Q: Explain venture capital financing and exit route of venture capital financing and also explain venture capital

in India? Ans. Venture capital financing: Venture capital is a source of financing for new
businesses. Venture capital funds pool investors' cash and loan it to startup firms and small businesses with perceived, long-term growth potential. This is a very important source of funding startups that do not have access to other capital and it typically entails high risk (and potentially high returns) for the investor. Most venture capital comes from groups 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 a limited operating history that cannot raise capital though a debt issue or equity offering. Often, venture firms will also provide start-ups with managerial or technical expertise. For entrepreneurs, venture capitalists are a vital source of financing, but the cash infusion often comes at a high price.

Stages of Venture Capital Financing:

The financing of high-tech., project in the form of venture capital financing is done in several stages. They broadly fall into two categories:

1. Early stage financing 2. Later stage financing

1. Early-stage financing: This stage of financing is done to the new project or to the new
technocrat who wishes to commercialize his research talents. The main instruments used for such financial assistance would be in the form of equity contribution, unsecured loans and optionally convertible securities. Once the financing is done, venture capitalists assist the firm in general administrative activities and allow the technocrat to concentrate on production and marketing. This stage of venture capital financing includes: a) Seed capital b) Start-up c) Second round financing

a) Seed capital: Seed capital financing includes the implementation of research project,
starting from all initial conceptual stage. This stage requires more time to complete the process. Because the entrepreneur made an effort to the maximum to meet the market potentiality. Therefore external equity in preferred. The key factors that influence equity financing at this stage are: The technology used in the project, possible threats of new technology in the near future different aspects of the product life cycle. The total investment required commercializing the product and time required to get suitable returns etc.

b) Start-up stage financing: At this stage innovator requires finance to commercialize

the product. This stage is not simple to execute, it requires more time in getting different

elements i.e., (patent rights, trade marks, design and copy rights) which are very essential to bring the product in the market. All these components are very essentially needed to launch the product effectively. Hence, time and finance is needed. On the other hand, the research must also be done to evaluate the probable opportunities to exploit the market. Therefore, venture capital investor evaluates the projects carefully and negotiates the terms and conditions with the entrepreneur with regard to sharing the management.

c) Second round financing: This type of financing is required when the project incurs loss
or inability to yield sufficient profits. The reasons could be due to internal or external factors. At this stage, if the venture capitalist is fully aware of the genuine reasons for the loss, he should decide on second round financing, or he may seek the support of new investor. This is a complex process as the original investor may express his inability to further finance the project or entrepreneur must have lost the confidence with the original investor or he may wishes to broad base the investment pattern. Lot of bargaining has been done to coordinate the financing with original investor and with the technocrat or promoter.

2. Later Stage Financing: Later stage financing is considered to be the easy means of
assistance. The reason being, the product launched has not only reached the boom period but also indicator further expansion and growth. Hence it is a easy means of financing with low risk profile. The real problem associated at this stage is entrepreneur not be willing to give majority of his stake to the venture capitalists but may accept for more number of executive directors in the board. It includes: a) Expansion finance b) Replacement capital c) Buyout financing d) Turn around capital.

a) Expansion finance:

This finance by VCIs involves low risk perception and a time-frame of one to three years. This finance is executed to expand the market, production or to establish warehouses etc. 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. Export trade activities may also be considered for financing the project.

b) Replacement capital Under this stage, the promoter may prefer to buy the entire equity
stake of the project by approaching some other financiers. He may also wish to increase his holding by buying more number of equity shares. Replacement capital is normally preferred at the time of public issues. If the company is unlisted, getting capital gains on the fresh issues needs more time, tilt then replacement capital can be obtained in the form of convertible preference shares from the second financier.

c) Buyout financing: These refer to the transfer of management control. They fall into

two categories: Management buyouts Management buy- in

Management buyouts: 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. In management buyout, venture capitalist helps the management of a company to buy or take over the ownership of the business. This would help the managementto reshuffle or reengineer the entire project. Management buy- in: 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.

d) Turn around capital: These are a sub-set of buyouts and involve buying the control
of a sick company. Two kinds of inputs are required in a turnaround- money and management. The VCIs have to identify good management and operations leadership. Such form of venture capital financing involves medium to high risk and a time-frame of three to five years. It is gaining widespread acceptance and increasingly becoming the focus of attention of VCIs.

