot of cynicis m
amongst many about all the hype that private equity and venture capital is getting in India [ Images ] of late. However, the truth is that, in recent times in India, the VCs have actually provided capital to relatively new, start-up companies that have a reasonable, though not certain, prospects to develop into highly profitable ventures. Travelguru.com is a case in point, funded by Sequoia Capital and Battery Ventures. The advent of firms like Helion Ventures with a $140 million corpus is helping the VC scenario to improve in the country. The three key people behind Helion Ventures, Ashish Gupta, Sanjeev Aggarwal and Kanwaljit Singh, all carry with them a successful track record across various companies in the international arena. What is interesting is that for first time in India, venture capital will be backed by successful entrepreneurs who themselves have a hands-on experience in handling and developing businesses. The National Venture Capital Association defines venture capital as: "Money provided by professionals who invest alongside management in young, rapidly growing companies that have the potential to develop into significant economic contributors." Innovation is the key driver of competitiveness within organisations as well as within countries. It has been well said: "Nothing is more powerful than an idea whose time has come." However, innovative ideas need more than research and knowledge to succeed. They need not only financial, but also, managerial (technical, marketing and HR), support to achieve success. This support is lent in many forms by private funding and incubation organisations such as venture capitalists. Akhil Gupta, JMD & CFO of Bharti Airtel [ Get Quote ], once remarked, "While we could have raised funding from other sources, Warburg Pincus' involvement helped us in scaling up significantly." Almost identical has been the findings of a research conducted recently by Venture Intelligence (founded by Arun Natarajan, a leading provider of information and networking services to the private equity and venture capital ecosystem in India) with the guidance of Prof. Amit Bubna of Indian School of Business, Hyderabad, to study the economic impact of PE and VCs on the Indian businesses. The following are some of the interesting observations of this study:

The study shows that the PE and VC backed companies grew faster compared to the non-PE backed peers and even better than the benchmark indices like the NSE Nifty. They found that the sales of listed PE-backed companies grew at 22.9% as compared to 10% for non-PE-backed listed firms.

PE backed firms added more jobs to the economy and even the wages at listed PE financed firms grew at around 32% as compared to 6% for non-PE-backed firms. An astonishing finding was that almost 96% of the top executives felt that without the support and the backing of private equity these companies would not have existed or would have grown at a slower rate, while only about 4% felt that they would have developed the same way even without PE funding. The study also shows that the biggest support of the PE investors were provided in the area of strategic direction followed by the financial advice and then recruitment and the marketing activities.

Thus venture capital has become an important source of finance for innovative ideas that are risky and have a potential for high returns over a long-term horizon. Venture capitalist investment is driven by the expectation that the start-ups invested in could give them a higher rate of return than other firms. In the process venture capitalists have created some of the best known companies in the world. Without VCs we might not have seen companies such as Apple, Compaq, Sun Microsystems, and Intel to name a few. Some of the unique features of a VC firm are:

Investment in high-risk, high-returns ventures: As VCs invest in untested, innovative ideas the investments entail high risks. In return, they expect a much higher return than usual. (Internal Rate of return expected is generally in the range of 25 per cent to 40 per cent). Participation in management: Besides providing finance, venture capitalists may also provide technical, marketing and strategic support. To safeguard their investment, they may also at times expect participation in management. Expertise in managing funds: VCs generally invest in particular type of industries or some of them invest in particular type of businesses and hence have a prior experience and contacts in the specific industry which gives them an expertise in better management of the funds deployed. Raises funds from several sources: A misconception among people is that venture capitalists are rich individuals who come together in a partnership. In fact, VCs are not necessarily rich and almost always deal with funds raised mainly from others. The various sources of funds are rich individuals, other investment funds, pension funds, endowment funds, et cetera, in addition to their own funds, if any. Diversification of the portfolio: VCs reduce the risk of venture investing by developing a portfolio of companies and the norm followed by them is same as the portfolio managers, that is, not to put all the eggs in the same basket. Exit after specified time: VCs are generally interested in exiting from a business after a pre-specified period. This period may usually range from 3 to 7 years.

Buyouts and second-stage financing are the most popular stages of venture capital financing. Globally, according to a report by PricewaterhouseCoopers, around 80 per cent of the total private equity investment is done at these stages. However, in spite of the venture capital scenario improving, several specific VC funds are setting up shop in India, with the year 2006 having been a landmark year for VC funding in India. Sumir Chadha, MD of Sequoia Capital India, feels that a slowdown could be on the cards for the year 2007 as the companies and investors may try to give some time and test the investment decisions made by them over the last year. The first quarter of the calendar year 2007 is already over. There is no sign of the VC story slowing down. This is a good sign for all the entrepreneurs out there with an idea! If you have an idea, this is the time to tell it. You never know, someone might be listening round the corner!

