风险投资流程 management, investment, financing, statements, 风险投资

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Venture capitalists are a busy lot. This chapter aims to highlight the approach to an investor and the entire process that goes into the wooing the venture capital with your plan.

First, you need to work out a business plan. The business plan is a document that outlines the management team, product, marketing plan, capital costs and means of financing and profitability statements.

The venture capital investment process has variances/features that are context specific and vary from industry, timing and region. However, activities in a venture capital fund follow a typical sequence. The typical stages in an investment cycle are as below:

Generating a deal flow Due diligence Investment valuation Pricing and structuring the deal Value Addition and monitoring Exit

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Generating A Deal Flow

In generating a deal flow, the venture capital investor creates a pipeline of ‘deals’ or investment opportunities that he would consider for investing in. This is achieved primarily through plugging into an appropriate network. The most popular network obviously is the network of venture capital funds/investors. It is also common for venture capitals to develop working relationships with R&D institutions, academia, etc, which could potentially lead to business opportunities. Understandably the composition of the network would depend on the investment focus of the venture capital funds/company. Thus venture capital funds focussing on early stage technology based deals would develop a network of R&D centers working in those areas. The network is crucial to the success of the venture capital investor. It is almost imperative for the venture capital investor to receive a large number of investment proposals from which he can select a few good investment candidates finally. Successful venture capital investors in the USA examine hundreds of business plans in order to make three or four investments in a year.

It is important to note the difference between the profile of the investment opportunities that a venture capital would examine and those pursued by a conventional credit oriented agency or an investment institution. By definition, the venture capital investor focuses on opportunities with a high degree of innovation.

The deal flow composition and the technique of generating a deal flow can vary from country to country. In India, different venture capital funds/companies have their own methods varying from promotional seminars with R&D institutions and industry associations to direct advertising campaigns targeted at various segments. A clear pattern between the investment focus of a fund and the constitution of the deal generation network is discernible even in the Indian context.

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Due Diligence

Due diligence is the industry jargon for all the activities that are associated with evaluating an investment proposal. It includes carrying out reference checks on the proposal related aspects such as management team, products, technology and market. The important feature to note is that venture capital due diligence focuses on the qualitative aspects of an investment opportunity.

It is also not unusual for venture capital fund/companies to set up an ‘investment screen’. The screen is a set of qualitative (sometimes quantitative criteria such as revenue are also used) criteria that help venture capital funds/companies to quickly decide on whether an investment opportunity warrants further diligence. Screens can be sometimes elaborate and rigorous and sometimes specific and brief. The nature of screen criteria is also a function of investment focus of the firm at that point. Venture capital investors rely extensively on reference checks with ‘leading lights’ in the specific areas of concern being addressed in the due diligence.

A venture capitalist tries to maximize the upside potential of any project. He tries to structure his investment in such a manner that he can get the benefit of the upside potential ie he would like to exit at a time when he can get maximum return on his investment in the project. Hence his due diligence appraisal has to keep this fact in mind.

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New Financing

Sometimes, companies may have experienced operational problems during their early stages of growth or due to bad management. These could result in losses or cash flow drains on the company. Sometimes financing from venture capital may end up being used to finance these losses. They avoid this through due diligence and scrutiny of the business plan.

Inter-Company Transactions

When investments are made in a company that is part of a group, inter-company transactions must be analyzed.

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Investment Valuation

The investment valuation process is an exercise aimed at arriving at ‘an acceptable price’ for the deal. Typically in countries where free pricing regimes exist, the valuation process goes through the following steps:

Evaluate future revenue and profitability Forecast likely future value of the firm based on experienced market capitalization or expected acquisition proceeds depending upon the anticipated exit from the investment. Target an ownership position in the investee firm so as to achieve desired appreciation on the proposed investment. The appreciation desired should yield a hurdle rate of return on a Discounted Cash Flow basis. Symbolically the valuation exercise may be represented as follows: NPV = [(Cash)/(Post)] x [(PAT x PER)] x k, where

