Section C : Chapter 12

Business Financing
Financial management is an integral part of business administration and ranks equally in
importance with other key result areas such as production and marketing. The
fundamental objectives of any venture are survival and growth, though there could be
other social objectives too. It could, however, be said that all objectives too. All
objectives center on the economic objectives, which` means maximization of profits.
Financial Management plays a major role in fulfilling the above and includes functions
like analyzing and forecasting financial needs, managing working capital, planning the
capital structure, etc.
Short Term and Long Term Finance
Financial resources can be categorized into short term and long term. While short term
finance is utilized for short term requirements, long term finance is deployed to meet both
long term and short term uses.
The sources of short-term finance include:
a. Sundry creditors
b. Bank borrowings for working capital
c. Deposits / borrowings from friends, relatives and others
d. Advances received from customers
The sources of long-term finance include:
i)

Equity/owners capital and deposit

ii)

Term loans from financial institutions and banks

iii)

Seed capital, margin money and subsidy from Government and financial
institutions.

Besides the above external sources, there is an internal source of funds that is generated
by the industry itself through retention of profits or conversion of assets into funds. For
sound financial health of any industry, it is essential that short-term finance be utilized for

acquisition of current assets only which are normally converted into cash within one year.
Long-term finance, on the other hand, is utilized for acquiring fixed assets as also partly
for financing current assets, that is, for meeting margin on working capital.
The application for loan or say a short-term finance always needs the backup of a Project
Report, is essential when the Small-Scale wants to apply for the loan for
monetary support.
Management of working capital
Working capital is defined as that part of the capital which is invested in the working or
current assets like stock of raw materials, semi-finished goods, Sundry debtors, bills
receivables etc. this capital is also known as circulating capital or revolving capital.
Working capital is used for financing current assets i.e. the day-to day business needs. It
is also used for purchasing raw-materials. A major portion of the working capital lies in
the business in the form of semi-finished, finished goods and cash. Working capital is
also required for payment of wages and salaries, overhead expenses like power, rent,
taxes, repairing and upto date maintenance of machinery etc. The amount in respect of
goods sold on credit (Sundry Debtors) represents a vital portion of the working capital.

Classification of working capital

1)Regular Working capital meeting continuous day-to-day business needs of the firm,
changes its form, it is invested and reinvested in the business called as fixed or regular
working capital.
2)Variable Working capital not regular, not static, required to meet the requirements of a
rise in the total quantity of goods produced during certain seasons in the year, this
additional capital is called variable or seasonal working capital.
3)Special working capital needed on special occasions viz. increasing prices of raw
materials, business recession, strike, failure of the machinery, fire, etc. Special working
capital is needed to finance the firm on such occasions.

Working capital is often classified as gross working capital and networking capital. The
former refers to the total of all the current assets and the latter is the difference between
total current assets and total current liabilities. Ongoing review of gross working capital
is essential for efficient management of current assets. However, for a long-term view, we
have to concentrate on net working capital. The net working capital of a healthy unit
should have a positive rule. A periodic study of the causes of changes that take place in
the net working capital is necessary. Changes in net working capital can be measured in
terms of value as also in percentages by comparing current assets, current liabilities and
working capital over a given period. this involves the basic approach to working capital
analysis.
Deployment of working capital is best explained by what is called the operating cycle.
Fig. 10.1 Operating Cycle
Stage 1
CASH

Stage 5
Sundry Debtors
(Receivables)

Stage 4
Finished Goods

Stage 2
Raw
Materials

Stage 3
Stock-inprocess

Any manufacturing organization is characterized by a cycle of operations consisting of

purchase of raw materials, converting the raw materials, converting the raw materials into
finished goods and realizing cash. It is diagrammatically represented above.

This operating cycle is also called the cash to cash cycle indicates how cash is converted
into raw materials, work-in-process, finished goods, bills and finally back to cash.
Working capital is the total cash that is circulating in this cycle. It also becomes clear that
working capital cash be turned over, or reused after completing the cycle.
Essentially. Management of working capital will mean, apart from finding out the source
of meeting capital requirements by reducing the cycle time for optimum results.
The following factors are pertinent for having an overall view of the forces affecting
working capital needs:
1. Nature of business;
2. Production policies;
3. Manufacturing process;
4. Growth and expansion of business;
5. Business cycle fluctuations;
6. Terms of purchase and sales;
7. Withdrawals by promoters, etc.
It may be noted that, for any industry, there are likely to be periodic changes in
any or all of the above. Therefore, management of working capital becomes a
dynamic activity.
Raising working capital
Working capital requirements of a unit are met by internal as well as external sources.
The major external source is the banking system. Banks offer various types of credit
facilities for meeting the financial requirements of their customers. Their approach is
normally flexible particularly towards small-scale sector. Credit facilities are granted by
banks against the inventory holdings, book debts and bills receivables, for export oriented
units by way of export finance (pre-shipment credit and post-shipment credit) etc. Certain
contingent facilities like issuing letters of credit and guarantees are also offered by them.
Though banks have flexible schemes for financing working capital needs, larger units
with working capital requirements above Rs. 10 lakhs are required to comply with the

norms laid by the Tandon Committee and Chore Committee accepted by Reserve Bank of
India.
Tandon Committee
The important features are:
1. Classification of industry and fixation of inventory/receivables norms: The
Committee

classified

certain

industries

into

distinct

groups

and

fixed

inventory/receivables norms for 15 industry groups.