The requirements of funds vary with the life cycle stage of the enterprise. Even before a business plan is prepared the entrepreneur invests his time and resources in surveying the market, finding and understanding the target customers and their needs. At the seed stage the entrepreneur continue to fund the venture with his own or family funds. At this stage the funds are needed to solicit the consultants services in formulation of business plans, meeting potential customers and technology partners. Next the funds would be required for development of the product/process and producing prototypes, hiring key people and building up the managerial team. This is followed by funds for assembling the manufacturing and marketing facilities in that order. Finally the funds are needed to expand the business and attaint the critical mass for profit generation. Venture capitalists cater to the needs of the entrepreneurs at different stages of their enterprises. Depending upon the stage they finance, venture capitalists are called angel investors, venture capitalist or private equity supplier/investor. Venture capital was started as early stage financing of relatively small but rapidly growing companies. However various reasons forced venture capitalists to be more and more involved in expansion financing to support the development of existing portfolio companies. With increasing demand of capital from newer business, Venture capitalists began to operate across a broader spectrum of investment interest. This diversity of opportunities enabled Venture capitalists to balance their activities in term of time involvement, risk acceptance and reward potential, while providing on going assistance to developing business. Different venture capital firms have different attributes and aptitudes for different types of Venture capital investments. Hence there are different stages of entry for different Venture capitalists and they can identify and differentiate between types of Venture capital investments, each appropriate for the given stage of the investee company, These are:1. Early Stage Finance Seed Capital Start up Capital Early/First Stage Capital Later/Third Stage Capital 2. Later Stage Finance Expansion/Development Stage Capital Replacement Finance Management Buy Out and Buy ins Turnarounds Mezzanine/Bridge Finance

Not all business firms pass through each of these stages in a sequential manner. For instance seed capital is normally not required by service based ventures. It applies largely to manufacturing or research based activities. Similarly second round finance does not always follow early stage finance. If the business grows successfully it is likely to develop sufficient cash to fund its own growth, so does not require venture capital for growth. The table below shows risk perception and time orientation for different stages of venture capital financing.

Financing Stage

Period (funds Risk perception locked in years) Extreme

Activity to be financed For supporting a concept or idea or R & D for product development Initializing operations developing prototypes or

Early stage finance 7-10 Seed Start up First stage Second stage Later stage finance 5-9 3-7 3-5 1-3

Very high High

Start commercial production and marketing

Sufficiently high Expand market & growing working capital need Medium Market expansion, acquisition & product development for profit making company Acquisition financing

Buy out-in

1-3

Medium

Turnaround Mezzanine
1. Seed Capital

3-5 1-3

Medium to high Low

Turning around company

sick

Facilitating public issue

It is an idea or concept as opposed to a business. European Venture capital association defines seed capital as The financing of the initial product development or capital provided to an entrepreneur to prove the feasibility of a project and to qualify for start up capital. The characteristics of the seed capital may be enumerated as follows: Absence of ready product market Absence of complete management team Product/ process still in R & D stage Initial period / licensing stage of technology transfer Broadly speaking seed capital investment may take 7 to 10 years to achieve realization. It is the earliest and therefore riskiest stage of Venture capital investment. The new technology and innovations being attempted have equal chance of success and failure. Such projects, particularly hi-tech, projects sink a lot of cash and need a strong financial support for their adaptation, commencement and eventual success. However, while the earliest stage of financing is fraught with risk, it also provides greater potential for realizing significant gains in long term. Typically seed enterprises lack asset base or track record to obtain finance from conventional sources and are largely dependent upon entrepreneurs personal resources. Seed capital is provided after being satisfied that the entrepreneur has used up his own resources and carried out his idea to a stage of acceptance and has initiated research. The asset underlying the seed capital is often technology or an idea as opposed to human assets (a good management team) so often sought by venture capitalists. Volume of Investment Activity It has been observed that Venture capitalist seldom make seed capital investment and these are relatively small by comparison to other forms of venture finance. The absence of interest in providing a significant amount of seed capital can be attributed to the following three factors: 1. Seed capital projects by their very nature require a relatively small amount of capital. The success or failure of an individual seed capital investment will have little impact on the performance of all but the smallest venture capitalists portfolio. Larger venture capitalists avoid seed capital investments. This is because the small investments are seen to be cost inefficient in terms of time required to analyze, structure and manage them. 2. The time horizon to realization for most seed capital investments is typically 7-10 years which is longer than all but most long-term oriented investors will desire. 3. The risk of product and technology obsolescence increases as the time to realization is extended. These types of obsolescence are particularly likely to occur with high technology investments particularly in the fields related to Information Technology. 2. Start up Capital It is the second stage in the venture capital cycle and is distinguishable from seed capital investments. An entrepreneur often needs finance when the business is just starting. The start up stage involves starting a new business. Here in the entrepreneur has moved closer towards establishment of a going concern. Here in the business concept has been fully investigated and the business risk now becomes that of turning the concept into product.

