Sources of capital,

Informal risk capital & venture capital

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Capital is always required for a business to start and grow.

There are a number of alternative methods to fund growth like:

• owner or proprietor’s own capital,

• arranging debt finance, or
• seeking an equity partner, as is the case with private equity and
venture capital

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Sources of capital
1. Debt or equity financing
2. Internal or external funds
3. Personal funds
4. Family and friends

5. Commercial banks loan

Type of bank loan:
a. Account receivable loans
b. Inventory loans
c. Equipment loans
d. Real estate loans
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5. Cash flow financing
a. Installment loans
b. Straight commercial loans
c. Long term loans
d. Character loans

6. Research and development partnership

a. General partner
b. Limited partner

7. Government grants
8. Private placement
9. Bootstrap financing
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 Informal risk capital:
 It consist of a virtually invisible group of wealthy investors often
called as business angels.

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 Venture capital
 Venture capital is a new financial service, towards
developing strategies to help a new class of new
entrepreneurs to translate their business into ideas
into realities.

 It broadly implies an investment in long term, equity

finance in high risk projects with high reward
possibilities.

 Venture capital is “equity support to fund new concepts

that involve a higher risk and at a same time have higher
growth and profit potential”

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The SEBI has defined Venture Capital Fund in its Regulation 1996 as

‘a fund established in the form of a company or trust which raises money through
loans, donations, issue of securities or units as the case may be and makes or proposes
to make investments in accordance with the regulations’.

Venture capital is a means of equity financing for rapidly-growing private

companies.

Finance may be required for the start-up, development/expansion or purchase of

a company.

Venture Capital is a form of "risk capital".

In other words, capital that is invested in 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.

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Venture Capital provides long-term, committed share capital, to help unquoted
companies grow and succeed.

If an entrepreneur is looking to start-up, expand, buy-into a business, buy-out a

business in which he works, turnaround or revitalize a company, venture capital
could help do this.

Obtaining venture capital is substantially different from raising debt or a loan

from a lender. Lenders have a legal right to interest on a loan and repayment of
the capital, irrespective of the success or failure of a business.

As a shareholder, the venture capitalist's return is dependent on the growth and

profitability of the business.

This return is generally earned when the venture capitalist "exits" by selling its
shareholding in the business

The goal of venture capital is to build companies so that the shares become liquid
(through IPO or acquisition) and provide a rate of return to the investors (in the
form of cash or shares) that is consistent with the level of risk taken

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Vision of Venture Capital

The vision of venture capital is focussed on new projects, seed capital,

technology and innovation.

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Venture Capitalists generally:

• Finance new and rapidly growing companies

• Purchase equity securities

• Assist in the development of new products or services

• Add value to the company through active participation.

Characteristics

• Long time horizon

• Lack of liquidity

• High risk

• Equity participation

• Participation in management
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What kind of businesses are attractive to venture capitalists:

Venture capitalists prefer to invest in "entrepreneurial businesses".

This does not necessarily mean small or new businesses.

Rather, it is more about the investment's aspirations and potential for growth, rather
by current size.

Venture capital investors are interested in companies with high growth prospects,
which are managed by experienced and ambitious teams who are capable of turning
their business plan into reality.

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 Stages of financing

1. Seed Money:
Low level financing needed to prove a new idea.
2. Start-up:
Early stage firms that need funding for expenses associated with marketing and
product development.
3. First-Round:
Early sales and manufacturing funds.
4. Second-Round:
Working capital for early stage companies that are selling product, but not yet
turning a profit .
5. Third-Round:
This is expansion money for a newly profitable company
6. Fourth-Round:
Also called bridge financing, it is intended to finance the "going public" process
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INVESTMENT PROCESS

The investment process begins with the venture capitalist conducting an initial review
of the proposal to determine if it fits with the firm's investment criteria.

If so, a meeting will be arranged with the entrepreneur/management team to discuss

the business plan.

