The Venture Capital Process

The venture capital investment activity is a sequential process involving five steps

1. Deal origination
2. Screening
3. Evaluation or due diligence
4. Deal structuring
5. Post-investment activities and exit

1. Deal origination
A continuous flow of deals is essential for the venture capital business. Deals may originate in various ways. Referral system is an important source of deals. Deals may be referred to the VCs through their parent organizations, trade partners, industry associations, friends etc. The venture capital industry in India has become quite proactive in its approach to generating the deal flow by encouraging individuals to come up with their business plans. Consultancy firms like Mckinsey and Arthur Anderson have come up with business plan competitions on an all India basis through the popular press as well as direct interaction with premier educational and research institutions to source new and innovative ideas. The short listed plans are provided with necessary expertise through people who have experience in the industry.

2. Screening
VCFs carry out initial screening of all projects on the basis of some broad criteria. For example the screening process may limit projects to areas in which the venture capitalist is familiar in terms of technology, or product, or market scope. The size of investment, geographical location and stage of financing could also be used as the broad screening criteria.

3. Evaluation or due diligence
Once a proposal has passed through initial screening, it is subjected to a detailed evaluation or due diligence process. Most ventures are new and the entrepreneurs may lack operating experience. Hence a sophisticated, formal evaluation is neither possible nor desirable. The VCs thus rely on a subjective but comprehensive, evaluation. VCFs evaluate the quality of the entrepreneur before appraising the characteristics of the product, market or technology. Most venture capitalists ask for a business plan to make an assessment of the possible risk and expected return on the venture.

According to a study conducted by Professor IM Pandey of Indian Institute of Management, Ahmedabad a venture capital fund places most importance on the following eleven parameters in the same order of importance while evaluating a venture for possible funding.
   Integrity  Urge to grow  Long-term vision  Commercial orientation  Critical competence vis-à-vis venture  Ability to evaluate and react to risk  Well-thought out strategy to remain ahead of competition  High market growth rate  Expected return over 25% p.a. in five years  Managerial skills  Marketing skills

Investment Valuation
The investment valuation process is aimed at ascertaining an acceptable price for the deal. The valuation process goes through the following steps:

  •  Projections on future revenue and profitability
  •  Expected market capitalization
  •  Deciding on the ownership stake based on the return expected on the proposed investment

The pricing thus calculated is rationalized after taking in to consideration various economic scenarios, demand and supply of capital, founder’s/management team’s track record, innovation/ unique selling propositions (USPs), the product/service size of the potential market, etc

4. Deal Structuring
Once the venture has been evaluated as viable, the venture capitalist and the investment company negotiate the terms of the deal, i.e. the amount, form and price of the investment. This process is termed as deal structuring. The agreement also includes the protective covenants and earn-out arrangements. Covenants include the venture capitalists right to control the investee company and to change its management if needed, buy back arrangements, acquisition, making initial public offerings (IPOs) etc, Earn-out arrangements specify the entrepreneur’s equity share and the objectives to be achieved.

Venture capitalists generally negotiate deals to ensure protection of their interests. They would like a deal to provide for
 

  •  A return commensurate with the risk
  •  Influence over the firm through board membership
  •  Minimizing taxes
  •  Assuring investment liquidity
  •  The right to replace management in case of consistent poor managerial performance.

The investee companies would like the deal to be structured in such a way that their interests are protected. They would like to earn reasonable return, minimize taxes, have enough liquidity to operate their business and remain in commanding position of their business.

There are a number of common concerns shared by both the venture capitalists and the investee companies. They should be flexible, and have a structure, which protects their mutual interests and provides enough incentives to both to cooperate with each other.

The instruments to be used in structuring deals are many and varied. The objective in selecting the instrument would be to maximize (or optimize) venture capital’s returns/protection and yet satisfy the entrepreneur’s requirements. The different instruments through which a Venture Capitalist could invest a company include: Equity shares, preference shares, loans, warrants and options.

5. Post-investment Activities and Exit
Once the deal has been structured and agreement finalized, the venture capitalist generally assumes the role of a partner and collaborator. He also gets involved in shaping of the direction of the venture. This may be done via a formal representation of the board of directors, or informal influence in improving the quality of marketing, finance and other managerial functions. The degree of the venture capitalists involvement depends on his policy. It may not, however, be desirable for a venture capitalist to get involved in the day-to-day operation of the venture. If a financial or managerial crisis occurs, the venture capitalist may intervene, and even install a new management team.

Venture capitalists typically aim at making medium-to long-term capital gains. They generally want to cash-out their gains in five to ten years after the initial investment. They play a positive role in directing the company towards particular exit routes. A venture capitalist can exit in four ways
 

  •  Initial Public Offerings (IPOs)
  •  Acquisition by another company
  •  Repurchase of the venture capitalist’s share by the investee company
  •  Purchase of the VC’s share by a third party.