Financial Instruments:

Financial instruments a VCI can choose from fall into two

categories Equity instruments and Debt instruments.

a) Equity Instruments: The main characteristics of an equity instrument are as follows:

Can be floated at face value or at a premium based on the valuation of the company and the portion of the equity offered for investment No guarantee of fixed returns to the investors Carries residual claim on the assets of the firm in the event of bankruptcy Limited liability for the investor or promoter to the extent of his investment (for businesses incorporated as a limited company under the Companies Act). High risk, return characteristics

Types of Equity Instruments : Equity instruments can be further classified into the
following categories based on the different characteristics with which they are floated in the market: 1. Equity shares (at par/ premium) 2. Preference shares 3. Depositary receipts (American and Global) 4. Warrants

1. Equity shares (at par/ premium):

Shares are floated at face value or at a premium Only companies with a track record or companies floated by other firms/companies with a track record are allowed to charge premium Premium is normally arrived at after detailed discussions with the lead managers Premium can be any amount but has to be justified as per Malegam Committee recommendations 2. Preference shares: Preference shares refer to a form of shares which lie in between pure equity and debt. These are shares which do not carry voting rights The amount of dividend, which is to be paid is fixed beforehand but is paid only in the event of profit subsequent to the payment of fixed obligations such as interest and tax. Claims of these shareholders carry higher priority than ordinary share holders but lower than debt holders These can be issued for subscription from the general public only after a public issue of ordinary shares Subscription can be solicited either through private placement or a public issue. 3. Depository Receipts (GDRs and ADRs): Global Depositary Receipts mean any instrument in the form of a depositary receipt or certificate (by whatever name it is called) created by the Overseas Depositary Bank outside India and issued to non-resident investors against the issue of ordinary shares or Foreign Currency Convertible Bonds of issuing company. A GDR issued in America is an American Depositary Receipt (ADR). Issue of

equity in the form of GDR/ADR is possible only for the few top notch corporate of the country.

4. Warrant: Warrant is a certificate giving the holder the right to purchase securities at a
stipulated price within a specified time limit or perpetually. Sometimes a warrant is offered with securities as an inducement to buy. The warrant acts as a sweetener because the holder of the warrant has the right but not the obligation of investing in the equity at the indicated rate. Debt instruments: Debt instruments can be further classified into the following categories based on the different characteristics with which they are floated in the market: Debentures Bonds Conditional loan Conventional loan Income Notes Debentures: Main characteristics of debentures are: They are fixed interest debt instruments with varying period of maturity. Can either be placed privately or offered for subscription. May or may not be listed on the stock exchange. If listed on the stock exchanges, they should be rated prior to the listing by any of the credit rating agencies designated by SEBI. When offered for subscription a debenture redemption reserve has to be maintained. The period of maturity normally varies from 3 to 10 years and may also be more for projects with a high gestation period.

b)
1.
2.

3. 4. 5.

1.

Types of debentures: There are different kinds of debentures, which can be offered. They are
as follows:

Non convertible debentures (NCD) Partially convertible debentures (PCD) Fully convertible debentures (FCD)

Non convertible debentures (NCD): In case of NCDs, the total amount of the instrument is redeemed by the issuer. Partially convertible debentures (PCD): In case of PCDs, part of the instrument is redeemed and part of it is converted into equity. Fully convertible debentures (FCD: In case of FCDs, the whole value of the instrument is converted into equity. The conversion price is stated when the instrument is issued.

