Venture capital investment process is different from normal project financing. In order to understand the investment process a review of the available literature on venture capital finance is carried out. Tyebjee and Bruno in 1984 gave a model of venture capital investment activity which with some variations is commonly used presently.
As per this model this activity is a five step process as follows:
- Deal Organization
- Evaluation or Due Diligence
- Deal Structuring
- Post Investment Activity and Exit
In generating a deal flow, the VC investor creates a pipeline of deals or investment opportunities that he would consider for investing in. Deal may originate in various ways. referral system, active search system, and intermediaries. Referral system is an important source of deals. Deals may be referred to VCFs by their parent organisaions, trade partners, industry associations, friends etc. Another deal flow is active search through networks, trade fairs, conferences, seminars, foreign visits etc. Intermediaries is used by venture capitalists in developed countries like USA, is certain intermediaries who match VCFs and the potential entrepreneurs.
VCFs, before going for an in-depth analysis, 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.
Due diligence is the industry jargon for all the activities that are associated with evaluating an investment proposal. The venture capitalists evaluate the quality of 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 return on the venture. Business plan contains detailed information about the proposed venture. The evaluation of ventures by VCFs in India includes;
- Preliminary evaluation: The applicant required to provide a brief profile of the proposed venture to establish prima facie eligibility.
- Detailed evaluation: Once the preliminary evaluation is over, the proposal is evaluated in greater detail. VCFs in India expect the entrepreneur to have:- Integrity, long-term vision, urge to grow, managerial skills, commercial orientation.
VCFs in India also make the risk analysis of the proposed projects which includes: Product risk, Market risk, Technological risk and Entrepreneurial risk. The final decision is taken in terms of the expected risk-return trade-off as shown in Figure.
In this process, the venture capitalist and the venture company negotiate the terms of the deals, that is, the amount, form and price of the investment. This process is termed as deal structuring. The agreement also include the venture capitalist’s right to control the venture company and to change its management if needed, buyback arrangements, acquisition, making initial public offerings (IPOs), etc. Earned out arrangements specify the entrepreneur’s equity share and the objectives to be achieved.
Post Investment Activities:
Once the deal has been structured and agreement finalised, the venture capitalist generally assumes the role of a partner and collaborator. He also gets involved in shaping of the direction of the venture. The degree of the venture capitalist’s 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 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 may exit in one of the following ways:
There are four ways for a venture capitalist to exit its investment:
- Initial Public Offer (IPO)
- Acquisition by another company
- Re-purchase of venture capitalist’s share by the investee company
- Purchase of venture capitalist’s share by a third party