Venture capital – a new window of financing to the startup companies
Mahbub H. Mazumdar, FCMA
Venture Capital
When an entrepreneur makes a business plan, he uses his own money, talent and experience to start the business if it is a new business. After starting the business, when business needs finance at the initial stage, he collects money from relatives, friends to run the business. However, when the business has potential and success, he needs huge finance but at that time his own money or family funds is not sufficient enough for the required finance. So he searches for second or third options for financing. In our country, we go to bank for financing. Bank gives loan for short term. Bank does not finance for long time in ideal situation. In addition, Bank takes collateral, guarantee from Companys Directors and considers past good performance, future potential to disburse loan. Moreover, Bank Interest is high in our country. Hence, business can not be successful because of paying high interest, regulatory expenses, which are resulting in high cost of capital for the new business. In contrast to Bank, Venture Capital looks into potentially innovative business ideas while financing the company.
Venture capital provides required finance to the start-up companies which are young, potential of rapidly growing to develop into significant economic contributors. Venture capital is an important source of equity for start-up companies. Professionally managed venture capital firms generally are private partnerships or closely-held corporations funded by private and public pension funds, endowment funds, foundations, corporations, wealthy individuals, foreign investors, and the venture capitalists themselves.
Legal Framework
In Bangladesh, Legal framework for Venture Capital published on June 22, 2015 by Bangladesh Securities And Exchange Commission defining the rules as Bangladesh Securities and Exchange Commission (Alternative Investment) Rules, 2015. This law defines alternative investment fund or fund means any fund established or constituted in Bangladesh in the form of a trust which, is a private equity fund or a venture capital fund or an impact fund or any other type of fund as declared by the Commission as alternative investment fund from time to time; is a privately pooled investment vehicle which collects funds from eligible investors for investing in accordance with a defined investment policy for the benefit of its investors; is a closed end fund with specific tenure; collect subscription by way of private placement only and does not offer its units for public subscription
Venture Capital fills the void
Venture capitals suitability exists because of the structure and rules of capital markets. Someone with an idea or a new technology often has no other institution to be financed. Bankers will only finance a new business to the extent that there are hard assets against which to secure the debt. And in todays information-based economy, many start-ups have few hard assets. Furthermore, investment banks and public equity are both constrained by regulations to protect the public investors. A company can not access to the public market without reasonable profit history.
Hence, Venture capital can fill the void of sources of funds. Filling that void successfully requires the venture capital to provide a sufficient return on capital to attract private equity funds, attractive returns for its own participants, and sufficient benefit potential to entrepreneurs to attract high-quality ideas that will generate high returns. Put simply, the challenge is to earn a consistently superior return on investments in inherently risky business ventures.
Venture money is not long-term money. The idea is to invest in a companys balance sheet and infrastructure until it reaches a sufficient size and credibility so that it can be sold to a corporation or so that the institutional public-equity markets can step in and provide liquidity. In essence, the venture capitalist buys a stake in an entrepreneurs idea, nurtures it for a short period of time, and then exits with the help of an investment banker.
Venture Capitalists Generally: Finance new and rapidly growing companies. Purchase equity securities. Assist in the development of new products or services. Add value to the company through active participation. Take higher risks with the expectation of higher rewards
International Scenario
Venture capitalists mitigate the risk of venture investing by developing a portfolio of young companies in a single venture fund. Often they will co-invest with other professional venture capital firms. In addition, many venture partnership will manage multiple funds simultaneously. For decades, in USA, venture capitalists have nurtured the growth of high technology and entrepreneurial communities resulting in significant job creation, economic growth and international competitiveness. Companies such as Digital Equipment Corporation, Apple, Federal Express, Compaq, Sun Microsystems, Intel, Microsoft, Genentech and Google are some famous examples of companies that received venture capital early in their development.
