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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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