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By CoWin Investment, China. From the web. (Not endorsed.)

Investment Process and Management Mechanism of Venture Capital

By shenglijun

Venture capital investment involves roughly a five-step process:

1.Raising fund from limited partners;
2.Identifying, analysing and selecting appropriate entities to invest;
3 Structuring the terms of the investment;
4.Implementing the deal and monitoring the portfolio firms;
5.Achieving returns and ultimately exiting from the investment.

Raising fund

Contracts are designed to protect the limited partners from the possibility that the venture capitalist will make decision against their interest:

First, the life of a venture capital fund is limited, the venture capitalist can't keep the money forever. In contrast mutual funds or corporation have indefinite life spans. Second, the limited partners preserve the right to withdraw from funding by reneging on their commitment to invest beyond the initial capital infusion. Third, the compensation system is structured to give the venture capitalist the appropriate
incentive. The general partners typically are entitled to receive 20% of profit generated by the investment and 2-3% management fee of total capital infused.

Fourth, the mandatory distribution policy ensures the proceeds from the sale of asset in the portfolio to return the investors. The general partners can't choose to invest in securities that serve their own interest at the expense of the limited partners.

Finally the contract address area of conflict between venture capitalist and limited partners. The venture capitalists are often explicitly prohibited from self-dealing (e.g. buy stock in the portfolio on preferential terms). Also the venture capitalists are contractually required to commit a certain percentage of their effort to the activities of the fund.

Besides the contract, the reputation of venture capitalists as the general partners who are successful at identifying profitable venture and have a good performance in their portfolio is important to attract the fund from limited partners.

Identifying Investment

Venture capitalist identify and select investment with an eye toward firms that have good quality management team and that offer a competitively advantaged product with good growth potential. In addition to review the business plan and meeting the entrepreneurial team members, venture capitals will do due diligence before they commit money to a venture.

Five of 10 top-ranked criteria considered in evaluate deals by venture capitalist dealt with an aspect of the entrepreneurial teams, including "capable of sustained intense effort, thoroughly familiar with market, demonstrated leadership in past". Venture capitalist's emphasis on a business plan on the belief that the quality of the plan signals the quality of the entrepreneurs. A well-conceived and organized business plan with supporting documentation indicates a term with both technical and marketing ability and foresight.

Deal Structure

Venture capital deal structure provisions are designed to control agency cost in the venture capitalist-entrepreneurial team relationship. Terms are structured so as to shift risk to the entrepreneurial team. If the firm progresses according to plan, they will benefit from a rising firm value. In LBO, debt service is management's primary motivation; In venture capital deal covenants motivate the entrepreneurial team.

Many times the investment is backed only by intangible assets and trust in the ethics and ability of the entrepreneurial team. Thus there is a need for the monitoring and bonding of agents in the venture capital investment. The security of choice in many venture capital deals is convertible preferred stock . Preferred stock offers a preference over cash flow and assets that common equity does not, and unlike debt, preferred stock may not drain cash flow from the growing firm and does not preclude future financing with a more senior security. Preferred stock arrangement typically include conversion provision so the venture capitalist can participate in the firm's success. The use of a financing vehicle such as convertible
preferred stock allows the two sides to agree on a price despite different perceptions regarding potential return and risks.

Monitoring

Venture capitalist keep in regular contact with their portfolio firms and frequently sit on the board of the firms. The monitoring function of venture capital and their ability to function as expert consultants helps to increase return potential, lower risk and reduce agency cost concern. Areas for greater monitoring and input which the venture capitalist selected and which have major impacts on the portfolio firms'
success included areas most vulnerable to agency cost concern: formulating business strategy and market plans, acting as a sounding board, replacing management personnel, interviewing and selecting the management team, monitoring operation performance.

Venture capitalist risk perception change over subsequent financing stages. Total risk is perceived to decline as an investment progresses from seed stage to exit stage. External risk such as new competition, change in technology or recessions is fairly constant over the portfolio firm's life. Internal risk such as poor management, excessive use of cash, cost overrun falls sharply in successive financing rounds Internal risk is the major risk component in early stage deals, but in latter stage deals external risk outweigh to internal risk. This has clear agency cost implication.

Three control mechanisms are common used to nearly all venture capital financing (1) the use of convertible securities;(2) syndication of investment (3) the staging of capital infusion, which Sahlman notes is the most potent control mechanism. The evidence indicates that the staging of capital infusion allow venture capitalist to gather information and monitor the progress of firms, maintaining the option to periodically abandon projects. Prospects for the firms are periodically reevaluated. The shorter the duration of an individual round of financing, the more frequently the venture capitalist monitors the entrepreneur's progress and the greater the need to gather information. The role of staged capital infusion is analogous to that of debt in highly leveraged transaction, keep the owner/management on a tight leash and reducing the potential losses from bad decision

They also found in1992 that the greater the level of innovation pursued by the venture, the more frequent the contact between investor and the CEO, the more open the communication, and the less conflict of perspective in the venture capitalist-CEO pair, the greater was value of involvement.

Harvest and exit investment

Venture capitalists have a certification role in initial public offering. It's found that venture capital backing result in significantly lower initial return and gross spread. The presence of venture capital in the issuing firm serves to lower the total costs of going public and to maximize the net proceeds to the offing firms. Besides venture capitalists retain a significant portion of their holding in the firm after the IPO.

It is found that venture capitalist-backed IPO firms exhibit relatively superior post-issue operation performance compared to non-venture capitalist-backed IPO firms. Furthermore, the market appears to recognize the value of monitoring by venture capitalists as reflected in the higher valuation at time of the IPO.

On the other hand, firms will not be able to go public unless public market can monitor the firm just as well as or better than private investors. Public money may be cheaper to obtain than another venture capital financing round and it is generally assumed that most entrepreneurs and venture capitalist prefer IPO exit, little empirical evidence exists to support this belief. Going public can be a curse if the firm's second market trading is thin and the firm is ignored by market analysts. In some cases it's reasonable to expect that an acquisition by a widely held and liquid corporation may provide better liquidity for investors and better monitoring of the venture-backed firm than IPO.

Other agency cost concern may increase the likelihood a portfolio firm will merge with or be acquired by another firms. If the firm's market is narrow and specialized and the firm has developed proprietary technology with potential application to other firms or industries, merger and acquisition may provide better monitor and resolution of agency concern than going public. In this case the public market's ability to monitor the firm is hindered by the firm's need to keep its competitive advantage hidden from its rivals. The problem resulting from public disclosure of information can be resolved by seeking another firm that has a good strategic fit with the portfolio firm to acquire it. Internal monitoring can persist after the acquisition so the new owner can reap the full benefit of the product.

A company buyback and management LBO is another exit strategy that can be explained by agency concern on the part of both the firm and venture capitalist. This exit strategy is mostly likely to be used in situation in which the firm is not well-positioned for an IPO or acquisition, but still has potential as a going concern. However, the cost of monitor the firm by the venture capital may outweigh the perceived benefit, the venture capitalist will have incentive to achieve liquidity and investment return to increase their reputation capital. LBOs are well-known for their ability to offer effective monitoring and management incentives in situation where change is needed in order to make the firm attractive for later sale to the public equity market. If the benefit from LBO monitoring exceed those from venture capitalist oversight, LBO are likely to occur.

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