Start up capital is defined as: Capital needed to finance the product development, initial marketing and establishment of product facility. The characteristics of start-up capital are: Establishment of company or business. The company is either being organized or is established recently. New business activity could be based on experts, experience or a spin-off from R & D. Establishment of most but not all the members of the team. The skills and fitness to the job and situation of the entrepreneurs team is an important factor for start up finance. Development of business plan or idea. The business plan should be fully developed yet the acceptability of the product by the market is uncertain. The company has not yet started trading. In the start up preposition venture capitalists investment criteria shifts from idea to people involved in the venture and the market opportunity. Before committing any finance at this stage, Venture capitalist however, assesses the managerial ability and the capacity of the entrepreneur, besides the skills, suitability and competence of the managerial team are also evaluated. If required they supply managerial skills and supervision for implementation. The time horizon for start up capital will be typically 6 or 8 years. Failure rate for start up is 2 out of 3. Start up needs funds by way of both first round investment and subsequent follow-up investments. The risk tends t be lower relative to seed capital situation. The risk is controlled by initially investing a smaller amount of capital in start-ups. The decision on additional financing is based upon the successful performance of the company. However, the term to realization of a start up investment remains longer than the term of finance normally provided by the majority of financial institutions. Longer time scale for using exit route demands continued watch on start up projects. Volume of Investment Activity Despite potential for specular returns most venture firms avoid investing in start-ups. One reason for the paucity of start up financing may be high discount rate that venture capitalist applies to venture proposals at this level of risk and maturity. They often prefer to spread their risk by sharing the financing. Thus syndicates of investors often participate in start up finance. 3. Early Stage Finance It is also called first stage capital is provided to entrepreneur who has a proven product, to start commercial production and marketing, not covering market expansion, de-risking and acquisition costs. At this stage the company passed into early success stage of its life cycle. A proven management team is put into this stage, a product is established and an identifiable market is being targeted. British Venture Capital Association has vividly defined early stage finance as: Finance provided to companies that have completed the product development stage and require further funds to initiate commercial manufacturing and sales but may not be generating profits. The characteristics of early stage finance may be: Little or no sales revenue. Cash flow and profit still negative. A small but enthusiastic management team which consists of people with technical and specialist background and with little experience in the management of growing business. Short term prospective for dramatic growth in revenue and profits. The early stage finance usually takes 4 to 6 years time horizon to realization. Early stage finance is the earliest in which two of the fundamentals of business are in place i.e. fully assembled management team and a marketable product. A company needs this round of finance because of any of the following reasons: Project overruns on product development.

Initial loss after start up phase. The firm needs additional equity funds, which are not available from other sources thus prompting venture capitalist that, have financed the start up stage to provide further financing. The management risk is shifted from factors internal to the firm (lack of management, lack of product etc.) to factors external to the firm (competitive pressures, in sufficient will of financial institutions to provide adequate capital, risk of product obsolescence etc.) At this stage, capital needs, both fixed and working capital needs are greatest. Further, since firms do not have foundation of a trading record, finance will be difficult to obtain and so Venture capital particularly equity investment without associated debt burden is key to survival of the business. The following risks are normally associated to firms at this stage:

The early stage firms may have drawn the attention of and incurred the challenge of a larger competition. There is a risk of product obsolescence. This is more so when the firm is involved in high-tech business like computer, information technology etc. 4. Second Stage Finance It is the capital provided for marketing and meeting the growing working capital needs of an enterprise that has commenced the production but does not have positive cash flows sufficient to take care of its growing needs. Second stage finance, the second trench of Early State Finance is also referred to as follow on finance and can be defined as the provision of capital to the firm which has previously been in receipt of external capital but whose financial needs have subsequently exploded. This may be second or even third injection of capital. The characteristics of a second stage finance are:

A developed product on the market A full management team in place Sales revenue being generated from one or more products There are losses in the firm or at best there may be a break even but the surplus generated is insufficient to meet the firms needs. Second round financing typically comes in after start up and early stage funding and so have shorter time to maturity, generally ranging from 3 to 7 years. This stage of financing has both positive and negative reasons. Negative reasons include:

1. Cost overruns in market development. 2. Failure of new product to live up to sales forecast. 3. Need to re-position products through a new marketing campaign. 4. Need to re-define the product in the market place once the product deficiency is revealed. Positive reasons include: 1. Sales appear to be exceeding forecasts and the enterprise needs to acquire assets to gear up for production volumes greater than forecasts. 2. High growth enterprises expand faster than their working capital permit, thus needing additional finance. Aim is to provide working capital for initial expansion of an enterprise to meet needs of increasing stocks and receivables. It is additional injection of funds and is an acceptable part of venture capital. Often provision for such additional finance can be included in the original financing package as an option, subject to certain management performance targets. 5. Later Stage Finance

