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Introduction to Venture Capital Investment
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Let us first understand what is meant by ‘venture capital’. Venture Capital is nothing but a form of financing provided by firms/funds to early stage or emerging firms that are deemed to have high growth potential. Venture Capitalists take on the risk of financing risky start-ups in the hope that the firms they are supporting will turn out to be profitable. Many people believe that venture capital is similar to the idea of financing technology-centric businesses or innovative / ‘not tried before’ business ideas. However, in reality, it is just a flexible form of financing that invests in a broad range of businesses. For instance, a manufacturer of auto parts for export market competing on the basis of operational efficiencies and low cost, without compromising on quality. Another example can be the exceptional growth prospects and a sustainable competitive advantage that helps maintain growth in sales and profitability, which could potentially result in superior returns to the investor. Thus, VC investments usually involve:

  1. Businesses with high growth potential in terms of sales and profitability.
  2. Medium to long term investment horizons ranging from two – ten years.
  3. Risk levels which are higher than that inherent in debt financing transactions or investment in equities of well-established firms with a history of profitable operations.
  4. Active investor involvement in the investee after the funding.

Now, one may wonder how VC is different from traditional investment in the equity of a firm. The two can be differentiated in the following manner:

 

High uncertainty levels: VC investors usually fund firms that are exposed to high degrees of uncertainty. Often there is little or no historical information relating to the firm or the industry based on which scenarios of likely future performance can be developed. The various risks involved can be:

  1. Technology risk – The risk that a product, service based on an untried technology may fail to perform as expected or run into problems.
  2. Product market risk – The risk that the realizations from sales of a product may be lower than expected due to poor customer acceptance of the product or unanticipated competitive conditions.
  3. Management risk – The risk that the management team may not have the capability to deliver the results projected in the business plan. Consequently, the failure of the management could be due to reasons ranging from lack of competence to issues such as lack of integrity.
  4. Liquidity risk - The risk that the VC investor may not be able to encash his investment when he wishes to or without incurring a high transaction cost. VC funds mostly invest in unlisted companies. Unless the shares of these companies are traded on a stock exchange, the investment in these companies could turn out to be illiquid.

 

Another point is that unlike in the case of public companies, unlisted companies, which VC funds invest in, are not mandatorily required to disclose information. The investor has to ensure that he seeks out all the information that he needs to make an informed decision. This, in turn, contributes to the risky nature of VC investment.

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