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Introduction to Venture Capital 5th

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  1 INTRODUCTION TO VENTURE CAPITAL Venture Capital is a form of risk capital . In other words, capital that is invested in a project (in this case - a business) where there is a substantial element of risk relating to the future creation of profits and cash flows. Risk capital is invested as shares (equity) rather than as a loan and the investor requires a higher‖ rate of return to compensate him for his risk.  The main sources of venture capital in the UK are venture capital firms and business angels - private investors. Separate Tutor2u revision notes cover the operation of business angels. In these notes, we  principally focus on venture capital firms. However, it should be pointed out the attributes that both venture capital firms and business angels look for in potential investments are often very similar. WHAT IS VENTURE CAPITAL? Venture capital is equity financing provided by institutional investors that either manage a fund on  behalf of large institutions (usually pension funds and insurance companies) or have their own  proprietary pool of capital. Venture capital is raised in a series of stages or rounds. Venture capital investors usually specialize in one specific investment stage. Each stage also has its own unique set of  parameters with respect to the: ã Operational progress that a potential investment needs to demonstrate   ã Amount of capital a fund might invest in a given venture   ã Investment time horizon (i.e., how long  before the investor expects to get its money back) ã Investor return expectations (i.e., how much of the company will the investor expect to satisfy their return requirements. CONCEPT OF VENTURE CAPITAL The terms venture capital comprises of two words tha t is, ―Venture‖ and ―Capital‖. ―Venture‖ is a course of proceeding the outcomes of which is uncertain but to which is attended the risk or danger of ―Loss‖. ―Capital‖ means recourses to start an enterprise. To connote the risk and adventure of such a fund, the generic name Venture Capital was coined. Venture capital is considered as financing of high technology based enterprises. It is said that Venture capital involves investment in new or relatively untried technology, initiated by relatively new and  professionally or technically qualified entrepreneurs with inadequate funds. The conventional financiers, unlike Venture capital mainly finance proven technologies and established markets. However, high technology need not be prerequisite for venture capital. Venture capital has also been described as ‗unsecured risk financing‘. The relatively high risk of Venture capital is compensated by the possibility of high return usually through substantial capital gains in terms. Venture capital is broader sense is not solely an injection of funds in to a new firms, it is also an input of skills needed to set up the firms, design its marketing strategy, organize and manage it. Thus it is a long term association with successive stages of company‘s development under highly  risky investment condition with distinctive type of financing appropriate to each stage of development. Investors join the entrepreneurs as co-partner and support the project with finance and business skill to exploit the market opportunities.  2 Venture capital is not a passive finance. It may be at any stage of business/production cycle, that is startup, expansion or to improve a product or process, which are associated with both risk and reward. Thee Venture capital gains through appreciation in the value of such investment when the new technology succeeds. Thus the primary return sought by the investor is essentially capital gain rather than steady interest income or dividend yield. MEANING OF   VENTURE CAPITAL & PRIVATE EQUITY Venture Capital/Private Equity; provides long-term, committed share capital, to help unquoted companies grow and succeed. If you are looking to start up, expand, buy into a business, buy out a division of your parent company, turnaround or revitalize a company, Private Equity could help. Obtaining private equity is very different from raising debt or a loan from a lender, such as a bank. Lenders, who usually seek security such as a charge over the assets of the company, will charge interest on a loan and seek repayment of the capital. Private equity is invested in exchange for a stake in your company and, as shareholders, the investors' returns are dependent on the growth and profitability of your business. The investment is unsecured, fully at risk and usually does not have defined repayment terms. It is this flexibility which makes private equity an attractive and appropriate form of finance for early stage and knowledge-based projects in particular. WHY VC? The venture capital industry in India is still at a nascent stage. With a view to promote innovation, enterprise and conversion of scientific technology and knowledge based ideas into commercial  production, it is very important to promote venture capital activity in India. India‘s recent success story in the area of information technology has shown that there is a tremendous potential for growth of knowledge based industries. This potential is not only confined to information technology but is equally relevant in several areas such as bio-technology, pharmaceuticals and drugs, agriculture, food  processing, telecommunications, services, etc. Given the inherent strength by way of its skilled and cost competitive manpower, technology, research and entrepreneurship, with proper environment and policy support, India can achieve rapid economic growth and competitive global strength in a sustainable manner. A flourishing venture capital industry in India will fill the gap between the capital requirements of technology and knowledge based startup enterprises and funding available from traditional institutional lenders such as banks. The gap exists because such startups are necessarily based on intangible assets such as human capital and on a technology-enabled mission, often with the hope of changing the world.   