JAIIB IE and IFS Paper-1 Module-D Unit 10 : Venture Capital

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Aug 2

JAIIB Paper 1 (IE and IFS) Module D Unit 10 : Venture Capital (New Syllabus)

IIBF has released the New Syllabus Exam Pattern for JAIIB Exam 2023. Following the format of the current exam, JAIIB 2023 will have now four papers. The JAIIB Paper 1 (Indian Economy & Indian Financial System) includes an important topic called "Venture Capital ". Every candidate who are appearing for the JAIIB Certification Examination 2023 must understand each unit included in the syllabus. In this article, we are going to cover all the necessary details of JAIIB Paper 1 (IE and IFS) Module D (FINANCIAL PRODUCTS AND SERVICES ) Unit 10 : Venture Capital, Aspirants must go through this article to better understand the topic, Venture Capital and practice using our Online Mock Test Series to strengthen their knowledge of Venture Capital. Unit 10 : Venture Capital

Introduction

Venture Capital is a private institutional investment made to start-up companies, at early stage.
Venture capital funds are the investments made by the investors, who seek private equity stakes, in small to medium business, which have potential to grow.
These investments are generally high-risk/high-return opportunities.
The ventures involve risk in the expectation of sizable gain.
The people who invest this money become the financial partners are called venture capitalists (VCs).
Venture capital is the most suitable option for funding capital for companies, which are start-ups, with little or no track record of performance.

Concept Of Venture Capital

When an entrepreneur is a new and unknown technocrat, who possesses innovative ideas to develop a new product, but lacks his own capital, which is essential to turn his ideas into a successful commercial venture.
Risk involved as the innovative ideas of the entrepreneur have not been tried on a commercial scale.
On the other hand, if the venture proves successful, it has potential for high returns.
Usual sources of finance cannot be tapped by the entrepreneurs, for lack of availability of funds from his own sources.
In such circumstances, the Venture Capitalist comes to his rescue by providing risk bearing capital, which is widely known as Venture Capital.
Venture Capital may be broadly defined as long-term investment in business, which has potential for significant growth and financial returns.
In the form of equity, apart from conditional loans and conventional loans.
Venture Capitalists: Financiers + Risk bearer .
Their return from the enterprise depends upon the extent of the success achieved by them.
The most distinguishing feature: That it meets the needs of a business wherein the probability of loss is quite high, because of the uncertainties associated with the business, but the returns expected are also higher than normal.
Venture Capital is therefore termed as high risk, high return capital.

Evolution Of Venture Capital In India

1972: Bhatt Committee (Committee on Development of Small and Medium Entrepreneurs) ,
Recommendation: Creation of venture capital in India.
The committee urged the need for providing such capital to help new entrepreneurs and technologists in settings up industries.

A brief description of some of the venture capital funds which have been established are as follows:

Risk Capital Foundation: The Industrial Finance Corporation of India (IFCI) launched the first venture capital fund, in the year 1975. The fund, 'Risk Capital Foundation' (RCF) aimed at supplementing promoters' equity, with a view to encouraging technologies and professionals to promote new industries.
Seed Capital Scheme: This venture capital fund was launched by IDBI in 1976, with the same objective in mind.
Venture capital schemes: Venture capital funding obtained official patronage, with the announcement by the Central Government of the "Technology Policy Statement" in 1983. It prescribed guidelines for achieving technological self-reliance, through commercialisation and exploitation of technologies. ICICI Ltd set up a Venture Capital Scheme in 1986, to encourage new technocrats in the private sector, to enter new fields of high technology, with inherent high risk. The scheme aimed at allocating funds for providing assistance in the form of venture capital to economic activities having risk, but also high profit potential.
PACT: ICICI undertook the administration of Programme for Application of Commercial Technology (PACT) aided by USAID, with an initial grant of USD 10 million. The programme aims at financing specific needs of the corporate sector industrial units along the lines of venture capital funding.
Government fund: IDBI, as nodal agency, administers the venture capital fund created by the Central Government, with effect from April 1, 1986. The government started imposing a Research and Development (R & D) levy on all payments made for the purchase of technology from abroad, including royalty payments, lump sum payments for foreign collaboration and payment for designs and drawings under the R & D Cess Act, 1986. The levy was used as a source of funding the venture capital fund.
TDICI: In 1988, an ICICI sponsored company, viz., Technology Development and Information Company of India Ltd. (TDICI) was founded, and venture capital operations of ICICI were taken over by it, with effect from July 1, 1988.
RCTFC: The Risk Capital Foundation (RCF) sponsored by IFCI was converted into Risk Capital and Technology Finance Corporation Ltd. (RCTFC) in the year 1988. It took over the activities of RCF, in addition to the management of other financing technology development schemes and venture capital fund.