Preliminary Screening
Negotiating Investment
Approvals and Investment Completed

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Preliminary Screening

The initial meeting provides an opportunity for the venture capitalist to meet with the
entrepreneur and key members of the management team to review the business plan
and conduct initial due diligence on the project.

It is an important time for the management team to demonstrate their

understanding of their business and ability to achieve the strategies outlined in the
plan.

The venture capitalist will look carefully at the team's functional skills and
backgrounds.

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Negotiating Investment

This involves an agreement between the venture capitalist and management of the
terms of the term sheet, often called memorandum of understanding (MoU).

The venture capitalist will then proceed to study the viability of the market to
estimate its potential.

Often they use market forecasts which have been independently prepared by
industry experts who specialize in estimating the size and growth rates of markets and
market segments

The venture capitalist also studies the industry carefully to obtain information about
competitors, entry barriers, potential to exploit substantial niches, product life
cycles, and distribution channels.

The due diligence may continue with reports from other consultants.

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Approvals and Investment Completed

The process involves due diligence and disclosure of all relevant business
information.

Final terms can then be negotiated and an investment proposal is typically submitted
to the venture capital fund’s board of directors.

If approved, legal documents are prepared.

The investment process can take up to two months, and sometimes longer. It is
important therefore not to expect a speedy response.

It is advisable to plan the business financial needs early on to allow appropriate time to
secure the required funding.

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 VC INVESTMENT PROCESS

Deal origination

Screening

Due diligence (Evaluation)

Deal structuring

Post investment activity

Exit plan

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Methods of Venture Financing

The financing pattern of the deal is the most important element.

Following are the various methods of venture financing:

 Equity

 Conditional loan

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 Exit route

 Initial public offer(IPOs)

 Promoter buy back

 Acquisition by another company

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 Valuing your company:
 A problem confronting the entrepreneur in obtaining outside
equity funds, whether from the informal investor market (
business angels) or from the venture capital industry , is
determining the value of the company.

 This valuation is at the core of determining how much

ownership an investor is entitled to for funding the venture.

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 Factors in valuation :
 Nature and history of business
 Financial data of the venture
 Book value of the stock of the company
 Future earning capacity of the firm
 Dividend paying capacity of the venture
 Assessment of goodwill and other intangibles of the venture
 Previous sale of stock

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Ratio analysis:
1. Liquidity ratios
2. Activity ratio
3. Leverage ratio
4. Profitability ratio

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 1. Liquidity ratio:
A. Current ratio = C.A / C.L
 This ratio is commonly used to measure the short-term solvency
of the venture or its ability to meet its short-term debts.

 Ratio of 2:1 is generally considered as favorable.

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 B. Acid test ratio:
 Formula: (C.A – inventories ) / current liabilities

 It eliminates inventory from C.A.

 Usually 1:1 ratio would be favorable in most industries.

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 2. Activity ratio
a. Average collection period = account receivable / average
daily sales
 This ratio indicates the average number of days it takes to
convert account receivables into cash.

b. Inventory turnover = cost of goods sold / inventory

 This ratio measures the efficiency of the venture in managing
and selling its inventory.

 High turnover is favorable sign indicating that the venture is able

to sell its inventory quickly.

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 3. Leverage ratios:
a. Debt ratio: total liabilities / total assets
 The debt ratio helps the entrepreneur to assess the firms
ability to meet all its obligations.

b. Debt to equity = total debt/ shareholders equity.

 The higher the percentage of debt the greater the degree of
risk to any of the creditor.

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 4. Profitability ratio:
a. Net profit ratio= net profit / net sales
 It represents the ventures ability tp translate sales into profit.

b. Return on investment = net profit/ total assets

 The return on investment measures the ability of the venture to
manage its total investment in assets.

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 General valuation approaches:
The following are various methods for determining the value of the
company :
1. Present value of future cash flow
2. Replacement value
3. Book value
4. Earning approach
5. Factor approach

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 If You Cannot Do Great Things,
Do Small Things In A Great Way.

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