2. Application of margin and eligibility for borrowing. In order to avoid double
financing, the Committee recommended that only a part of the working capital gap
(current assets minus current liabilities excluding bank borrowings) be financed by
banks. The Committee suggested three months for computing the maximum
permissible level of bank borrowings.
Method 1: This method stipulates that banks would finance 75 percent of the
working capital gap the remaining 25 percent to come from long term sources such
as owned funds of term borrowings.
Method 2: this method stipulates that the borrower should provide for 25 percent of
the gross current assets through long term sources and the rest to be provided by trade
credit, other current liabilities and the bank.
Method 3: This method is similar to method 2, only if further stipulates that the core
current assets should be taken out from the total current assets separately funded from
long-term sources.
The above speculations are to be applied progressively.
3. Suggested reporting system for follow-up of bank credit: The committee has also
recommended submission of periodic statements regarding operations of the units for
the purpose of effective monitoring and supervision by banks.

Chore Committee
The important recommendations are:
1. The borrowers enjoying aggregate working capital limits of Rs.50 lakhs and over
would require to conform to second method of lending prescribed by Tandon
Committee which would give a minimum current ratio of 1.33;
2. The borrower would be required to submit to the bank his quarterly requirement of
funds on the basis of his budget and provide periodical information of the actual
performance vis--vis the estimates.
FINANCIAL FORECASTING
Financial Forecasting follows a systematic projection of the expected actions of the
management in the form of financial statements, budgets, etc. The process involves use of
past records, funds flow statement, budgets etc. the process involves use of past records,
funds flow behavior, financial ratios and expected economic conditions in the industry as
a whole as well as in the unit. It is a sort of working plan formulated for a specific period
by arranging future activities.
The activities of financial forecasting are varied:

It enables optimum utilization of funds

It helps in planning the units growth and in setting performance goals.

It is used to anticipate the financial needs and it reduces ad hoc and

emergency decisions.

It serves as a good basis not only for negotiating confidently with

banks/financial institutions.
Financial statements meant to display the effects of future circumstances are described as
Performa statements. Since business, decisions are based on the judgement or the
influence of future needs on a units financial position, these projected statements provide
an important base for financial forecasting and planning. They are prepared on certain

assumptions and expectations and give a reasonable estimate of revenues, costs, profits,
taxes, other uses and sources of funds.
Projected profit and loss statement
This statement begins with the estimate of the expected sales for the forecast period and
is an important step in financial forecasting. The purpose of this statement is to have a
fair and reasonable estimate of expected revenue, costs, profits, taxes, etc.
Projected Balance Sheet
It is a forecast of expected funds flow of each item therein to be expected accordingly.
Various items of assets and liabilities of the projects balance sheet are explained below:
Assets
1.

Cash: Usually there is an assumption for a minimum level of cash or liquid

funds desired at the end of the period of forecasting. It can also be a balancing assets and
liabilities.

2.

Trade Debtors: Magnitude of debtors is closely linked to sales. Based on the

past trend/ performance expected credit policy and the pattern of future clientele, a
certain number of days debtors or receivables is expected to be outstanding. Thus, to
forecast trade debtors, one has to study historical data about the industry as a whole as
also the unit, market conditions, and nature of customers.

3.

Inventories: The estimate of inventories is prepared on the basis of past

operating data together with an examination of future policies. It involves an analysis of
the additions to opening stocks, purchases and production of goods during the period and
reduction therein through use and sale.

4.

Fixed assets: Outlays for factory building, plant and machinery are
generally planned in advance. Adjustments, however, have to be made for additions and
sales of old assets. Adequate provision for depreciation should be made year-by-year to
generate funds for replacement of the relative assets.

5.

Liabilities

 Trade creditors Creditors can be estimated by analyzing schedules of purchases

payments maturing during the period or by calculating the ratio of accounts payable
to purchases.

Loans and advances this is usually the balancing figure to equalize assets and
liabilities.

Accrued liabilities these are arrived at by analyzing the pattern of wage payments,
the tax & dues, interest obligations arrives these at and repayment of loans.