It is called third stage capital is provided to an enterprise that has established commercial production and basic marketing set-up, typically for market expansion, acquisition, product development etc. It is provided for market expansion of the enterprise. The enterprises eligible for this round of finance have following characteristics. Established business, having already passed the risky early stage. Expanding high yield, capital growth and good profitability. Reputed market position and an established formal organization structure. Funds are utilized for further plant expansion, marketing, working capital or development of improved products. Third stage financing is a mix of equity with debt or subordinate debt. As it is half way between equity and debt in US it is called mezzanine finance. It is also called last round of finance in run up to the trade sale or public offer. Venture capitalist s prefer later stage investment vis a vis early stage investments, as the rate of failure in later stage financing is low. It is because firms at this stage have a past performance data, track record of management, established procedures of financial control. The time horizon for realization is shorter, ranging from 3 to 5 years. This helps the venture capitalists to balance their own portfolio of investment as it provides a running yield to venture capitalists. Further the loan component in third stage finance provides tax advantage and superior return to the investors. There are four sub divisions of later stage finance. 1. Expansion / Development Finance 2. Replacement Finance 3. Buyout Financing 4. Turnaround Finance Expansion / Development Finance An enterprise established in a given market increases its profits exponentially by achieving the economies of scale. This expansion can be achieved either through an organic growth, that is by expanding production capacity and setting up proper distribution system or by way of acquisitions. Anyhow, expansion needs finance and venture capitalists support both organic growth as well as acquisitions for expansion. At this stage the real market feedback is used to analyze competition. It may be found that the entrepreneur needs to develop his managerial team for handling growth and managing a larger business. Realization horizon for expansion / development investment is one to three years. It is favored by venture capitalist as it offers higher rewards in shorter period with lower risk. Funds are needed for new or larger factories and warehouses, production capacities, developing improved or new products, developing new markets or entering exports by enterprise with established business that has already achieved break even and has started making profits. Replacement Finance It means substituting one shareholder for another, rather than raising new capital resulting in the change of ownership pattern. Venture capitalist purchase shares from the entrepreneurs and their associates enabling them to reduce their shareholding in unlisted companies. They also buy ordinary shares from non-promoters and convert them to preference shares with fixed dividend coupon. Later, on sale of the company or its listing on stock exchange, these are re-converted to ordinary shares. Thus Venture capitalist makes a capital gain in a period of 1 to 5 years. Buy out / Buy in Financing It is a recent development and a new form of investment by venture capitalist. The funds provided to the current operating management to acquire or purchase a significant share holding in the business they manage are called management buyout. Management Buy-in refers to the funds provided to enable a manager or a group of managers from outside the company to buy into it.

It is the most popular form of venture capital amongst later stage financing. It is less risky as venture capitalist in invests in solid, ongoing and more mature business. The funds are provided for acquiring and revitalizing an existing product line or division of a major business. MBO (Management buyout) has low risk as enterprise to be bought have existed for some time besides having positive cash flow to provide regular returns to the venture capitalist, who structure their investment by judicious combination of debt and equity. Of late there has been a gradual shift away from start up and early finance to wards MBO opportunities. This shift is because of lower risk than start up investments. Turnaround Finance It is rare form later stage finance which most of the venture capitalist avoid because of higher degree of risk. When an established enterprise becomes sick, it needs finance as well as management assistance foe a major restructuring to revitalize growth of profits. Unquoted company at an early stage of development often has higher debt than equity; its cash flows are slowing down due to lack of managerial skill and inability to exploit the market potential. The sick companies at the later stages of development do not normally have high debt burden but lack competent staff at various levels. Such enterprises are compelled to relinquish control to new management. The venture capitalist has to carry out the recovery process using hands on management in 2 to 5 years. The risk profile and anticipated rewards are akin to early stage investment. Bridge Finance It is the pre-public offering or pre-merger/acquisition finance to a company. It is the last round of financing before the planned exit. Venture capitalist help in building a stable and experienced management team that will help the company in its initial public offer. Most of the time bridge finance helps improves the valuation of the company. Bridge finance often has a realization period of 6 months to one year and hence the risk involved is low. The bridge finance is paid back from the proceeds of the public issue.

Related posts: 1. Introduction to Venture Capital 2. Difference between Venture Capital & Other Funds 3. Venture Capital Investment Process 4. Export financing programmes provided by EXIM Bank India 5. Working Capital Management 6. Capital Structure of a Company 7. Financing of Mergers & Acquisitions 8. Management Information System Growth Stages 9. Development Stages of a Transnational Corporation 10. Capital and Capitalization Recommended Articles Venture Capital Investment Process Difference between Venture Capital & Other Funds Introduction to Venture Capital