NPV = Net Present Value of the cash flows relating to the investment comprising outflow by way of investment and inflows by way of interest/dividends (if any) and realization on exit. The rate of return used for discounting is the hurdle rate of return set by the venture capital investor. Post = Pre + Cash Cash represents the amount of cash being brought into the particular round of financing by the venture capital investor. ‘Pre’ is the pre-money valuation of the firm estimated by the investor. While technically it is measured by the intrinsic value of the firm at the time of raising capital. It is more often a matter of negotiation driven by the ownership of the company that the venture capital investor desires and the ownership that founders/management team is prepared to give away for the required amount of capital PAT is the forecast Profit after tax in a year and often agreed upon by the founders and the investors (as opposed to being ‘arrived at’ unilaterally). It would also be the net of preferred dividends, if any. PER is the Price-Earning multiple that could be expected of a comparable firm in the industry. It is not always possible to find such a ‘comparable fit’ in venture capital situations. That necessitates, therefore, a significant degree of judgement on the part of the venture capital to arrive at alternate PER scenarios. ‘k’ is the present value interest factor (corresponding to a discount rate ‘r’) for the investment horizon.

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It is quite apparent that PER time PAT represents the value of the firm at that time and the complete expression really represents the investor’s share of the value of the investee firm. The following example illustrates this framework:

Example: Best Mousetrap Limited (BML) has developed a prototype that needs to be commercialized. BML needs cash of Rs2mn to establish production facilities and set up a marketing program. BML expects the company will go public in the third year and have revenues of Rs70mn and a PAT margin of 10% on sales. Assume, for the sake of convenience that there would be no further addition to the equity capital of the company.

Prudent Fund Managers (PFM) propose to lead a syndicate of like minded investors with a hurdle rate of return of 75% (discounted) over a five year period based on BML’s sales and profitability expectations. Firms with comparable sales and profitability and risk profiles trade at 12 times earnings on the stock exchange. The following would be the sequence of computations:

In order to get a 75% return p.a. the initial investment of Rs2 million must yield an accumulation of 2 x (1.75)5 = Rs32.8mn on disinvestment in year 5.

BML’s market capitalization in five years is likely to be Rs (70 x 0.1 x 12) million = Rs84mn.

Percentage ownership in BML that is required to yield the desired accumulation will be (32.8/84) x 100 = 39%

Therefore the post money valuation of BML At the time of raising capital will be equal to Rs(2/0.39) million = Rs5.1 million which implies that a pre-money valuation of Rs3.1 million for BML

Another popular variant of the above method is the First Chicago Method (FCM) developed by Stanley Golder, a leading professional venture capital manager. FCM assumes three possible scenarios – ‘success’, ‘sideways survival’ and ‘failure’. Outcomes under these three scenarios are probability weighted to arrive at an expected rate of return:

In reality the valuation of the firm is driven by a number of factors. The more significant among these are:

Overall economic conditions: A buoyant economy produces an optimistic long- term outlook for new products/services and therefore results in more liberal pre-money valuations.

Demand and supply of capital: when there is a surplus of venture capital of venture capital chasing a relatively limited number of venture capital deals, valuations go up. This can result in unhealthy levels of low returns for venture capital investors. Specific rates of deals: such as the founder’s/management team’s track record, innovation/ unique selling propositions (USPs), the product/service size of the potential market, etc affects valuations in an obvious manner. The degree of popularity of the industry/technology in question also influences the pre-money. Computer Aided Skills Software Engineering (CASE) tools and Artificial Intelligence were one time darlings of the venture capital community that have now given place to biotech and retailing. The standing of the individual venture capital Well established venture capitals who are sought after by entrepreneurs for a number of reasons could get away with tighter valuations than their less known counterparts. Investor’s considerations could vary significantly. A study by an American venture capital, VentureOne, revealed the following trend. Large corporations who invest for strategic advantages such as access to technologies, products or markets pay twice as much as a professional venture capital investor, for a given ownership position in a company but only half as much as investors in a public offering. Valuation offered on comparable deals around the time of investing in the deal. Quite obviously, valuation is one of the most critical activities in the investment process. It would not be improper to say that the success for a fund will be determined by its ability to value/price the investments correctly.

Sometimes the valuation process is broadly based on thumb rule metrics such as multiple of revenue. Though such methods would appear rough and ready, they are often based on fairly well established industry averages of operating profitability and assets/capital turnover ratios

Such valuation as outlined above is possible only where complete freedom of pricing is available. In the Indian context, where until recently, the pricing of equity issues was heavily regulated, unfortunately valuation was heavily constrained.

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Structuring A Deal

Structuring refers to putting together the financial aspects of the deal and negotiating with the entrepreneurs to accept a venture capital’s proposal and finally closing the deal. To do a good job in structuring, one needs to be knowledgeable in areas of accounting, cash flow, finance, legal and taxation. Also the structure should take into consideration the various commercial issues (ie what the entrepreneur wants and what the venture capital would require to protect the investment). Documentation refers to the legal aspects of the paperwork in putting the deal together.

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 instruments could be as follows:

Instrument

Issues

Loan

clean vs secured

Interest bearing vs non interest bearing

convertible vs one with features (warrants)

1st Charge, 2nd Charge,

loan vs loan stock

maturity

Preference shares

redeemable (conditions under Company Act)

participating

par value

nominal shares

Warrants

exercise price, expiry period

Common shares

new or vendor shares

par value

partially-paid shares

Options

exercise price, expiry period, call, put

In India, straight equity and convertibles are popular and commonly used. Nowadays, warrants are issued as a tool to bring down pricing.

A variation that was first used by PACT and TDICI was "royalty on sales". Under this, the company was given a conditional loan. If the project was successful, the company had to pay a % age of sales as royalty and if it failed then the amount was written off.

In structuring a deal, it is important to listen to what the entrepreneur wants, but the venture capital comes up with his own solution. Even for the proposed investment amount, the venture capital decides whether or not the amount requested, is appropriate and consistent with the risk level of the investment. The risks should be analyzed, taking into consideration the stage at which the company is in and other factors relating to the project. (eg exit problems, etc).

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Promoter Shares

As venture capital is to finance growth, venture capital investment should ideally be used for financing expansion projects (eg new plant, capital equipment, additional working capital). On the other hand, entrepreneurs may want to sell away part of their interests in order to lock-in a profit for their work in building up the company. In such a case, the structuring may include some vendor shares, with the bulk of financing going into buying new shares to finance growth.

Handling Director’s And Shareholder’s Loans

Frequently, a company has existing director’s and shareholder’s loans prior to inviting venture capitalists to invest. As the money from venture capital is put into the company to finance growth, it is preferable to structure the deal to require these loans to be repaid back to the shareholders/directors only upon IPOs/exits and at some mutually agreed period (eg 1 or 2 years after investment). This will increase the financial commitment of the entrepreneur and the shareholders of the project.

A typical proposal may include a combination of several different instruments listed above. Under normal circumstances, entrepreneurs would prefer venture capitals to invest in equity as this would be the lowest risk option for the company. However from the venture capitals point of view, the safest instrument, but with the least return, would be a secured loan. Hence, ultimately, what you end up with would be some instruments in between which are sold to the entrepreneur.

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Monitoring And Follow Up

The role of the venture capitalist does not stop after the investment is made in the project. The skills of the venture capitalist are most required once the investment is made. The venture capitalist gives ongoing advice to the promoters and monitors the project continuously.

It is to be understood that the providers of venture capital are not just financiers or subscribers to the equity of the project they fund. They function as a dual capacity, as a financial partner and strategic advisor. Venture capitalists monitor and evaluate projects regularly. They keep a hand on the pulse of the project. They are actively involved in the management of the of the investee unit and provide expert business counsel, to ensure its survival and growth. Deviations or causes of worry may alert them to potential problems and they can suggest remedial actions or measures to avoid these problems. As professional in this unique method of financing, they may have innovative solutions to maximize the chances of success of the project. After all, the ultimate aim of the venture capitalist is the same as that of the promoters – the long term profitability and viability of the investee company.

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Exit

One of the most crucial issues is the exit from the investment. After all, the return to the venture capitalist can be realized only at the time of exit. Exit from the investment varies from the investment to investment and from venture capital to venture capital. There are several exit routes, buy-buck by the promoters, sale to another venture capitalist or sale at the time of Initial Public Offering, to name a few. In all cases specialists will work out the method of exit and decide on what is most profitable and suitable to both the venture capitalist and the investee unit and the promoters of the project.

At present many investments of venture capitalists in India remain on paper as they do not have any means of exit. Appropriate changes have to be made to the existing systems in order that venture capitalists find it easier to realize their investments after holding on to them for a certain period of time. This factor is even more critical to smaller and mid sized companies, which are unable to get listed on any stock exchange, as they do not meet the minimum requirements for such listings. Stock exchanges could consider how they could assist in this matter for listing of companies keeping in mind the requirement of the venture capital industry.