Provision for taxes closing balance of the provision will be found by starting with
the opening balance of the provision for taxes, adding the new provision for taxes and
deducting the actual payment of taxes.
CASH MANAGEMENT
A cash flow statement will forecast the probable time of receiving cash from sales and
estimates the time after which the bills are paid. The projected cash flow statement
shows all cash receipts from every source as they are expected to be received and of
cash payments by the business as they are to be made. While the projected profit and
loss is recorded in the monthly profit and loss statement at the time, the services are
provided; as the sales are recorded in the cash flow statement only at the time when
the cash payments for the services are received.
Importance of Cash Flow Statement
Managing cash flow is one of the most important tasks business owners face. It is an
essential tool for a good cash management.
Cash flow gives the following:

A list of bills giving details on how much is due and when it is due.
A schedule of anticipated cash receipts.

A schedule of priorities for the payment of accounts

 An estimate of the amount of money needed to borrow in order to finance day-to-day

operations. This is perhaps the most important aspect of a complete cash flow
projection.

A format for planning the most effective use of your cash(cash management)
A measure of the effects of unexpected changes in circumstances i.e. loss of many
bids, bankruptcy of general contractor or a developer, strikes, poor estimates, etc.

An outline to show the financier the sufficient cash to make loan payments, if there
are any plans to borrow money on a long-term basis.
Preparing a cash Flow Statement
The preparation of a Cash Flow Statement involves six basic steps:

Estimate cash receipts for the budget period.

Estimate cash disbursement for the budget period.
Calculate the net cash inflow (or outflow)
Add in cash on hand at the beginning of the month.
Compute cash balance (or shortage)
Project amount of loans necessary.
A cash flow statement is normally prepared for twelve months.
It is computed on an on-going basis and is revised as the situation changes. It assists in
financial planning, inventory purchases and formulating credit and collection policies. It
also serves as an early indicator when expenses are getting out of line. It is one of the
most important tools an owner/manager has to control his or her business.
Estimating your Operating Cash Requirements
The cash flow statement is to estimate the amount of money required to be borrowed in
order to finance the day-to-day operations. When the cash flow statement is ready we
realize how much operating capital must be injected into business by doing the following
calculations:

1. Identify your initial bank loan balance or overdraft, before the start of the year, if
applicable.
2. Proceeding month by month, add the increase or deduct the decrease in your
operating bank loan to determine the monthly operating loan balance.
3. Identify the highest operating balance; this represents the minimum operating loan
or line of credit that should be obtained.
The operating cash requirements are the funds you will need to keep your business
running during the first year without a major cash crisis. Unless your projections are
unrealistic or unexpected circumstances arise, you need not modify your projections.
Break-Even Analysis
Break-even analysis also called cost-volume-profit analysis helps in finding out the
relationship of costs and revenues to output. The analysis can be done only after
calculating the break-even point (BEP) .The BEP is defined as that level of sales at which
the total cost equals total revenue, i.e., the sales level at which there is no profit or no
loss. The BEP is calculated using the formula:
BEP = Fixed Expenses/Contribution per unit where contribution is sales minus variable
costs per unit.
The BEP thus obtained will be in number of units(pieces).
A different way of calculating BEP is BEP= Fixed Expenses*Sales/Total contribution
where contribution is the total sales minus the total variable expenses.
In this case the BEP will be in Rupees. Graphically BEP is presented as below:
For calculation of BEP, therefore, it is essential to classify the expenses into fixed
expenses and variable expenses. The break-even point as mentioned shows the level of
sales at which there is no profit or loss. This information itself is of immense use to units
because it gives the minimum level at which the unit should operate, at given cost and
price, to start generating profit. However, apart from this the break-even analysis is useful
inter alia in the following areas:.

 Determining product mix. This is done by knowing the contributions of different

products and choosing the products in such a way that the total contribution is
maximized.

Make or buy decisions. If the variable cost is less than the price that has to be paid
to an outside supplier, it may be better to manufacture than to buy.

Knowing profits at given sales volume and finding the effects of changes in fixed
and variable costs to profits.
In the case of SSI units it is essential that the break-even point is as low as possible. This
can be ensured by minimizing the fixed expenses or by increasing the contribution.
However, since contribution is largely dependent on market conditions it is essential to
keep the fixed expenses at the minimum level.

Fig 10.2 Break-Even Analysis

Sales Revenue Line

Total Cost Line

BreakEven
Point
Cost and sales
Revenue (Rs.)

