Chapter 26 –

Venture Capital Financing

Copyright © 2019 McGraw Hill Education, All Rights Reserved.

PROPRIETARY MATERIAL © 2019 The McGraw Hill Education, Inc. All rights reserved. No part of this PowerPoint slide may be displayed, reproduced or distributed in any form or by any
Copyright © 2019
means, without the prior written permission of the publisher, or used beyond the limited distribution to teachers and educators permitted by McGraw Hill for their individual course
preparation. If you are a student using this PowerPoint slide, you are using it without permission.
 Learning Objectives
• Discuss the basic features of venture capital: selection of investments, stages of
financing, financial analysis, structuring the deal/financing instruments;
investment monitoring/nurturing in terms of style, objectives of after care and
techniques; portfolio valuation; structure and legal framework; and exit of
investments
• Review of Indian venture capital scenario in terms of the SEBI regulations

Copyright © 2019
 Introduction
• Venture capital institutions which emerged the world over to fill gaps in the
conventional financial mechanism focused on new entrepreneurs, commercialization
of new technologies and support to small and medium enterprises in the
manufacturing and the service sectors
• Over the years, the concept of venture capital has undergone significant changes.
• Although the development of the venture capital started in the US in the mid-fifties,
venture capital institutions are of fairly recent origin in India.

Copyright © 2019
 Theoretical Framework
• Venture capital financing is emerging as a new institutional mechanism post-1990 in
the country.
• As a new technique of financing to inject long-term capital into the small and
medium sectors, it has made notable contribution to growth in the developed
countries.
• The nascent venture capital industry in India can profitably draw upon their
experiences.

Copyright © 2019
 Features
• Venture capital is defined as an equity/ equity-related investment in a growth-
oriented small/medium business to enable investees to accomplish corporate
objectives, in return for minority shareholding in the business or the irrevocable right
to acquire it.
• Venture capital institution (fund) is a financial intermediary between investors looking
for high potential returns and entrepreneurs who need institutional capital as they are
yet not ready to go to the public.

Copyright © 2019
 Selection of Investment
Stages of Financing
• The selection of investment by a VCI is closely related to the stages and type of
investment.
• The stages of financing, as differentiated in the venture capital industry, broadly
fall into two categories:
early stage
later stage.

Copyright © 2019
 Early Stage Financing
• This stage includes
 seed capital/ pre-start-up,
 start-up and
 second-round financing

Seed Capital
• This stage is essentially an applied research phase where the concepts and ideas of
the promoters constitute the basis of a pre-commercialisation research project usually
expected to end in a prototype which may or may not lead to a business launch.

Copyright © 2019
Start up
• Start up is a stage when product/service is commercialised for the first time in
association with venture capital institutions.
Second Round Financing
• This represents the stage at which the product has already been launched in the
market but the business has not yet become profitable enough for public offering to
attract new investors.

Copyright © 2019
 Later Stage Financing

• This stage of venture capital financing involves established businesses which

require additional financial support but cannot take recourse to public issues of
capital.
• It includes
mezzanine/development capital,
bridge/expansion,
buyouts and turnarounds.

Copyright © 2019
Mezzanine/Development Capital
• This is financing of established businesses which have overcome the extremely high-risk
early stage and have recorded profits for a few years.
Bridge/Expansion
• This finance by VCIs involves low risk perception and a time-frame of one to three years.
Buyouts
• Buyouts implies transfer of management control.
• They fall into two categories:
management buyouts (MBOs)
management buyins (MBIs)
Management buyouts
• Management buyouts are provisions of funds to enable existing management/ investors
to acquire an existing product.
Management buyins
• Management buyins are funds provided to enable an outside group buy an ongoing
venture/ company.
Copyright © 2019
Turnarounds
• 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—namely, 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.

Copyright © 2019
 Financial Analysis
• Venture capital investments are generally idea-based and growth-based in contrast to
the conventional investments which are asset-based.
• Some of the valuation methods which illustrate the approach that VCIs can adopt are:
conventional venture capitalist valuation method,
the first Chicago method and
the revenue multiplier method.

