In this article, Anupam Pandey discusses how do venture capital and private equity deals work.

Introduction

Investor and investee, both need each others existence in order to make their own sustenance. Investor has an ample amount of fund but he needs proper avenues to invest money and investee needs assistance and guidance regarding the source for procurement of the money. Venture capital and private equity are the investors in this section and promoter is the investee.

Venture capital

Venture Capital is long-term risk capital invested in order to finance high technology projects. These projects have a potential for growth in the future. In order to assist new entrepreneurs in their initial phase of the project venture capitalist invests his resources and managerial abilities in the startup. When the project reaches the stage of boom, they sell their shares at a high premium to others and earn profit from it.

Venture Capital refers to the capital which invested in the firm specializing in novelty, as a shareholding. It does not merely include injection of funds into a new firm but also simultaneous input of skills, designing its marketing strategy, organize and manage it. It is a relationship with progressive phases of firms’ advancement with particular sorts of financing fitting to each phase of improvement.

Motive

The primary motive of any businessman would be to earn profit and Venture Capital puts resources into high risk ventures with the expectation of exceptional yields. These resources are invested into several ventures, which require funding, however can’t get to it through the customary sources, for example, banks and monetary organizations. Mostly new entrepreneurs undertake such enterprises. Such enterprises, for the most part, don’t have any significant collateral security to offer as security, subsequently banks and financial institutions are not inclined to fund them. Venture capital comes to rescue in this case for procuring fund in the form of equity or debt, however, equity is the most favoured choice. Since the vast majority of the ventures are financed through this course, the likelihood of progress is low. All ventures financed don’t give an exceptional yield. A few activities come up short and some give direct returns. The venture, be that as it may, is a long haul capital which typically takes 3 to 7 years to produce significant returns.

Financial speculators’ offer “more than money” to the venture and try to increase the value of the investee unit by active participation in its administration. They screen and assess the task consistently. The Venture Capitalists are anyway not stressed over disappointment of an investee’s organization, since they invest in many other alternatives which compensates their loss. The profits generally come from the sale of shares when the stocks get listed on a stock exchange or by timely offer of their stake in the organization to a strategic buyer.

Venture Capital Investment Criteria

Venture Capital alludes to the capital put into “unsafe” venture to acquire a high rate of profits. Funding is put into equity instead of loans to get a high rate of return. The Venture Capital is given to organizations in the different phases of improvement and Venture Capital speculation criteria are the techniques took after by Venture Capitalists to choose fitting endeavours for speculation. Venture capital investment criteria not only simply imply for small and medium sized organizations but also it can be a speculation into a task of a vast business, or into a new business expecting to develop essentially. The Venture Capital speculation criteria depend on the capability of the organization to develop quickly within constraints of limited time and resources.

The Venture Capital speculation criteria defines a set of standards in ventures to get a high development potential. The venture which can give extraordinary returns and the venture where the speculator can have an easy “exit” within the desired framework of time from three to seven years is thought to be a perfect Venture Capital investment option. The new business which depends on novelty structure and an all around planned model bolstered by a strong management group attracts Venture Capitalists.

The Venture Capitalists guarantee stocks take after the coveted Venture Capital speculation criteria to make mature investment in stocks to get significant yields. Venture capitalists should consider fundamental Venture Capital investment criteria before making any speculation. The fundamental Venture Capital speculation criteria are “never pay with pay off” and “prepare an exit plan.” The Venture Capitalists ought to never pay with pay off and dependably keep cash for individual needs before spending on Venture Capital in light of the fact that the disappointment rate can be over half. In a few stocks it can be more than 90% and if the venture fails, the whole financing is composed off. The Venture Capitalists burn through cash to collect more cash and the Venture Capital speculation criteria assist them with making the correct choices. Some huge Venture Capital speculation criteria are as per the following:

Criteria 1: More Risk More Returns- One of the main Venture Capital speculation criteria is “more risk gives more returns.” Investment in risky ventures can get higher returns if they are chosen deliberately. The financial specialist should know for which phase of development the speculation is required. It will give an essential element of the risk and uncertainty included and duration of the investment. There are diverse alternatives to profit in the venture – IPO, and Merger and Acquisition.