Variable Cost Line

Fixed Cost Line

Volume of Output (units)

ESTIMATION OF GROSS FIXED ASSETS/CAPITAL:

Land, building, plant and machinery these are by and large, met out of market
borrowings or term loans from financial institutions, including banks.
Estimation of Gross Fixed Assets/Capital
A. LAND
1. Location
2. Area
3. Whether freehold or leasehold
4. Purchase price of land, if owned
5. Rent in case of leased land
6. Terms of lease
7. Ground rent payable per year
B. BUILDING
1. Location
2. Whether owned or leased
3. Purchase price of Building, if owned
4. Rent in case of leased/ rented premises
Structure

5. Terms of lease
Type of Structure

Dimensions

Area

Actual

Date

of
(whether temporary)

Sq. mts. Cost/Rs.

Erection
1. Workshop
2. Godown
3. Administrative
4. Other buildings
C.. COST OF EXISTING MACHINERY RS.
In case the assets have been revalued or written off at any time during the
existence of company, furnish full details of such revaluation together with

the reason therefore.

EVALUATION OF PRE - OPERATIVE EXPENSES
Cost already Proposed to be
Total

incurred

Pre-operative expenses
a) Establishment
b) Rent, rates and taxes
c) Traveling expenses
d) Miscellaneous expenses
e) Interest and commitment charges on
borrowings (details of calculations)
f) Insurance during construction including
erection insurance
g) Mortgage expenses (stamp duty, registration
charges and other legal expenses)
(.% of loan of Rs lakhs)
h) Interest on deferred payments, if any.

incurred

Table 3.1 EVALUATION OF WORKING CAPITAL REQUIREMENTS

1ST year of 2ND year of 3RD
operation

operation

year

of
operation

1. CURRENT ASSETS
i) Raw materials (including stores and other
items used in the process of manufacture)

Imported (Months consumption)

Indigenous (Months consumption)

ii) Other consumable spares(excluding those included
under item (i) above)
iii) Stock-in-process (Months cost of production)
iv) Finished goods (Months cost of sales)
v) Receivables other than export and deferred
receivables (including bills purchased and
discounted by bankers)
(Months domestic sales excluding deferred
payment sales)
vi) Export receivables (including bills purchased
by bankers) (Months export sales)
vii) Advances to suppliers of raw materials and stores/
spares consumable
viii) Other current assets including cash and bank balances
and deferred receivables due within one year
(major items to be specified individually)
Total current assets (I)
II. Current Liabilities
Other than bank borrowings for working capital)
i) creditors for purchases of raw materials and sores and
consumables spares (Months purchases )
ii) Advances from customers
iii) Accrued expenses
iv) Statutory liabilities major items to be specified individually
a
b
c
Total current liabilities (II)
III. Working capital gap(I minus II)
IV. Margin on working capital (25% of III/25% of I)
V. Bank borrowings (III-IV)

i. The periods to be shown should be in relation to the annual projection for the relative
item during that year.
ii. If the canalized item form a significant part of raw material inventory, they may be
shown separately.
iii. Spares not exceeding 5% of total inventory or those expected to be consumed within
12 months, whichever are lower, may be shown against item I (ii).
iv. Other current liability item II (v) will include installments of term loans/ liabilities due
within one year.
Planning for working capital is very crucial. It is generally observed that entrepreneurs
assess the WC requirements in their own way. There are often three forms and recast
working capital requirements according to their forms.
The forms are :
Form for WC requirement less than Rs. 25000
Form for WC requirement less than Rs. 25000 Rs. 200000
Form for WC requirement greater than Rs. 200000
This limit changes as per the government regulation and the banks policy.
Financial Statements
There are various financial statements but the key one are Balance Sheet and the Profit
and Loss account
1. Balance Sheet: it is the statement of the financial position of business enterprise as on
a particular date. It indicates the total assets and a liability of the enterprise on that date or
in other words, describes the sources from which the business entity obtained funds and
the uses that have been made of these funds.
Format of Balance Sheet is given on the following page:

Projected

Previous

Balance

Year

Sheet as on Actual

Current

Next Year

Assets

Year Projected
Projected

31st March
(In Rupees
000s
omitted)y
Current

Current

Bank

Cash and

Sundry Creditors

Bank

Other

Investments

Statutory

Loans

Inventory

Other Liabilities

Sundry

Income Tax

debtors
Stores
Others
Tax
Fixed

Deferred
Friends

and

Balance

Relatives

Add

Term Loan

Less:
Depreciatio

Capital

and

Surplus
Capital

n
Miscellaneou
s

General Reserves

Long Term

Investment

Advances

Allowance

Others

Other

Reserves

Previous

Current

Next Year

Year

Year

Projected

Actual

Projected

and Surplus
Total

Total

Projected Profit and Loss Account (Format)