Copyright © 2019
 Conventional Venture Capitalist Valuation
Method
• Conventional method is a method of valuation of venture capital undertakings
which takes into account only the starting time of investment and the exit time.
• The weakness of this method is that it ignores the stream of earnings (losses)
during the entire period and over-emphasises the one exit date.

Copyright © 2019
 The First Chicago Method
• This method is an improvement over the conventional method of valuation.
• The first chicago method is a method of valuation that considers the entire
earnings stream of the venture capital undertaking/investor companies.

Copyright © 2019
 Revenue Multiplier Method
• A revenue multiplier is a factor that can be used to estimate the value of a VCU.
Symbolically,

Copyright © 2019
 Structuring the Deal/Financial
Instruments
• The structuring of the deal refers to the financial instruments through which venture
capital investment is made.
• The availability of a wide variety of financial instruments provides considerable
flexibility in structuring a venture capital deal.
• From the point of view of nature, the financial instruments a VCI can choose from, can
be broadly divided into equity and debt instruments.

Copyright © 2019
 Investment Nurturing/Aftercare
• The enduring relationship between the VCIs and VCUs and the active role by the
former in the management of the latter is termed as investment nurturing/after care.
• The after care stage of venture capital financing relates, inter alia, to:
 different styles of nurturing,
 its objectives and
 techniques.

Copyright © 2019
 Styles
• The styles of nurturing refers to the extent of participation by VCIs in the affairs of VCUs.
• It broadly falls into three categories:
hands-on,
hands-off and
hand-holding.
Hands-on nurturing
• Hands-on nurturing is a continuous and constant involvement in the operations of the
investee company by the venture capital institution which is institutionalized in the form of
representation on the board of directors.
Hand-off nurturing
• Hand-off nurturing is the passive role played by venture capital funds in formulating
strategies/
policy matters.
Hands-holding Nurturing
• This is mid-way between hands-on and hands-off styles. Copyright © 2019
 Objectives of Aftercare
• Few of the objectives of nurturing by VCIs, inter alia, are:

 To ensure the proper utilisation of assistance provided;

 To anticipate likely problems and advise preventive/remedial actions;
 To utilise the experience gained for a better appraisal of new ventures.

Copyright © 2019
 Techniques
• VCIs follow systematic techniques to achieve the foregoing objective.
• Some of the important techniques are briefly discussed below:
Personal Discussions
Plant Visits
Feedback Through Nominee Directors
Periodic Reports
Commissioned Studies

Copyright © 2019
 Valuation of Portfolio
• The portfolio valuation approaches/techniques depend on the type of
investments, namely, equity and debt instruments.
• These, in turn, depend on the stage of investment: seed, start-up, early and later
stages of the venture.

Copyright © 2019
 Equity Investments
• The valuation methods for equity instruments of VCUs are:
cost method, and
market value-based methods.
Cost Method
• According to this method, the value of equity holding is computed/recorded at the
historical cost of acquisition until it is disposed of.
Market Value-based Methods
• They are conceptually superior to the cost method.
• Such methods can be divided into:
quoted market value,
fair market value and
others.
Copyright © 2019
Quoted Market Value Method
• This is based on market quotations of securities.
• It is, therefore, relevant only to organisations listed on stock exchanges.
Fair Market Value Method
• Fair value is the price to be agreed upon in an open and unrestricted market
between parties and equationally expressed as: a representative level of earnings
¥ appropriate capitalisation rate.
• This approach to valuation of venture capital investements is based on
assumptions that assets are worth what they can earn.

Copyright © 2019
 Stages of Investments

• As pointed out earlier, the methods of portfolio valuation of shares depend on

the stage of venture capital investments.
• From the viewpoint of stages of investments, the equity investments fall into
three broad categories:
Unquoted Venture Investments
Unquoted Development Investments
Quoted Investments

Copyright © 2019
 Debt Instruments
• VCIs provide, in addition to equity capital, debt finance.
• From the point of view of their valuation as a part of the overall portfolio (fund),
they are divided into
convertible,
non-convertible and
leveraged.

