Venture Capital Funds

The principal sources of venture capital funds for a business firm are equity capital, preference capital, debenture capital and term loans. Equity capital represents ownership capital because equity shareholders collectively own the company. They enjoy the rewards, as well as bear the risks of ownership. However, their liability, unlike the liability of the owner in a proprietary firm and the partners in a partnership concern, is limited to their capital contributions. As equity capital funds represent permanent capital, there is no liability for repayment. It enhances the creditworthiness of the company. In general, the larger the equity base, the higher the ability of the company to obtain credit.

Preference capital represents a hybrid form of financing. It partakes of some characteristics of equity and some attributes of debentures. It resembles equity in the way that preference divided is payable only out of distributable profits and is not an obligatory payment. Preference capital is similar to debentures in that the dividend rate on preference dividend is usually fixed and preference stockholders do not normally enjoy the right to vote. When using preference capital funds, there is no legal obligation to pay preference dividend. A company does not face bankruptcy or legal action if it skips preference dividend, and there is no redemption liability in the case of perpetual preference shares.

Akin to promissory notes, debentures are instruments for raising long-term debt capital. Debenture holders are the creditors of the company. The obligation of the company towards its debenture holders is similar to that of a borrower who promises to pay interest and capital at specified times. The specific cost of debt capital, represented by debentures, is much lower than the cost of preference or equity capital. This is because the interest on debentures is tax-deductible, and the effective cost of debentures is much less. Debenture financing does not result in dilution of control since debenture holders are not entitled to vote.

Term loans, also referred to as term finance, represent a source of debt finance that is generally repayable in more than one year but less than 10 years. They are employed to finance acquisition of fixed assets and working capital margin.

Small Business Venture Capital

Capital budgeting is very important in small business venture capital. It is the process of making investment in capital expenditure. Capital expenditure refers to expenditure and the benefits that are expected over a period of time, especially exceeding one year. The chief characteristic of capital expenditure is that expenses are incurred aggressively at one point in time. The benefits are realized at different points in time in the future. Capital expenditure decisions are also called long-term investment decisions.

Capital budgeting is very important in small business venture capital. It is the process of making investment in capital expenditure. Capital expenditure refers to expenditure and the benefits that are expected over a period of time, especially exceeding one year. The chief characteristic of capital expenditure is that expenses are incurred aggressively at one point in time. The benefits are realized at different points in time in the future. Capital expenditure decisions are also called long-term investment decisions.

The decisions concerning capital budgeting are crucial because they are long-term oriented and are irreversible in nature. The efficient running of a firm is reflected by the way decisions are made for the effective utilization of the firm's financial resources. Such capital budgeting decisions are considered to be of paramount importance in heavy investment, long-term commitment of funds and impact on profitability.

The capital budgeting decisions generally involve very large amounts of capital funds. However, the availability of such funds is very limited. It is essential that thoughtful and wise decisions be made concerning investment of capital funds. This would, result in flow of profits for the firm. Capital budgeting involves employment of capital funds in the activities of the firm on a long-term basis. This increases the financial risk involved in such investment decisions, and necessitates careful and efficient planning. This is because, any wrong and unwise decision may prove disastrous for the small business venture capital firm.

Venture Capital Investors

While evaluating the profitability of venture capital investment proposals under the capital budgeting techniques such as Net Present Value (NPV) and Internal Rate of return are used. It should be noted here that these sophisticated methods use the "cost of capital" as the criterion to accept or reject an investment proposal.

Under the NPV method, the cost of capital is used to discount the future cash flows, whereas under the Internal Rate of return method, the cost of capital is compared with the calculated Internal rate of return in order to determine the efficacy of the capital investment proposals.

The minimum required rate of return that a firm must earn on its investments in order to keep the present wealth of the shareholders unchanged or keep the market value of the firm's equity shares is referred to as "cost of capital". In the context of evaluating the investment projects, cost of capital refers to the discount rate used for evaluating the desirability of the investment proposals.

Cost of capital plays a crucial role in the sphere of capital budgeting decisions. It serves as an important basis for financial appraisal of new capital investment proposals. For instance, the cost of capital is compared with the discounted rate of return to determine whether the proposed project satisfies one of the minimum acceptable standards. The expected rate of returns on a project must be greater than the cost of capital.

If the cost of capital of a firm is known, it is possible to make a fair estimation of the amount of risks that is involved in the company's investment projects. For instance, if a firm were required to pay more than the market rate of interest in order to procure funds from the investors, this would show investors that the earnings rate of the firm is moderate or less and that the firm has limited opportunities to develop in future.

Venture Capital Investing

When investing in venture capital, always keep one thing in perspective. All investments have equal risk, and the average cost of capital for the firm can be used for evaluating investment proposals. Investment proposals differ in risk. An investment proposal to manufacture a new product, for example, is likely to be more risky than one involving replacement of an existing plant. In view of such differences, variations in risk need to be considered in venture capital investment appraisal.

In many cases, the revenues expected from a project are conservatively estimated to ensure that the viability of the proposed project is not easily threatened by unfavorable circumstances. The capital budgeting systems often have built-in devices for conservative estimation.