Criteria 2: Company’s Profile- The Venture Capital speculation criteria depends mostly on organization’s profile. The organization ought to be a quickly developing organization which has an enormous market presence and the organization ought to have plenteous intellectual property to have the capacity to put hindrance to its rival’s development. The organization ought to be huge or presumed enough to have the capacity to develop quickly. The organization ought to be into a promising business field.

Criteria 3: Company’s Development Stage -Venture Capital investment criteria are designed to anticipate the phase of development of the company and the risks involved. Ideally, Venture Capital speculation is needed for four different phases of company’s development – Idea generation, Start up, Ramp up and Exit (ISRE). The Venture Capital can be approached for getting the “seed money” i.e. for introducing a new idea in the market. Since new venture involves high risk, it consists of high profit too. It can be for start up of a company or for marketing and development in the existing company. Some companies require Venture Capital at initial stage– early sales and manufacturing, and some companies may need working capital.

Criteria 4: The business model- Venture Capital investment criteria aims to provide investor secure and high returns, and the business model of the company helps it to grow quickly. If the products sold by the company have a high market demand and coverage then the company will fulfil the investment criteria. The delivery of products should be successful to satisfy customers make them as permanent customers. The company should be able to generate more income with limited and adequate resources. It should have the tendency to attract customers and remain ahead of competitors.

Criteria 5: Management team- For sustainability of a company a strong management team is needed. In the event that an organization is not bolstered by a strong management, it won’t have the capacity to convey its designs and the organization may not perform well, in this way, a great management team is a standout amongst the most essential Venture Capital speculation criteria. There are numerous organizations which are not able to convey the expected results in light of the fact that there exists a conflict between the top management. The main administration of the organization ought to be strong, professional and master at its activity. The management team ought to have talented, sensible, honest and consist of individuals who possess will to convert a plan into reality. The organization ought to have individuals to have the capacity to foresee the issues and keep the organization from threats.

Criteria 6: Company’s Valuation- The market valuation of the company in term of investments and equity should be appealing because a good valuation reduces the risks and uncertainty involved in the investment.

Criteria 7: The Exit Plan- Three to seven years is the ideal time considered by the venture capitalist and they also consider a proper and easy exit plant to opt out of speculation.

PRIVATE EQUITY

Private value gives long term, conferred share capital, to help unquoted organizations to grow, develop and succeed. In the event that one is hoping to initiate, grow, buy into a business, purchase out a division of your parent organization, turnaround or renew an organization, private equity can assist him with doing this. Getting private value is altogether different from raising debt or a credit from a lender, for example, a bank. Lenders possess legal right to interest from the loan and reimbursement of the capital, independent of your prosperity or disappointment. Private equity is invested in order to trade for a stake in a company and, as investors, the investors’ returns are subject to the development and profit of the business.

Private Equity Investment criteria

Market criteria-

Market criteria are the ones initially considered in the investment process regardless of PE firm strategy. Market criteria along with financial criteria are of equal importance. The size of the market and the size of the potential investment in relation to the market are to be evaluated. Potential substitute for the company’s products is to be considered. The entry and exit barriers in the market and Innovation cycles of the product are to be considered before investing. Trends in the market are to be evaluated as it would clarify the fundamental trends like demographics, digital or environmental to be visible. Structural growth trends – trends that are not affected by the economic situation is also a part of market criteria which is considered important for many PE investors.

Financial criteria

The financial criteria are the second most occurring criteria in the investment process and are considered from the very start of the process. The majority of investors investing in companies in an early stage of the company first check that all of the financial information is correctly reported. Cashflow of the companies is the criteria mostly considered when focusing on the financials, as the cash flow reveals the liquidity of the company and explains how well it is positioned to pay its expenses. The turnover and profitability of the company are the parameters which tell how desirable the product or service is. The financial growth potential in future is regarded as important in order to predict some certainty. The inventory and customer receivables are important to assess, if analyzing producing companies, since many companies easily give misleading information regarding earnings before interest, taxes, depreciation and amortization (EBITDA).