2. Bonds: Bonds may be of many types - they may be regular income, infrastructure, tax
saving or deep discount bonds. These are financial instruments with a fixed coupon rate

and a definite period after which these are redeemed. From the point of view of the investor bonds are instruments carrying higher risk and higher returns as compared to debentures. The three main kinds of instruments in this category are as follows:

Fixed rate Floating rate Discount bonds

Fixed rate bonds: The bonds may also be regular income with the coupons being paid at fixed interval or cumulative in which the interest is paid on redemption. Floating rate bonds: Unlike debentures, bonds can be floated with a fixed interest or floating interest rate. Discount bonds: They can also be floated without interest and are called discount bonds as they are issued at a discount to the face value and an investor is paid the face value on redemption and if offered for longer terms are known as deep discount bonds.

3. Conditional loan: This is a quasi-equity instrument without any pre-determined

repayment schedule or interest rate. The suppliers of such loans recover a specified percentage of sales towards the recovery of the principal as well as revenue in a predetermined ratio usually 50:50. The charge on sales is known as royalty. 4. Conventional loans: These are modified to the requirements of venture capital financing. They carry lower interest initially which increase after commercial production commences. A small royalty is additionally charged to cover the interest foregone during the initial years. 5. Income Notes: Income notes fall between the conditional and conventional loans and carry a uniform low rate of interest plus a royalty on sales.

Exit Route of Venture Capital:

The main aim of venture capitalist is to realize the investment with huge profit after the completion of successful efforts with the promoter in launching or commercializing the product. The exit route will be well thought by the investor at the stage of marking investments. Exit means realization of investment through the issue of equity shares to the public. The main motto of venture capitalist is find exit at maximum profit or if it is unavoidable with minimum loss. There are alternative routes of disinvestment which are related to the type of investment, namely, equity / quasi-equity and debt instruments. These are:

Disinvestments of Equity/Quasi-Equity Investments: There are five disinvestment

channels for realization of such investments: a) Going public b) Sale of shares to Entrepreneurs c) Sale of the company to another company d) Finding a new investor e) Liquidation

a) Going Public: Most of the venture capital assisted firms prefers to go in for public issue
to recover their investments with profits. This process not only helps the entrepreneur but also the investor in different ways. The main benefit of going public increases the liquidity of the business firm. This liquidity will increase the percentage returns over the private placements. (If it were sold through private placements). The public issue provides another opportunity for the business firm to list its shares in the stock market. Once the shares are listed, it increases the image of the organization. In addition to this, it increases and attracts efficient persons to work in the organization. In addition to this, the commercial banks and financial institutors will forward to offer different types of loans. If the firm wishes to raise additional capital for expansion and growth, it could be done easily through the public issue. However, going public is not an easy route to exit or venture capital assisted units because; it has to observes several legal formalities of stock exchange. The company must also disclose part a considerable ar1t of information at the time of issuing the shares; this could be a sales threat with the global competition. Employees may ask for better comfort with huge hike in the salaries and perks. The expenditure incurred during the course of the issue in also substantially high, which may affect the profitability. As the company is going for public issue, its social responsibility increases and they have to be accountable to all the organs of the society, which burdens the financial affairs of the company. With all these demerits or bottlenecks going public for exit route is widely used in seal life situations.

b) Sale of shares to entrepreneur: Sometimes, promoter may prefers to have exit route
through, Over The Counter Exchange by entering into bought out deals with the member of O.T.C. He may purchase the shares with a view of entering in to the primary market at the later stage. In certain circumstances, an entrepreneur himself prefers to buy the entire shares. He may even buy the shares with the help of his own group-even the employees are allowed to do so at an agreed price for buying such shares. If necessary, the entrepreneur may approach financial institutions for loans. The price at which the stake of the V. C. assisted may be done as several methods:

Book value method: According to this method, the price is fixed on the basis of book value method or a predetermined multiple applied to determine the book value. Price-earning ratio: This method is widely in practice. The price of the share is determined as the basis of multiplying the price earnings ratio to earning per share.