Previous

Current

year

year

i) Sales Realisation
ii) Variable Expenses
Raw Materials consumed
Wages
Power and Electricity
Consumables
Repairs and Maintenance
Interest on Working
Capital
Selling Expenses
iii) Contribution ( i - ii)
iv) Fixed Expenses
Salaries
Interest on Loan
Depreciation
Administrative Overheads
v) Total Expenses ( ii + iv)
vi) Profit before Tax (i-v)

Venture Capital

Next Year

Invention and innovation drive the US economy. What's more, they have a
powerful grip on the nations collective imagination. Tales abound of against-allodds success stories of Silicon Valley entrepreneurs. In these sagas, the
entrepreneur is the modern-day cowboy, roaming new industrial frontiers much the
same way that earlier Americans explored the West. At his side stands the Venture
Capitalist, a trail-wise sidekick ready to help the hero through all the tight spots in exchange, of course, for a piece of the action.
As with most myths, theres some truth to this story. Arthur Rock, Tommy Davis,
Tom Perkins, and other early venture capitalists are legendary for the parts they
played in creating the modem computer industry. Their investing knowledge and
operating experience were as invaluable as their capital. But as the venture capital
business has evolved over the past 30 years, the image of the cowboy with his
side-kick has become increasingly outdated. Today's venture capitalists look more
like bankers, and the entrepreneurs they fund look more like MBAS.
The U.S. venture capital industry is envied throughout the world as an engine of
economic growth. Although the collective imagination romanticizes the industry,
separating the popular myths from the current realities is crucial to understanding
how this important piece of the U.S. economy operates. For entrepreneurs (and
would-be entrepreneurs), such an analysis may prove especially beneficial.
Venture Capital Fills Voice
Contrary to popular perception venture capital plays only a minor role in finding
basic innovation. Venture capitalists invested more that $10 billion in 1997, but
only 6% or $600 million, went to start-ups. Moreover, it is estimated that less than
$1 billion of the total venture-capital pool goes to R&D. The majority of that
capital went to follow-on finding for projector, originally developed through the
far greater expenditures of governments ($63 billion) and corporations ($133
billion).
Where venture money plays an important role is in the next stage of the
innovation life cycle the period in a company's life when it begins to
commercialize its innovation. It is estimated that more than 80% of the money
invested by venture capitalists goes into building the infrastructure required to
grow the business - in expense investments (manufacture & marketing & and
sales) and the balance sheet (providing fixed assets and working capital).

Venture money is not long-term money. The idea is to invest in a company's

balance sheet and infrastructure until it reaches a sufficient size and credibility so
that it can be sold to a corporation or so that the institutional public-equity
markets and step in and provide liquidity. In essence, the venture capitalist buys
a stake in an entrepreneurs idea, nurtures it for a short period, and then exits
with the help of an investment banker.
Venture capital's niche exists because of the structure and rules of capital markets.
Someone with an idea or a new technology often has no other institution to turn to.
Laws limit the interest banks can charge on loans - and the risks inherent in startups usually justify higher rates than allowed by law. Thus bankers will only
finance a new business to the extent that there are hard assets against which to
secure the debt and in today's information-based economy, many start-ups have
few hard assets.
Further-more, investment banks and public equity are both constrained by
regulations and operating practices meant to protect the public investor.
Historically, a company could not access the public market without sales of about
$15 millions assets of $10 Trillion and a reasonably profit history. To put this in
perspective, less than 2% of the more than 5 million corporations in the United
States have more than $10 million in revenues. Although the IPO threshold has
been lowered recently (through the issuance of development-stage company
stocks), in general the financing window for companies with less than $10 Union
in revenue remains closed to the entrepreneur.
Venture capital fills the void between the sources of funds for innovation (chiefly
corporations, government bodies, and the entrepreneurs friends and family) and
traditional lower-cost sources of capital available of ongoing concerns. Filling
that void successfully requires the venture capital industry to provide a sufficient
retain on capital to attract private equity funds, attractive return for its own
participants, and sufficient upside potential to entrepreneurs to attract high-quality
ideas that will generate high returns. Put simply, the challenge is to earn a
consistently superior return on investments in inherently risky business ventures.
Profile of the ideal Entrepreneur
From a venture capitalists perspective, the ideal entrepreneur:
Is qualified in hot area of interest.
Delivers sales or technical advances such as FDA approval with reasonable
probability.
Tells compelling story and is presentable to outside investor.

 Recognizes the need of an IPO for liquidity.

Has a good reputation and can provide reference that shows competence and
skill.
Understand the need for team with variety of skill and therefore sees why
equity has to be allocated to other people.
Works diligently towards the goal but maintains flexibility.
Gets along with investor group.
Understands the cost of capital and typical deal structures and is not offended
by them.
Is sort after by many VCs.
Has realistic expectation about process and outcome.

