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Chapter 1 INTRODUCTION TO VENTURE CAPITAL FUNDS 1.1 1.2 1.3 1.4 1.5 1.6 Introduction The Origin Background Meaning and Definition Characteristics Types of VCF
INTRODUCTION to Venture Capital1.1 VENTURE CAPITALSmall businesses never seem to have enough money. Bankers and Suppliers, naturally, are important in financing small business growth through loans and credit, but an equally important source of long term. Growth Capital is the venture capital firm. Venture Capital financing may have an extra bonus, for if a small firm has an adequate equity base; banks are more willing to extend credit. Venture capital is money provided by professionals who invest alongside management in young, rapidly growing companies that have the potential to develop into significant economic contributors. Venture capital is an important source of equity for start-up companies. Venture capital is capital typically provided by outside investors for financing of new, growing or struggling businesses. Venture capital investments generally are high risk investments but offer the potential for above average returns and/or a percentage of ownership of the company. A venture capitalist (VC) is a person who makes such investments. A venture capital fund is a pooled investment vehicle (often a partnership) that primarily invests the financial capital of third-party investors in enterprises that are too risky for the standard capital markets or bank loans. The term Venture Capital is understood in many ways. In a narrow sense, it refers to, investment in new and tried enterprises that are lacking a stable record of growth. In a broader sense, venture capital refers to the commitment of capital as shareholding, for the formulation and setting up of small firms specializing in new ideas or new technologies. It is not merely an injection of funds into a new firm, it is a simultaneous input of skill needed to set up the firm, design its marketing strategy and organize and manage it. It is an association with successive stages of firms development with distinctive types of financing appropriate to each stage of development.
According to International Finance Corporation (IFC), venture capital is equity or equity featured capital seeking investment in new ideas, new companies, new production, new process or new services that offer the potential of high returns on investments. As defined in Regulation 2(m)of SEBI (Venture Capital Funds) Regulation , 1996 "venture capital fund means a fund established in the form of a company or trust which raises monies through loans, donations issue of securities or units as the case may be, and makes or proposes to make investments in accordance with these regulations. Thus venture capital is the capital invested in young, rapidly growing or changing companies that have the potential for high growth. The VC may also invest in a firm that is unable to raise finance through the conventional means. Professionally managed venture capital firms generally are private partnerships or closely-held corporations funded by private and public pension funds, endowment funds, foundations, corporations, wealthy individuals, foreign investors, and the venture capitalists themselves. 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; Take higher risks with the expectation of higher rewards; Have a long-term orientation
When considering an investment, venture capitalists carefully screen the technical and business merits of the proposed company. Venture capitalists only invest in a small percentage of the businesses they review and have a long-term perspective. Going forward, they actively work with the company's management by contributing their experience and business savvy gained from helping other companies with similar growth challenges.
Venture capitalists mitigate the risk of venture investing by developing a portfolio of young companies in a single venture fund. Many times they will co-invest with other professional venture capital firms. In addition, many venture partnership will manage multiple funds simultaneously. For decades, venture capitalists have nurtured the growth of America's high technology and entrepreneurial communities resulting in significant job creation, economic growth and international competitiveness. Companies such as Digital Equipment Corporation, Apple, Federal Express, Compaq, Sun Microsystems, Intel, Microsoft, Yahoo, Airtel and Genentech are famous examples of companies that received venture capital early in their development. Venture Capital is the business of establishing an investment fund in the form of equity financing via investments in the common stocks, preferred stocks and convertible debentures of various companies. These companies are seen to have a high growth potential and are able to be listed on the stock exchange in order to gain the highest returns in dividends and capital gain.
1.2 The Origin of Venture CapitalIn the 1920's & 30's, the wealthy families of and individuals investors provided the start up money for companies that would later become famous. Eastern Airlines and Xerox are the more famous ventures they financed. Among the early VC funds set up was the one by the Rockfeller Family which started a special fund called VENROCK in 1950, to finance new technology companies. USA is the birth place of Venture Capital Industry as we know it today. During most its historical evolution, the market for arranging such financing was fairly informal, relying primarily on the resources of wealthy families. In 1946, American Research and Development Corporation (ARD), a publicly traded, closed-end investment company was formed. ARD's best known investment was the start-up financing it provided in 1958 for computer maker Digital Equipment Corp. ARD was eventually profitable, providing its original investors with a 15.8 percent annual rate of return over its twenty-five years as an independent firm. General Doriot, a professor at Harvard Business School, set up the ARD, the first firm, as opposed to private individuals, at MIT to finance the commercial promotion of
advanced technology developed in the US Universities. ARD's approach was a classic VC in the sense that it used only equity, invested for long term, and was prepared to live with losers. ARD's investment in Digital Equipment Corporation (DEC) in 1957 was a watershed in the history of VC financing. The number of such specialized investment firms, eventually to be called venture capital firms, began to boom in the late 1950s.The growth was aided in large part by the creation in 1958 of the federal Small Business Investment Company program. Hundreds of SBICs were formed in the 1960s, and many remain in operation today. Slow Growth in 1960s & early 1970s, and the First Boom Year in 1978 During the 1960s and 1970s, venture capital firms focused their investment activity primarily on starting and expanding companies. More often than not, these companies were exploiting breakthroughs in electronic, medical or data-processing technology. As a result, venture capital came to be almost synonymous with technology finance. Venture capital firms suffered a temporary downturn in 1974, when the stock market crashed and investors were naturally wary of this new kind of investment fund. 1978 was the first big year for venture capital. The industry raised approximately $750 million in 1978. Highs & Lows of the 1980s In 1980, legislation made it possible for pension funds to invest in alternative assets classes such as venture capital firms. 1983 was the boom year - the stock market went through the roof and there were over 100 initial public offerings for the first time in U.S. history. That year was also the year that many of today's largest and most prominent firms were founded. Due to the excess of IPOs and the inexperience of many venture capital fund managers, VC returns were very low through the 1980s. VC firms retrenched, working hard to make their portfolio companies successful. The work paid off and returns began climbing back up.
Boom Times in the 1990s The 1990s have been, by far the best years for the Venture Capital Industry. The engine for growth has been the favourable economic climate in the US coupled with the advent of the Internet boom. During this decade, the interest rates were low and the P/Es were very high compared to historical averages. Finally, the rate of M&A activity has increased dramatically in the 1990s, creating more opportunities for small, venture-backed companies to exit (cash out) at high prices. The advent of the Internet as a new medium for both personal and business communications and commerce created an avalanche of opportunities for venture capitalists in the mid and late 1990s. As a result, the industry has experienced extraordinary growth in the past few years, both in the number of firms, and in the amount of capital they have raised.
1.3 The Background In September 1995, Government of India issued guidelines for overseas venture capital investment in India whereas the Central Board of Direct Taxes (CBDT) issued guidelines for tax exemption purposes. (The Reserve Bank of India governs the investment and flow of foreign currency in and out of India.) As a part of its mandate to regulate and to develop the Indian capital markets, Securities and Exchange Board of India (SEBI) framed the SEBI (Venture Capital Funds) Regulations, 1996. Pursuant to the regulatory framework, some domestic VCFs were registered with SEBI. Some overseas investments also came through the Mauritius route. However, the venture capital industry, understood globally as 'independently managed, dedicated pools of capital that focus on equity or equity linked investments in privatel