A margin of safety in venture capital investing is generally included in estimating cost figures. This varies between 10 and 30 per cent of what is deemed as normal cost. The size of the margin depends on how management feels about the likely variation in cost. The cut- off point on an investment varies according to the judgment of management on how risky the project might be. In one company, replacement investments are okayed if the expected post-tax return exceeds 15 per cent but new investments are undertaken only if the expected post-tax return is greater than 20 per cent. Another company employs a short payback period of three years for new investments. Its finance controller stated this rule as follows:

"Our policy is to accept a new project only if it has a payback period of three years. We have never, as far as I know, deviated from this. The use of a short payback period automatically weeds out risky projects." Some companies calculate what may be called the overall certainty index, based on a few crucial factors affecting the success of the project.

Venture Capital Firms

While the terms and conditions of venture capital are not standardized, there are some salient features of venture capital arrangements. The venture capital firm is inclined to assume a high degree of risk in the expectation of earning a high rate of return. The venture capital firm, in addition to providing funds, takes an active interest in guiding the assisted firm. The financial burden for the assisted firm tends to be negligible in the first few years. The venture capital firm normally plans to liquidate its investment in the assisted firm after 3 to 5 years. Typically, the promoter of the assisted firm is given the first option to acquire the equity investment held by the venture capital firm.

Venture capital firms can raise funds from different sources. The important long-term sources of finance are issue of equity shares and preference shares, issue of debentures of different types, raising of term loans from financial institutions and generation of reserves. Venture capital firms may use different combinations of these sources by considering their relative cost and availability and their impact on the value of the firm. Accordingly, a company can have patterns of capital structure such as equity shares only, equity shares and preference shares, equity shares and debentures, equity shares and preference shares reserves, equity shares and preference shares debentures, equity shares and preference shares/debentures reserves.

The capital structure of venture capital firms is influenced by number of factors such as trading on equity, growth and stability of sales. Trading on equity means the use of long-term, fixed interest bearing sources of finance along with equity capital. Adopting trading on equity can increase the return on equity. However, this is possible only when the return on investment is more than the cost of finance.

Venture Capital Business Plan 

Venture capital finance is instrumental in inducing technological development, stimulating creativity and innovation and nurturing entrepreneurship. Concerted efforts are required by financial institutions, private sectors and other agencies to create a conducive environment for the growth of venture capital. In particular, initiatives are required to widen the perspective of venture capital finance and create a favorable fiscal and regulatory environment.

The venture capital schemes of the term-lending financial institutions presently focus mainly on supporting development of technology and implementing indigenously developed yet untested technologies. While this concern is understandable because of a genuine need for expanding the base of viable indigenous technology, it leads to a somewhat limited view of venture capital. What is required is a broader perspective on venture capital so that it is viewed as an instrument for financing a wide range of projects that essentially have a "high risk- high-return" profile.

In this context, it is important that entrepreneurs, financing bodies, fiscal authorities, regulatory bodies and others understand the concept and relevance of venture capital. It should be appreciated that venture capital is an instrument for strengthening entrepreneurial forces in the economy; a device for inducing risk taking and a mechanism for promoting a closer investor/investee relationship. Those who participate in venture capital arrangements must overcome certain traditional psychological barriers and be willing to build a relationship of genuine partnership and not a perfunctory association of limited involvement.

To nurture the growth of venture capital, a favorable fiscal and regulatory environment should be created. Some of the specific things that may be are investors subscribing to the capital of venture capital funds may be given greater tax reliefs, and the long-term capital gains of the venture capital funds may be taxed at a concessional rate or even exempted totally from taxation. Orderly and efficient mechanisms must be evolved to facilitate liquidation of investments of venture capital funds.

Venture Capital Jobs

People spend a great deal of time on the job, and it is important, especially in venture capital to design jobs so that individuals feel good about their work. This requires an appropriate job structure in terms of content, function and relationships.

The focus of job design is on the individual position or on work groups. First, individual jobs are enriched by putting tasks into natural work units. This means putting tasks that are related into one category and assigning an individual to carry out these tasks. A second approach used in venture capital jobs is to combine several tasks into one job. For example, rather than having the tasks of assembling a water pump carried out by several people on the assembly line, workstations can be established with individuals doing the whole task of putting the unit together and even testing it.

Also, establishing direct relationships with the customer or client can enrich venture capital jobs. A systems analyst may present findings and recommendations directly to the managers involved in the systems change rather than reporting to a superior, who would then make recommendations to top management. Prompt and specific feedback is built into the system whenever appropriate. Venture capital jobs can also be enriched through vertical job loading that increases individual's responsibility for planning, doing and controlling their job.

Similar arguments can be made for improving the design of jobs for work teams. Jobs should be designed so that groups have a complete task to perform. Moreover, teams may be given authority and freedom to decide how well the jobs shall be performed, giving the groups a great deal of autonomy. Within the team, individuals can be trained so that they rotate to different jobs within the group. Finally, rewards may be administered on the basis of group performance that tends to induce cooperation rather than competition among team members.

About the Author

Venture Capital provides detailed information on Venture Capital, Venture Capital Firms, Venture Capital Investing, Venture Capital Funds and more. Venture Capital is affiliated with Angel Investor Networks.

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