There are a host of financial institutions that extend credit to businesses in India. But these institutions avoid giving long term capital to new entrepreneurs. Furthermore, they evaluate such risky ventures based on conservative criteria. Such evaluation criteria includes judging the profitability, liquidity, safety and security of a business project. But it does not evaluate the growth potential of the project.
Similarly, both capital markets and institutions like Mutual Funds also do not cater to the challenges faced by new entrepreneurs. Therefore, to cater to the financial needs of startups, venture capital firms came into the picture. These firms give wings to the high risk, high growth ventures of startups. Such institutions help new and small entrepreneurs in:
- bringing the requisite pool of funds and
- sharing risks and rewards involved in undertaking a given venture.
Therefore, before going deep into the functioning of Venture Capital in India, let’s first understand what is Venture Capital.
Venture Capital Meaning
Venture capital is a type of private equity capital. Such capital is typically provided to startups and small businesses by:
- wealthy investors
- investment banks and
- other financial institutions .
These businesses undertake projects that involve high risk but have strong potential for growth.
The term “Venture capital” is just not restricted to introducing funds into a startup or a small business. It also includes setting up of the business and providing technical and managerial expertise. However, the major disadvantage of getting a venture capitalist on board is that he gets a say in the company. This is in addition to the equity share that he gets in the business.
Furthermore, venture capital is not long term in nature. The very objective of such form of capital is to invest in the idea of the entrepreneur. Additionally, a venture capital nurtures the business idea until it gets turnaround.
What is a Venture Capital Company?
A venture capital company is a financial institution that backs the entrepreneur’s venture. Additionally, such an institution shares the risk and returns of the underlying startup or small business. Such a company is run by investment professionals who are commonly referred to as venture capitalists. They are high level professionals who have formerly worked at executive level positions in similar firms. Such professionals act as general partners for the venture capital company.
Additionally, a venture capital firm also has limited partners. They are high net worth individuals and institutions providing huge amount of capital to a venture capital. The institutions that invest money include:
- state and private pensions funds
- university financial endowments
- insurance companies and
- pooled investment vehicles called fund of funds.
Features of Venture Capital
A. High Risk
Venture capital is a highly risky source of finance. This is because it offers long term finance to startups engaged in risky ventures. However, such ventures have the potential to grow in the long term. Venture capital further caters to following types of risks.
I. Management Risk
Management risk involves risk associated with the destructive management of the company. Such a risk involves, financial, ethical or any other risk that leads to the underperformance of the management. The management risk impacts an investor’s holding in a company. Hence, management is the very reason why investors provide financial backing to the venture.
II. Market Risk
The market risk refers to the probability of an investor to suffer losses due to the factors that affect the overall performance of the financial markets. Such a risk is also called as systematic risk that is deep rooted in the market itself. This risk impacts the entire market, and not just the stock itself. The sources of systematic risk include interest rate changes, recession, inflation, political turmoil, natural disasters or terrorist attacks.
III. Product Risk
Product risk refers to the possibility of incurring losses owing to the marketing of a product or service. There are different types of product risks that a venture can face. These include risks related to:
- demand for a product
- price of a product
- experience of customers with the product
- operational list
- quality risk
- brand risk
- compliance and regulations
IV. Operational Risk
Operational risks include risks emanating from malfunctioning of internal procedures, people and systems. These are also called as human risks as these are the result of human error, fraud, accidents, failure of systems, problems arising due to personnel management etc.
B. Equity Participation
Venture capitalists invest money in a startup in exchange for equity holding in the firm. The return of venture capitalists on such investment is based on the growth and profitability of the venture. Once the venture gains size and credibility, venture capitalists liquidate their share with the help of the investment bankers. These investment banks are continuously looking for new, high growth issues that can be brought to the market and sold easily.
Both venture capitalists and investors gain through appreciation in the value of the venture capital fund. Accordingly, the limited partners take the major share of such capital gains. Whereas the remaining share goes to the venture capitalists.
C. Participation in Management
Besides providing the requisite finance, venture capital also adds value by offering managerial expertise. Since the general partners are professionals who have worked formerly at executive level with other companies, they act as co – promoters to the entrepreneurs. They advise them on financial management which includes working capital and public issue, project planning and monitoring.
These venture capitalists desire to be a part of the company’s board so as to guide the entrepreneur on major decisions impacting the company. The limited partners, on the other hand, provide capital but do not participate in the managerial decisions. They simply keep in touch with the promoters or entrepreneur to understand the way ahead with their investment.
D. Illiquid Investment
Venture capital is illiquid in nature. This means that the capital provided by the investors gets locked into the venture for a certain period of time – say 5 – 7 years. This means that the investors and venture capitalists seek returns via capital gains. Thus, this form of finance is not subject to repayment on demand, as in the case of an overdraft facility. Also, it does not follow a loan repayment schedule.
Furthermore, under venture capital, the investors get an exit opportunity when the firm gains a sufficient size and sells its investment at market place. However, there might me circumstances where the investor loses his money on account of failure of venture and hence its liquidation.
So to help you understand the concept behind venture capital, here is an infographic on Venture Capital in India.