Characteristics Of Venture Capital Finance

Largely in the form of equity

The most distinguishing feature of Venture Capital is that it is provided largely in the form of equity, when the investee company is unable to float its equity shares independently in the market, or from other sources, in the initial stage. Thus, risk capital is provided, which is not available otherwise, due to the high degree of risk involved in the venture.

Not act as owner:

The venture capitalist, though participating in the equity, does not intend to act as the owner of the enterprise. The venture capitalist does not participate in the day-to-day management, but aids and guides the management, by providing the benefit of the skill, experience and expertise.
The venture capitalist nurtures the new enterprise, till it enters the profit-earning stage.

Exit at the time of profit-earning

The Venture Capitalist does not intend to retain the investment in the investee company for ever.
He/she intends to divest his/her shares, as soon as the company becomes a profitable business and the returns from the business are high, as per expectations.
At this stage, he/she withdraws himself from the venture and in turn, provides finance for another venture.

Earning from capital gain

A Venture Capitalist intends to earn largely by way of capital gains arising out of sale of the equity holdings, rather than through regular returns, in the form of interest on loans.

Conditional Loan

A Venture Capitalist also provides conditional loans, which entitles him/her to earn royalties on sales, depending upon the expected profitability of the business. (Such loan is partly or fully waived, if the business enterprise does not prove to be a success).

Venture capital investments have the following features:

High risk investments made with an intention of making high profits;
Based on long-term goals;
Made in start-ups, which have potential to grow;
Money is invested, generally, by buying equity shares, in the start-up company;
Generally done in innovative projects in the fields of technology and biotechnology;
The provider of venture capital can participate in the management of the company.

Stages Of Venture Capital Financing

A venture capital fund provides finance to the venture capital undertaking at different stages of its life cycle, according to the requirements.

Process Of Venture Capital Financing

Venture capital financing consists of the following six steps:

Deal origination: Origination of a deal is the primary step, in venture capital financing. One of the most common sources of such origination is referral system. In referral system, deals are referred to the venture capitalist by their business partners, parent organisations, friends, etc.
Screening: Screening is the process by which, the venture capitalist scrutinises all the different projects which are available for investing in ventures. The projects are categorised under certain criterion, such as market scope, technology or product, size of investment, geographical location, stage of financing, etc. For the process of screening the entrepreneurs have to either provide a brief profile of their venture or they are invited for face-to-face discussions, for seeking certain clarifications.
Evaluation: The short-listed proposal is evaluated, after the screening and carrying out a detailed study. Some of the documents which are studied in detail are projected profile, track record of the entrepreneur, future prospects, etc. The process of evaluation is thorough, which not only evaluates the project capacity, but also the capacity of the entrepreneurs to meet such projections. Certain qualities in the promoters, such as entrepreneurial skills, technical competence, manufacturing and marketing abilities and experience are considered, during such evaluation. After considering all the factors, a thorough risk management study is done, which is then followed by deal negotiation.
Deal negotiation: Deal negotiation is a process by which, the terms and conditions of the deal are formulated so as to make it mutually beneficial. Both the parties put forward their demands and a mutually acceptable solution is sought, in order to meet the requirements. Some of the factors which are negotiated are, the amount of investment, the percentage of profit for both the parties, the rights of the venture capitalist and entrepreneur, etc.
Post investment activity: Once the deal is finalised, the venture capitalist becomes a part of the venture and takes up certain duties and responsibilities. The capitalist however does not take part in the daily activities of the firm, but becomes involved only during the situation of financial risk. The venture capitalists participate in the enterprise by a representation in the Board of Directors and ensures that the enterprise is operating, as per the plan.
Exit plan: The last stage of venture capital investment is to make an exit plan, based on the nature of investment, extent and type of financial stake, etc. The exit plan is made in order to minimise losses and maximise profits. The venture capitalist may exit through IPOs, acquisition by another company, purchase of the venture capitalist's share by the promoter or an outsider.