Sufficient Returns at Acceptable Risk

Investors in venture capital funds are typically very large institutions such as
pension funds, financial firms, insurance companies, and university endowments all of which put a small percentage of their total funds into high-risk investments.
They expect a return of between 25% and 35% per year over the lifetime of the
investment. Because these investments represent such a tiny part of the
institutional investors' portfolios, venture capitalists have a lot of latitude. What
leads these institutions to invest in a fund is not the specific investments but the
firms overall record of accomplishment, the funds story and their confidence in
the partners themselves.
How do venture capitalists meet their investors' expectations at acceptable risk
levels? The answer lies in their investment profile and in how they structure each
deal.
The investment profile.
One myth is that venture capitalists invest in good people and good ideas. The
reality is that they invest in good industries - that are industries that am more
competitively forgiving than the market as a whole. In 1980, for example, nearly
20% of venture capital investments went to the energy industry. More recently,
the flow of capital has shifted rapidly from genetic engineering specialty retailing
& computer hardware to CD-ROMS, multimedia, telecommunication, and
software computers. Now, more than 25% of disbursements are devoted to the
Internet 'space". The apparent randomness of these shifts among technologies and
industry segments is misleading; the targeted segment is each case was
growing fast, and its capacity promised to be constrained in the next
five years. To put this in context, it is estimated that less than 10% of all U.S.
economic activity occurs in segments projected to grow more than 15% a year
over the next five years.
In effects venture capitalists focus on the middle part of the classic industry Scurve. They avoid both the early stages, where technologies are uncertain and
market needs are unknown, and the later stages, when competitive stakeouts and
consolidations are inevitable and growth rates slow dramatically. Consider the
disk drive industry. In 1983, more than 40 venture-funded companies and more
and 80 others existed. By late 1984, the industry market value had plunged from
$5.4 billion to $l.4 billion. Today only five major players remain.

Growing within high-growth segments is a lot easier than doing so in low, no, or
negative growth Ones, as every businessperson knows. In other words, regardless
of the talent or charisma of individual entrepreneurs, they rarely receive backing
from a VC if their businesses are in low growth market segments. What these
investment flows reflect, then is a consistent pattern of capital allocation into
industries while most companies are likely to look good in the near term.
During this adolescent period of high and accelerating growth, it can be extremely
hard to distinguish the eventual winners from the losers because their financial
performance and growth rates look striking similar. At this stage, all companies
are struggling to deliver products to a product-starved market. Thus, the critical
challenge for the venture capitalist is to identify competent management that can
execute - that is, supply the growing demand.
Picking the wrong industry or betting on a technology risk in an unproven market
segment is something VCs avoid. Exceptions to this rule tend to involve "concept
stocks, those that hold great promise but take an extremely long time to succeed.
Genetic engineering companies illustrate this point In that industry, the venture
capitalist's challenge is to identify entrepreneurs who can advance a key
technology to a certain stage - FDA approval, for example - at which point the
company can be taken public or sold to a major corporation.
By investing in areas with high growth rates, VCs primarily consign their risks to
the ability of the companys management to execute. VC investments in highgrowth segment are likely to have exit opportunities because investment bankers
are continually looking for new high growth issues to bring to market. The issues
will be easier to sell and likely to support high relative valuations - and therefore
high commission for the investment bankers. Given the risk of these type of deals,
investment bankers, commissions are typically 6% to 8% of the money raised
through an IPO. Thus, an effort of only several months on the part of a few
Professionals and brokers can result in millions of dollars in commissions.
As long as venture capitalists are able to exit the company and industry before, it
tops out, they can reap extraordinary return at relatively low risk. Astute venture
capitalists operate in a niche where traditional, low-cost financing is unavailable.
High rewards can be paid to successful management teams, and institutional
investment will be available to provide liquidity in a relatively short period of
time.
The logic of the deal.

There are many variants of the basic deal structure, but whatever the specifics,
the logic of the deal is always the same: to give investors in the venture capital
fund both ample downside protection and a favorable position for additional
investment of the company proves to be a winner.
In a typically start-up deal, for example, the venture capital fund will invest $3
million in exchange for a 40% preferred-equity ownership positing although
recent valuations have been much higher. The prefer-red provisions offer
downside protection. For instance, the venture capitalists receive a liquidation
preference. A liquidation feature simulates debt by giving 100% preference over
common shares held by management until the VCs $3 million is returned. In
other words, should the venture fail, they are given first claim to all the
company's assets and technology. In addition, the deal often includes blocking
rights or disproportional voting rights over key decisions, including the sale of
the company or the timing of an IPO.
The contract is also likely to contain downside protection in the form of antidilution clauses, or ratchets. Such clauses protect against equity dilution if
subsequent rounds of financing at lower values take place. Should the company
stumble and have to raise more money at a lower valuation the venture firm will
be given enough shares to maintain its original equity position - that is, the total
percentage of equity owned. That preferential treatment typically comes at the
expense of the common shareholders, or management as well as investors who
are not affiliated with the VC firm and who do not continue to invest on a pro
rata basis.
Alternatively, if a company is doing well, investors enjoy upside provisions,
sometimes giving them the right to put additional money into the venture at a
predetermined price. That means venture investors can increase their stakes in
successful ventures at below market prices.
VC firms also protect themselves from risk by co-investing with other firms.
Typically, there will be a lead investor and several "followers". It is the
exception, not the rule, for one VC to finance an individual company entirely.
Rather, venture firms prefer to have two or three groups involved in most stages
of financing. Such relationships provide further portfolio diversification - that is,
the ability to invest in more deals per dollar of invested capital. They also
decrease the workload of the VC partners by getting others involved in assessing
the risks during the due diligence period and in managing the deal. And the

presence of several. VC firms adds credibility. In fact, observes have suggested

that the truly smart fund will always be a follower of the top-tier firms.
Attractive return for the VC
In return for financing one or two years of a companys start-up, venture
capitalists expect a ten times return of capital over five years. Combined with the
preferred position this is very high-cost capital: a loan with a 58% annual
compound interest rate that cannot be prepaid. However, that rate is necessary to
deliver average fund returns above 20%. Funds are structured to guarantee
partners a comfortable income while they work to generate those returns. The
venture capital Partners agree to return all the investors' capital before sharing in
the upside. However, the fund typically pays for the investors annual operating
budget - 2% to 3% of the pools total Capital - which they take as a management
fee regardless of the funds results. If there is a $100 million pool and four or five
partners, for example,, the partners are essentially assured salaries of $200,000 to
$400,000 plus operating expenses for seven to ten year.
The real upside lies in the appreciation of the portfolio. The investors get 70% to
80% of the gains; the venture capitalists get the remaining 20% to 30%. The
amount of money any partner receives beyond salary is a function of the total
growth of the Portfolios value and the amount of money managed per partner.
Thus for a typical portfolio - say, $20 million managed per partner and 30% total
appreciation on the fund - the average annual compensation per partner will be
about $2.4 million per Year, nearly all Of which comes from mutual fund
appreciation.
What part does the venture capitalist play in maximizing the growth of the
portfolios value?
In an ideal world, all of the firms investments would be winners. However, the
world isnt ideal; even with the best management, the odds of failure for any
individual company high.
On average, good plans, people, and businesses succeed only one in ten times. To
see why, consider that there are many components critical to a company's success.
The best companies might have an 80% probability of succeeding at each of them.

But even with these odds, the probability of eventual success will be less than 20%
because failing to execute on any component can torpedo the entire company.
These odds play out in venture capital portfolios: more than half the companies
will at best return only the original investment and at worst be total losses.
Given the portfolio approach and the deal structure VCs use, however, only 10%
to 20% of the companies funded need to be real winners to achieve the targeted
return rate of 25% to 30%. In fact, VC reputations are often bruit on one or two
good investments.
Those probabilities also have a great impact on how the venture capitalists spend
their time. Little time is required on the real winners - or the worst performers.
Instead, the VC allocates a significant amount of time to those middle portfolio
companies, determining whether and how the investment can be turned around
and whether continued participation is advisable. The equity ownership and the
deal structure described earlier give the VCs the flexibility to make management
changes, particularly for those companies whose performance has been mediocre.
Most VCs distribute their time among many activities. They must identify and
attract new deals, monitor existing deals, allocate additional capital to the most
successful deals, and assist with exit options. Astute VCs are able to allocate
their time wisely among the various functions and deals.
The popular image of venture capitalists as sage advisors is at odds with the
reality of their schedules. The financial incentive for partners in the VC firm is
to manage as much money as possible. The more money they manage, the less
time they have to nurture and advise entrepreneurs. In fact, virtual CEOs" are
now being added to the equity pool to counsel company management, which is
the role that VCs used to play.
The Upside for Entrepreneurs

Even though the structure of venture capital deals seems to put entrepreneurs at a
steep disadvantage, they continue to submit far more plans than actually get
funded, typically by ratio of more than ten to one. Why do seemingly bright and
capable people seek such high cost capital?
Venture-funded companies attract talented people by appealing to a 'lottery'
mentality. Despite the high risk of failure in new ventures, engineers and
businesspeople leave their jobs because they are unable or unwilling to perceive
how risky a start-up can be. Their situation may be compared to that of hopeful

high school basketball players, devoting hours to their sport despite the
overwhelming odds against turning professional and earning million-dollar
incomes. However, perhaps the entrepreneurs behavior is not so irrational.
Consider the options. Entrepreneurs - and their friends and families - usually
lack the funds to finance the opportunity. Many entrepreneurs also recognize the
risks in starting their own businesses, so they shy away from using their own
money. Some also recognize that they do not possess all the talent and skills
required to grow and ran a successful business.
Most of the entrepreneurs and management teams that start new companies come
from corporations or, more recently, universities. This is logical because nearly
all basic research money, and therefore- invented comes from corporate or
government funding. But those institutions are better at helping people find new
ideas than at turning them into new businesses. Entrepreneurs recognize that
their upside in companies is limited by institutions pay structure. The VC has no
such caps.
Downsizing and re-engineering have scattered the historical security of corporate
employment. The corporation has shown employees its version of loyalty. Good
employees today recognize the inherent insecurity of their positions and, in
return, have hide loyalty themselves.
Additionally, the United States is unique in its willingness to embrace risk-taking
and entrepreneurship. Unlike many Far Eastern and European cultures, the culture
of United States attaches little, if any, stigma to trying and failing in a new
enterprise. Leaving and returning to a corporation is often rewarded.
For all these reasons, venture capital is an attractive deal for entrepreneurs. Those
who lack new ideas, funds, skills, or tolerance for risk to start something alone
may be willing hired into well-funded and supported venture. Corporate and
academic training provides many of the technological and business skills
necessary for the task while venture capital contributes both the financing and an
economic reward structure well beyond what corporations or universities afford.
Even if a founder is ultimately demoted as the company grows, he or she can still
get rich because the value of the stock will far outweigh the value of any foregone
salaryBy understanding how venture capital actually works, astute entrepreneurs can
mitigate their risks and increase their potential rewards. Many entrepreneurs make

the mistake of thinking that venture capitalists are looking for good ideas when, in
fact, they are looking for good managers in particular industry segments. The
value of any individual to a VC is thus a function of the following conditions:

The number of people within the high-growth industry that are qualified for the
position;

The position itself (CEO, CFO, VP of R&D);

The match of the personal skills, reputation, and incentives to the VC firm
The willingness to take risks; and
The ability to sell oneself.
Entrepreneurs who satisfy these conditions come to the table with a strong
negotiating position. The ideal candidate will also have a business record of
accomplishment, preferably in a prior successful IPO, that makes the VC
comfortable. His reputation will be such that the investment in him will be seen as
a prudent risk. VCs want to invest in proven, successful people.
Just like VCs, entrepreneurs need to make their own assessments of the industry
fundamentals, the skills and funding needed, and the probability of success over a
reasonably short time frame. Many excellent entrepreneurs are frustrated by what
they see as an unfair deal process and equity position. They do not understand the
basic economics of the venture business and the lack of financial alternatives
available to them. The VCs are usually in the position of power by being the only
source of capital and by having the ability to influence the network. However, the
lack of good managers who can deal with uncertainty high growth and high risk
can provide leverage to the truly competent entrepreneur. Entrepreneurs who are
sought after by competing VCs would be wise to ask the following questions:

Who will serve on our board and what is that persons position in the VC firm?
How many other boards does the VC serve on?
Has the VC ever written and funded his or her own business plan successfully?

 What, if any, is the VCs direct operating or technical experience in this

industry segment?
What is the firms reputation with entrepreneurs who have been fired or
involved in unsuccessful ventures?
The VC partner with solid experience and proven skill is a true "trail-wise
sidekick. Most VCs, however, have never worked in the funded industry or have
never been in a down cycle. In addition, unfortunately many entrepreneurs are
self-absorbed and believe that their own ideas or skills are the key to success. In
fact, the VCs financial and business skills play an important role in the company's
eventual success. Moreover, every company goes through a life cycle- each stage
requires a different set of management skills. The person who starts the business
is seldom the person who can grow it, and that person is seldom the one who can
lead a much larger company.
Thus, it is unlikely that the founder will be the same person who takes the
company public.
Ultimately, the entrepreneur needs to show the venture capitalist that his team and
idea fit into the VCs current focus and that his equity participation and
management skills will make the VCs job easier and the returns higher. When the
entrepreneur understands the needs of the funding source and sets expectations
properly, both the VC and entrepreneur can profit handsomely.
Although venture capital has grown dramatically over the past ten years, it still
constitutes only a tiny part of the US economy. Thus in principle, it could grow
exponentially. More likely, however, the cyclical nature of the public marketing,
with their historic booms and busts, will check the industry's growth. Companies
are now going public with valuations in the hundreds of millions of dollars
without making a penny. Moreover, if history is any guide, most of these
companies never will.
The system-described here works well for the players it serves: entrepreneurs,
institute investors, investment bankers, and the venture capitalists themselves. It
also serves supporting cast of lawyers, advisers, and accountants. Whether it
meets the needs of investing public is still an open question.