Entrepreneur criteria

The entrepreneur criteria are considered as an important criterion for the business to flourish. These criteria mostly occur later in the investment process, after the initial evaluation of the investee companies. It is the most important criteria during the initial negotiation phase. Knowledge and business mindset of an entrepreneur is an important factor as his knowledgeable management will be able to understand the business and make better decisions successfully. Technical competence of entrepreneur is to be considered as in the modern era everything is technology based and one who lags behind in this would definitely face problems in the future. Prior experience in entrepreneurship will be helpful in avoiding mistakes. The persistence of the entrepreneur and management team is considered as those people are the ones who will make the business achieve its goals. Trust between entrepreneur and investor is considered very important for the future development of the business.

Product criteria

Investment process focuses on product criteria prior to investment. Focus on customers is laid when assessing the product or services of a potential investment in order to understand the customer and their desire and need. Differentiation of the potential investment is also an important factor. The technique used in order to produce the product or service are also considered in product criteria. The scalability of the product is also claimed when assessing the potential investment. Patents and other intellectual property is considered equally important as those reduce the risk of competitors.

Sustainability criteria

The environmental and social element in the sustainability criteria in the investment process and due diligence phase is considered to be an important factor in making the investment. There are two perspectives on sustainability criteria- first, minimizing risks, such as reduce dangerous emissions, avoid child labour and conduct sustainable production processes, and the second one is about the value-adding aspect of sustainability. Such factors have a commercial value as the customers mostly are willing to pay for environment-friendly products. It is complicated to quantify the sustainability thus it is considered as less important criteria.

Infrastructure criteria

The infrastructure of a product or service, as in IT sector, is of importance and that those aspects affect the scalability of a company. The age of the platform is important as it is costly to invest in new equipment or technology.

Relationship criteria

The importance of the relationship between the entrepreneur and the PE firm is vital in nature. The founders want to build a company for the rest of their lives and they want to build it big and nice, which is okay of course but simultaneously congruent goals, chemistry and a good relationship are essential otherwise they will meet obstacles in the development of the company.

Promoter’s Criteria for seeking investment

The criteria which should be followed by the promoter for seeking investment are as follows:

Name and Reputation of the Investor

Expertise, ability, experience and past performance tend to define the reputation of different venture capitalist. The name and notoriety of a VC regularly consider youthful organizations and impact future financing rounds. High reputation of speculators tends to boost the substantive value of the investing firm. The Promoter should be aware of the notoriety of the investors as it will be related to his organization

Development Phase of the Company

Different investors tend to finance different companies according to their development phase and one should consider his organisation’s phase of development i.e. seed,  startup or expansion and accordingly promoter should select the investors.

Industry Sector of Firm and Venture Capitalists

Venture Capitalists have a specialization in certain industry sector which should be considered by the promoter in order to seek assistance in the form of managerial experience other than investment.

Required Financing Volume

Promoter has to anticipate the required amount which he needs in order to run his business and accordingly seek assistance from the investors as different investors invest different amounts.

Location of the Investors

One should target investors that are geographically close to company’s offices as it can be helpful in the access of funds and credibility of the investors can be measured.

Win-Win Relation Between Investor And Investee

A win-win relationship is established where:

  1. Both the investor and investee have clear set of objectives and agree on the framework for achieving them;
  2. A clear and unhindered separation of management and board roles and responsibilities;
  3. Boards have the authority to make decisions and they do not refer to shareholders for decisions that boards should be making;
  4. To bring independence of board governance structure is explicitly mentioned and establish respective responsibilities of management, shareholders and board;
  5. Legal documentation is undisputed and comprehensible.

Characteristics of a win-win relationship within a company would imply a strong human and management capacity within the organization, Excellent performance culture; Achieving or exceeding of performance expectations; value creation for all stakeholders; achieving objectives within framed time-limit; quantifiable return both in financial and other relevant terms.

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