Percentage of sales method: Pricing under P/E ratio is popular only when the earnings are low or the company anticipated losses in the coming years PIE ratio is not suitable. On such circumstance, percentage of sale method is used. If the sales figures are highly volatile, the total average sale of the industry is taken into consideration. Multiple of cash flow method: According to this method, the value of the business is determined by multiplying the cash flow of the business by a multiplies which is similar to the industry. Hence it is considered to be a better method when compared to PIE ratio and Percentage of sales method. Independent Valuation: Sometimes, the task of determining the value of business is assigned to professionals like CAs or Merchant Bankers. They may use either price earnings ratio method or a traditional method for assessing the value of the assets. (Realizable value) Agreed price method: Venture capitalist and the entrepreneur follow the price that was determined mutually at the time of launching business. This is a traditional and simple method.

c) Sale of a company to another company: On many occasions, venture capitalist and the
entrepreneur may agree together to sell the business unit to some other company. The reasons could be many viz., the entrepreneurs may prefer to undertake some other new company. He may find it difficult to operate the business profitably. At the time of managerial difficulties he may search for a new company which is having similar line of business. The modalities of such a sale will be made on the basis of level of operations and, the nature of venture, which may be acceptable to both the parties.

d) Finding a new investor: Under this method, the venture capitalists and the investor may
decide to sell the unit to another new investor who may be a venture capitalist or a corporate that is having similar line of business. But buying venture from others and buying company may increase their operation and profitability. This provides an opportunity to exploit and can have economies of large scale operations

e) Liquidation: This is a lender of last resort, when a firm performs very badly, in other words if it
incurs continuous cash loss over the years, venture capitalist and the entrepreneur decides to close down the operations. Hence, it takes the firm to liquidation. The reason for such exercises would be many viz., stiff competition, technological failure, poor management by the entrepreneur etc.

Exit of Debt Instruments: Exit in case of debt component of venture capital financing, in
contrast with equity / quasi-equity component, has to normally follow the predetermined route. In case of a normal loan, the exit is possible only at the end of the period of the loan. If the loan agreement permits, whole or part can be converted into equity prior to that. For conditional loans, exit, earlier than projected at the time of initial investment, is possible on the basis of lump sum payment consistent with the expectations of the VCI of the likely return on the loan.

Venture Capital in India

In India the Venture Capital plays a vital role in the development and growth of innovative entrepreneurships. Venture Capital activity in the past was possibly done by the developmental financial institutions like IDBI, ICICI and State Financial Corporations. These institutions promoted entities in the private sector with debt as an instrument of funding. For a long time funds raised from public were used as a source of Venture Capital. This source however depended a lot on the market vagaries. And with the minimum paid up capital requirements being raised for listing at the stock exchanges, it became difficult for smaller firms with viable projects to raise funds from public. In India, the need for Venture Capital was recognized in the 7th five year plan and long term fiscal policy of GOI. In 1973 a committee on Development of small and medium enterprises highlighted the need to faster VC as a source of funding new entrepreneurs and

technology. VC financing really started in India in 1988 with the formation of Technology Development and Information Company of India Ltd. (TDICI) - promoted by ICICI and UTI. The first private VC fund was sponsored by Credit Capital Finance Corporation (CFC) and promoted by Bank of India, Asian Development Bank and the Commonwealth Development Corporation viz. Credit Capital Venture Fund. The SEBI Venture Capital Regulations were issued in 1996. According to this, venture capital fund means a fund established in the form of a company or trust, which raises monies through loans, donations, issue of securities or units as the case may be and makes or proposes to make investments in accordance with these regulations. For accessing venture capital funding the venture should be typically started by a first generation entrepreneur with high growth potential and an innovative concept. Normally these types of ventures do not have any assets to offer as collateral, which is needed to get funding from the conventional sources. Venture capital funding may be by way of investment in the equity of the new enterprise or a combination of debt and equity, though equity is the most preferred route. There are a number of funds currently operational in India and involved in funding start-up ventures. Most of them are not true venture funds, as they do not fund start-ups. What they do is provide mezzanine or bridge funding and are better known as private equity players. However, all this has changed in the last one year. With the Indian knowledge industry finally showing signs of readiness towards competing globally and awareness of venture capitalists among entrepreneurs higher than ever before, venture capitalists are really venturing out in funding new ideas and concepts particularly in internet related areas.