How venture capital funding works

It is popularly believed that venture capitalists fund only established players and proven products. There is a lot of cynicism amongst many about all the hype that private equity and venture capital is getting in India of late.

However, the truth is that, in recent times in India, the VCs have actually provided capital to relatively new, start-up companies that have a reasonable, though not certain, prospects to develop into highly profitable ventures. Travelguru.com is a case in point, funded by Sequoia Capital and Battery Ventures.

The advent of firms like Helion Ventures with a $140 million corpus is helping the VC scenario to improve in the country. The three key people behind Helion Ventures, Ashish Gupta, Sanjeev Aggarwal and Kanwaljit Singh, all carry with them a successful track record across various companies in the international arena.

What is interesting is that for first time in India, venture capital will be backed by successful entrepreneurs who themselves have a hands-on experience in handling and developing businesses.

The National Venture Capital Association defines venture capital as: "Money provided by professionals who invest alongside management in young, rapidly growing companies that have the potential to develop into significant economic contributors."

Innovation is the key driver of competitiveness within organisations as well as within countries. It has been well said: "Nothing is more powerful than an idea whose time has come." However, innovative ideas need more than research and knowledge to succeed.

They need not only financial, but also, managerial (technical, marketing and HR), support to achieve success. This support is lent in many forms by private funding and incubation organisations such as venture capitalists.

Akhil Gupta, JMD & CFO of  Bharti Airtel, once remarked, "While we could have raised funding from other sources, Warburg Pincus' involvement helped us in scaling up significantly." Almost identical has been the findings of a research conducted recently by Venture Intelligence (founded by Arun Natarajan, a leading provider of information and networking services to the private equity and venture capital ecosystem in India) with the guidance of Prof. Amit Bubna of Indian School of Business, Hyderabad, to study the economic impact of PE and VCs on the Indian businesses.

The following are some of the interesting observations of this study:

• The study shows that the PE and VC backed companies grew faster compared to the non-PE backed peers and even better than the benchmark indices like the NSE Nifty. They found that the sales of listed PE-backed companies grew at 22.9% as compared to 10% for non-PE-backed listed firms.
• PE backed firms added more jobs to the economy and even the wages at listed PE financed firms grew at around 32% as compared to 6% for non-PE-backed firms.
• An astonishing finding was that almost 96% of the top executives felt that without the support and the backing of private equity these companies would not have existed or would have grown at a slower rate, while only about 4% felt that they would have developed the same way even without PE funding.
• The study also shows that the biggest support of the PE investors were provided in the area of strategic direction followed by the financial advice and then recruitment and the marketing activities.

Thus venture capital has become an important source of finance for innovative ideas that are risky and have a potential for high returns over a long-term horizon. Venture capitalist investment is driven by the expectation that the start-ups invested in could give them a higher rate of return than other firms.

In the process venture capitalists have created some of the best known companies in the world. Without VCs we might not have seen companies such as Apple, Compaq, Sun Microsystems, and Intel to name a few.

Some of the unique features of a VC firm are:

• Investment in high-risk, high-returns ventures: As VCs invest in untested, innovative ideas the investments entail high risks. In return, they expect a much higher return than usual. (Internal Rate of return expected is generally in the range of 25 per cent to 40 per cent).
• Participation in management: Besides providing finance, venture capitalists may also provide technical, marketing and strategic support. To safeguard their investment, they may also at times expect participation in management.
• Expertise in managing funds: VCs generally invest in particular type of industries or some of them invest in particular type of businesses and hence have a prior experience and contacts in the specific industry which gives them an expertise in better management of the funds deployed.
• Raises funds from several sources: A misconception among people is that venture capitalists are rich individuals who come together in a partnership. In fact, VCs are not necessarily rich and almost always deal with funds raised mainly from others. The various sources of funds are rich individuals, other investment funds, pension funds, endowment funds, et cetera, in addition to their own funds, if any.
• Diversification of the portfolio: VCs reduce the risk of venture investing by developing a portfolio of companies and the norm followed by them is same as the portfolio managers, that is, not to put all the eggs in the same basket.
• Exit after specified time: VCs are generally interested in exiting from a business after a pre-specified period. This period may usually range from 3 to 7 years.

Buyouts and second-stage financing are the most popular stages of venture capital financing. Globally, according to a report by PricewaterhouseCoopers, around 80 per cent of the total private equity investment is done at these stages.

However, in spite of the venture capital scenario improving, several specific VC funds are setting up shop in India, with the year 2006 having been a landmark year for VC funding in India.

Sumir Chadha, MD of Sequoia Capital India, feels that a slowdown could be on the cards for the year 2007 as the companies and investors may try to give some time and test the investment decisions made by them over the last year.

The first quarter of the calendar year 2007 is already over. There is no sign of the VC story slowing down. This is a good sign for all the entrepreneurs out there with an idea! If you have an idea, this is the time to tell it. You never know, someone might be listening round the corner!

Also see:

• What VCs look for while funding a business

Puneet Bambha is an MBA from ICFAI Business School, Hyderabad. Dr Nupur Hetamsaria is Member of ACCA, UK; and a faculty member at ICFAI Business School, Hyderabad.