Regulatory Aspects Of Venture Capital Funds

Regulated by the guidelines issued by the Controller of Capital Issues, Government of India, in 1988.
In 1995: Securities and Exchange Board of India Act was amended, which empowered SEBI to register and regulate the Venture Capital Funds in India.
December, 1996: SEBI issued its regulations in this regard.
These regulations replaced the Government Guidelines issued earlier.

The SEBI guidelines, as amended in 2000, are as follows:

Definitions

A Venture Capital Fund has been defined to mean a fund established in the form of a trust or a company including a body corporate and registered with SEBI which –
has a dedicated pool of capital, raised in the specified manner; and
invests in venture capital undertakings, in accordance with these regulations.

A Venture Capital Fund may be set up either as a trust or as a company.

The purpose of raising funds should be to invest in Venture Capital Undertakings, in the specified manner.

A Venture Capital Undertaking means a domestic company –

Whose shares are not listed on a recognised stock exchange in India, and
Which is engaged in the business for providing services, production or manufacture of articles or things and does not include such activities or sectors, which have been included in the negative list by the Board.

The negative list of activities : Real estate, non-banking financial services, gold financing, activities not permitted under Government's Industrial Policy and any other activity specified by the Board.

As per SEBI definition "venture capital fund" means an Alternative Investment Fund which invests primarily in unlisted securities of start-ups, emerging or early-stage venture capital undertakings, mainly involved in new products, new services, technology or intellectual property-right based activities or a new business model and shall include an angel fund.

Registration of Venture Capital Funds

A venture capital fund may be set up either by a company or by a trust. SEBI is empowered to grant a certification of registration to the fund on an application made to it.

The applicant company or trust must fulfil the following conditions:

MoA of the company must specify, as its main objective, the details of business activity of the venture capital fund.
It is prohibited by its memorandum of association and Articles of Association from making an invitation to the public to subscribe to its securities.
Its director, or principal officer or employee is not involved in any litigation connected with the securities market.
Its director, principal officer or employee has not been, at any time, convicted of an offence involving moral turpitude or any economic offence.
The applicant is a 'fit and proper' person.

Resources for Venture Capital Fund

A Venture Capital Fund may raise moneys from any investor – India, foreign or Non-Resident Indian – by way of issue of units, provided, the minimum amount accepted from an investor is Rs. 5 lakhs.
This restriction does not apply to the employees, principal officer or directors of the venture capital fund, or non-Resident Indians or persons or institutions of Indian Origin.
It is essential that the venture capital fund shall not issue any document or advertisement inviting offers from the public for subscription to its securities/units.
Moreover, each scheme launched or fund set up by a venture capital fund shall have firm commitment from the investors to contribute at least Rs. 5 crores, before the start of its operations.

Modes Of Venture Capital Financing

Venture capital funds provide finance to venture capital undertakings through different modes/instruments, which are traditionally divided into:

(i)Equity

(ii)Debt instruments.

Equity Instruments

Equity instruments are ownership instruments and bestow the rights of the owner to the investor/VCFs. They are:

Ordinary Shares on which no dividend is assured. Non-voting equity shares may also be issued, which carry a little higher dividend, but no voting rights are enjoyed by the investors.
Preference Shares carry an assured dividend at a specified rate. Preference shares may be cumulative/non-cumulative, participating preference shares which provide for an additional dividend, after payment of dividend to equity shareholders. Convertible preference shares are exchangeable into equity shares, after a specified period of time.

Debt Instruments

VCFs may prefer debt instruments, in order to ensure a fixed return in the earlier years of financing, when the equity shares do not give any return. The debt instruments are of various types, as follows:

Conditional Loans

Conditional loans are the one that does not carry interest and are repayable to the lender in the form of royalty, after the venture capital undertaking is able to make revenue.
The VC funds recover their investments along with the return thereon, by way of a stake in the sale of the undertaking, after a specified period of time.
The recovery by the VCFs depends upon the success of the business enterprise. Hence, such loans are termed as 'conditional' l

Convertible Loans:

Sometimes loans are provided with the stipulation that they may be converted into equity at a later stage, at the option of the lender or as agreed upon between the two parties.

Conventional Loans: