Tutorial for Technopreneurs
Fundamentals of VC Funding
Angels are the earliest of early-stage investors. For many entrepreneurs, angels provide capital and frequently valuable guidance and strategic assistance-that they would likely not find anywhere else. The ideal angel is someone who is a generation ahead of the entrepreneur in creating value in the industry. They'll provide financial capital as well as intellectual capital, which could be even more important than the money. Angels are sometimes said to invest 'emotional money,' while venture capitalists are said to invest 'logical money'.
Venture Capital Fund or Venture Capital is the second or third stage of a traditional startup financing sequence, which starts with the entrepreneurs (inventors) putting their own available funding into a shoestring operation. Next, an angel investor may be convinced to contribute funding. Thereafter comes venture capital. Venture capital is independently managed, dedicated pools of capital that focus on equity or equity linked investments in privately held, high-growth companies. Venture capitalist or a venture capital company can be broadly defined as a financial institution, which joins the entrepreneurs as a co-promoter, in a project and shares the risks and rewards of an enterprise.
Venture capital is an investment, in the form of equity, quasi-equity and sometimes, debt-straight or conditional (i.e., interest and principal payable when the ventures starts generating sales), made in new or untried technology, or high risk venture, promoted by a technically or professionally qualified entrepreneur, where the venture capitalist.
- expects the enterprise to have a very high growth rate
- provides management and business skills to the enterprise
- expects medium to long-term gains and
- does not expect any collateral to cover the capital provided
Stages in Venture Funding
Funds are needed by an enterprise at all stages of its life cycle, but investment by VC is generally limited to few stages in business development.
- Seed Stage
The venture is at the idea stage or may be in the process of being organized and needs finance for research and development. This is usually funded by the entrepreneur's own resources.
- Early Stage
The company is in the process of being set up or may have been in business for a short time. Such firms have not yet sold their product commercially and have no track record. Investor companies have completed the product development stage and require funds to initiate commercial manufacturing and sales.
- Expansion/Development Stage
The company is now established and requires capital for growth and expansion. The company may or may not have made a profit at this stage. This is a period of rapid growth and the company will usually require several rounds of capital injection as it achieves the milestones set in the business plan.
- Management Buyout (MBO)
These are funds provided to enable a current operating management and investors to acquire an existing product or business from a public or private company.
- Management Buy-in (MBI)
These are funds provided to enable a manager or group of managers from outside the company to buy in to the company.
Funding can also be related to stages in the development of new technology as shown in the table below
Stage of development |
Activities |
Source of funds |
R&D |
-literature study
-patent search
-proving at prototype stage
-proving at pilot plant level
-patent registration
-market feasibility study |
-own funds
-Angel funds
-Government funds |
Start-up
( starting from proven technology to business break-even) |
--establishing production facilities
-product launch
|
Venture Capital |
Initial growth |
Product expansion , developing 2nd generation of products |
Joint funding by several VCs |
Take-off |
Consolidation
Achieving economies of scale in production and sales. |
DFIs ;like IDBI |
Maturity |
Broadening technology base and management capabilities. |
Stock market |
How to Impress a Venture Capitalist
- VC Fundamentals
- The venture capital firm get paid first. Whether by means of a liquidity event or the liquidation of the company in the event of failure, the VC firm will get p[aid first.
- Participation in the upside of the venture. The VC will benefit from the appreciation in value of the venture over and above the original investment.
- Control over critical events. VC will want to have decision rights in matters that vitally affect the business, such as the decision to do an IPO.
- Creation of a path to liquidity. There must be a way for the VC to cash out of the venture.
- Financials
No amount of enthusiasm will convince a venture capitalist if the financial statements aren't up to the mark. Balance sheets, income and cash flow statements, projections are important, but more important are figures for last month, last quarter, last year, and the current month. Details are needed, an income statement should break up expenses into subgroups such as sales and marketing, cost of goods sold, research and development, general administration, interest expense and income tax expense and balance sheet should be comprehensive. Be prepared to explain the assumptions you made.
Hockey Stick Appoach
The term has come to use because like the shape of a hocky stick there are no earnings in the early stages and then a rapid growth. The VC determines at the outset what returns on investment is required during the holding period, then it applies a P/E ratio to earnings at the end of the defined period to calculate the market value of the firm. From this the VC figures the percentage ownership required.
Suppose a new venture requires an investment of Rs 20 lakhs over a 3 year period. VCs normally seek to multiply their investment 5 times over 3 years or 10 times in 5 years. In this case, VC expects a return of 5 times the investment. The venture's after tax earning in the third year are forecasted to be Rs 30 lakhs and comparable Price Earning (P/E) ratio is taken as 10. VC would expect to acquire 33.3% of the equity of the venture
20X5/ 30X10= 100/300= 33.3 %
Debt
Debt payments are not to be worried, because VC want the entrepreneur and the management team to own the majority of the company. It's important that they feel they have a stake in the value of the company. But the kind of debt matters, expensive debt is not only costly, but may also reduce the value of equity. Where the promoters must have debt, then secured debt (that which is tied to an asset) is preferred, debt based on an asset that hasn't materialized is not acceptable. Some venture capitalists frown on using proceeds from first round of financing to pay off startup loans made by family, friends or even an angel. If the company can't service its debt and needs equity to restructure debt, it may raise concerns about management.
Inventors contribution
Venture capitalists want the inventor to put in his money before they invest. But how much? VCs want the entrepreneur to be as at risk as they are. Having money invested keeps an entrepreneur focused on profitability. Cash is not the only measure of investment, sweat equity also counts.
- Inventor's equity partners
Though it depends on the company's development stage, the founder and management should own around 15% or so and balance can be distributed to few people. If there are too many individual shareholders early in the game, it can be harder to get deals done.
- Inventors Salary
VCs expect the innovators to take a cut in his salary compared to the market rates. High salaries eat into the budgets of fast growing companies.
- Identify Market
One can have the most promising idea in the world for a product or service, but if the market conditions are not ripe for entry, do not look for a venture capitalist to bite the bait. The opportunity should be significant, big enough for the company to have revenues of 50 crores to 100 crores within five years. It's harder to capture market share in a mature market, which is why venture capitalists like hot industries such as telecommunications. Company must have a proprietary position that is defensible and sustainable.
- Exit Strategy
This is the most important part. VCs take two types of risk, the project may fall through or it may not grow into significant size. Profit from the few successful ones (20%) should cover losses from the failed ones (80%) and leave him enough. Dividend income is not the target of any VC. They invest in unlisted companies and exit when the company makes its Initial Public Offering (IPO). Venture funders want to know how they will get a return on their investment . Other exit route is selling the business to a strategic buyer, selling to a financial buyer such as a private equity fund, or having the company buy back the venture capitalist's position.
- Willingness to step down as CEO
VCs might ask you to step aside as chief executive, could be for lack of relevant operating experience. This is especially true when the growth is rapid and exceeds everyone's expectations. A change in market conditions also could prompt backers to look for a new chief executive.