Beginning with a consideration of the wide role of venture capital to encompass not just information technology, but all high-growth technology and knowledge-based enterprises, the endeavor of the Committee has been to make recommendations that will facilitate the growth of a vibrant venture capital industry in India. The report examines.    The vision for venture capital    Strategies for its growth and    How to bridge the gap between traditional means of finance and the capital needs of high growth startups .  3 ADVANTAGES OF VENTURE CAPITAL Venture capital has a number of advantages over other forms of finance, such as:    It injects long term equity finance which provides a solid capital base for future growth.    The venture capitalist is a business partner, sharing both the risks and rewards. Venture capitalists are rewarded by business success and the capital gain.    The venture capitalist is able to provide practical advice and assistance to the company based on past experience with other companies which were in similar situations.    The venture capitalist also has a network of contacts in many areas that can add value to the company, such as in recruiting key personnel, providing contacts in international markets, introductions to strategic partners, and if needed co-investments with other venture capital firms when additional rounds of financing are required.    The venture capitalist may be capable of providing additional rounds of funding should it be required to finance growth. FEATURES OF VENTURE CAPITAL i.   High Risk ii.   High tech iii.   Equity participation & Capital gains iv.   Participation in Management v.   Length of Investment vi.   Illiquid Investment High Risk By definition the Venture capital financing is highly risk and chances of failure are high as it provides long term start capital to high risky- high reward ventures. Venture capital assumes four types of risks, these are: Management Risk  –   Inability of management terms to work together. Market Risk     –   Product may fail in the market. Product Risk     –   Product may not be commercially viable. Operation Risk  –   Operation may not be cost effective resulting in increased cost decreased gross margin. High Tech  4 As opportunities in the low technology area tend to be few of lower order, and high tech projects generally offer higher returns than projects in more traditional area, venture capital investments are made in high tech. areas using new technologies or producing innovation goods by using new technology. Not just high technology, any high risk ventures where the entrepreneur has conviction but little capital gets venture finance. Venture capital is available for expansion of existing business or diversification to a high risk area. Thus technology financing had never been the primary objective but incidental to venture capital. Equity participation & Capital gains Investments are generally in equity and quasi equity participation through direct purchase of share, options, convertible debentures where the debt holder has the option to convert the loan instruments into stock of the borrower or a debt with warrant to equity investment. The funds in the form of equity help to raise term loans that are cheaper source of funds. In the early stage of business, because dividends can be delayed, equity investment implies that investors bear the risk of venture and would earn a return commensurate with success in the form of capital gains. Participation in Management Venture capital provides value addition by managerial support, monitoring and follow up assistance. It monitors physical and financial progress as well as market development initiative. It helps by identifying key resource person. They want one seat on the company‘s board of directors and involvement, for better or worse, in the major decision affecting the direction of company. This is unique philosophy of ―hand on management‖ where venture capitalist acts as complementary to the entrepreneurs. Based upon the experience other companies a venture capitalist advice the promoters on  project planning, monitoring, financial management, including working capital and public issue. Venture capital investor cannot interfere in day today management of the enterprise but keeps a close contact with the promoters or entrepreneurs to protect his investment. Length of Investment Venture capitalist help comprise grow, but they eventually seek to exit the investment in three to seven years. An early stage investment may take seven to ten years to mature, while most of the later stage investment takes only a few years. The process of having significant returns takes several years and calls on the capacity and talent of venture capitalist and entrepreneurs to reach fruition.  Illiquid Investment Venture capital investments are illiquid, that is not subject to repayment on demand or following a repayment schedule. Investors seek return ultimately by means of capital gain when the investment is sold at market place. The investment is realized only on enlistment of security or it is lost if enterprise is liquidated for unsuccessful working. It may take several years before the first investment starts too locked for seven to ten years. Venture capitalist understands this illiquidity and factors this in his investment decision.

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