Copyright © 2019
 Structural Aspects
• The structuring of VCIs is important from the viewpoint of the profitability of such
organisations and their contributors and participants.
• The alternative forms in which VCIs can be structured are:
 limited partnership,
 investment company,
 investment trust,
 offshore funds and
 small business investment company.

Copyright © 2019
 Indian Venture Capital Scenario

• The venture capital funds were regulated by the

 SEBI Venture Capital Funds Regulation, 2000
 SEBI Foreign Venture Capital Investors Regulation Act, 2000.
• The SEBI Alternative Investment Fund Regulations, 2012 has replaced the SEBI
VCF Regulations.

Copyright © 2019
 SEBI Alternative Investment Funds
Regulation, 2012
• AIF means any fund established/incorporated in India in the form of a
trust/company/limited liability partnership/body corporate which is
• (i) a privately pooled investment vehicle and collects funds from Indian/foreign
investors for investing in accordance with a defined investment policy for the benefit of
its investors, and
• (ii) not covered under the mutual fund/other regulations of the SEBI to regulate fund
management activities.

Copyright © 2019
• Venture capital fund means an alternative investment fund which invests primarily
in unlisted securities of start-ups, emerging/early-stage venture capital
undertakings mainly involved in new products/services, technology/intellectual
property right based activities/a new business model.
• Venture capital undertaking means a domestic company which is (i) not listed on a
recognised stock exchange in India at the time of making investment; and (ii)
engaged in the business for providing services, production/manufacture of
article/things.
• SME fund means an alternative investment fund which invests primarily in unlisted
securities of investee companies which are SMEs or securities of those SMEs which
are listed/proposed to be listed on a SME exchange/SME segment of an exchange.
• Social venture means a rust/society/company/venture capital undertaking/limited
liability partnership formed with the purpose of promoting social welfare/solving
social problems/providing social benefits.
Copyright © 2019
• Social venture fund means an alternative investment fund which invests
primarily in securities/ units of social ventures and which satisfies social
performance norms laid down by the fund and whose investors may agree to
receive restricted or muted returns.
• Private equity fund means an AIF which invests primarily in equity/ equity linked
instruments (i.e. instruments convertible into equity/ preference shares, share
warrants, compulsorily/ optionally convertible debentures) or partnership
interests of investee companies (i.e. companies/ SPVs/ limited partnership/ body
corporate in which an AIF makes an investment) according to the stated
objectives of the fund.
• Debt fund is an AIF which invests primarily in debt/debt securities of
listed/unlisted investee companies according to its stated objectives.
• Hedge funds employ diverse/complex trading strategies and invest in securities
having diverse risks or complex products including listed/unlisted derivatives.
• Units are beneficial interest of the investors in the AIF/a scheme of the AIF
including shares/partnership interests.
Copyright © 2019
• Corpus is total amount of funds committed by the investor in the AIF by way of a
written contract/any such document as on a particular date.
• Associates is a company/limited liability partnership/body corporate in which a
director/ trustee/ partner/ sponsor/ manager of the AIF or director/ partner of
the manager/sponsor holds individually/ collectively more than 15 per cent of its
paid-up equity share capital/partnership interest.
• Financially weak company is a company, which has at the end of the previous
financial year accumulated losses, resulting in erosion of more than 50 per cent
but less than 100 per cent of its net worth as at the beginning of the previous
financial year.

Copyright © 2019
 SEBI Foreign Venture Capital Investors
(FVCIs) Regulations, 2000
• A foreign venture capital investor (FVCI) is an investor incorporated and established
outside India and proposes to make investment in accordance with these regulations.
• The main elements of FVCIs are described below:
Registration
Investment Criteria
General Obligations and Responsibilities
Inspection and Investigation

Copyright © 2019
 Procedure for Action in Case of Default
• In addition to the issue of appropriate directions specified above, SEBI can also
suspend/cancel registration of the FVCI on the basis of the investigation report in
terms of the Intermediaries Regulation, 2008.

Copyright © 2019