Not all venture capitalists invest in start-ups. While venture firms will invest in companies that are in their initial start-up modes, venture capitalists will also invest in companies at various stages of the business life cycle. A venture capitalist may invest before there is a real product or company organized (seed investing), or may provide capital to start up a company in its first or second stages of development (early stage investing.) Also, the venture capitalist may provide needed financing to help a company grow beyond a critical mass to become more successful (expansion stage financing).
Venture capitalists may invest in a company throughout its life cycle and therefore some funds focus on later stage investing by providing financing to help the company grow to a critical mass to attract public financing through a stock offering.
Alternatively, the venture capitalist may help the company attract an acquisition offer or create a merger with another company and thereby provide liquidity and exit for the companys investors and employees/ founders.
At the other end of the spectrum, some venture funds specialize in the acquisition, turnaround or recapitalization of public and private companies that represent favorable investment opportunities.
While innovative technology and healthcare investments make up the majority of venture capital investing, venture capitalists also invest in industries such as construction, industrial products, business services, etc. There are several firms that have specialized in retail company investment and others that have a focus in investing only in socially responsible start-up endeavors.
Stakeholders of Venture Capital Regulatory Body, Fund Manager , Eligible Investors, Trustee, Company
Prime Responsibility of Fund Manager as per BSEC Rule
A fund manager shall:
Manage the fund in accordance with the constitutive documents and all applicable laws including notifications, circulars, guidelines and directives issued under those in the interest of unit holders, without gaining any undue advantage for itself or any of its connected persons;
Carry out all transactions involving the fund on an arms length basis;
Ensure that the fund manager, its directors and employees and members of the investment committee do not have any material interest in any portfolio company;
Collect undertakings from the investors to the effect that they have understood the constitutive documents and fully aware of the risk return potentials of the investment in the fund;
Prepare an investment and fund management guidelines with approval of the Trustee and ensure strict compliance of the said guidelines;
Prepare code of conduct for its directors and employees to mitigate conflict of interests;
Ensure that the investments made are properly identified and held for the benefit of the unit holders in accordance with the provisions of the constitutive documents, these Rules and all other applicable laws;
Ensure that all investments are made as per the investment guidelines and approved by the investment committee and the Trustee before disbursement;
Closely monitor the activities of portfolio companies and if necessary, participate in the management and represent in the board of directors of such companies with approval of the Trustee;
Invest and manage the investible funds in accordance with the investment and fund management guidelines and objectives depicted in the constitutive documents;
Ensure that no material change in the investment policy or objectives of the fund is made without the approval of the unit holders through a special resolution and the Trustee;
Undertake valuation of investments of the fund as per the valuation methodology, at least semi-annually, by an independent valuer appointed by the Trustee, other than statutory auditors of the fund, fund manager and the Trustee;
Ensure that the valuation methodology of the fund is prepared in accordance with the International Private Equity and Venture Capital Valuation Guidelines as updated from time to time, approved by the Trustee and published in the constitutive documents and annual reports of the fund;
Immediately inform the Commission of any special resolution passed by the unit holders ;
Establish and implement written policies and procedures to identify, monitor and appropriately mitigate conflicts of interest throughout the scope of business;
How Fund Manager organise the Fund
Sponsors, Fund Manager, Eligible Investors and Companies are jointly managing the fund. Here, Sponsors, Fund Manager and Eligible Investors will arrange the fund that will be invested into the potential companies and potential companies will have their own fund. Consequently, there will be pool of fund.
As per the Bangladesh Securities and Exchange Commission (Alternative Investment) Rules, 2015, an alternative investment fund shall have the following major criteria:
Minimum fund corpus shall be at least Tk.10,00,00,000.00 (taka one hundred million) and subscription by the sponsor(s) is not less than 10% (ten percent) of the corpus: Provided that, the sponsors shall subscribe at least 20% of its total subscription (i.e. 20% of 10%) to the fund before registration of the fund; Minimum investment by the fund manager shall be at least 2% (two percent) of the fund corpus: provided that, if the fund manager also acts as sponsor of a fund, this investment shall be made in addition to its investment as sponsor of the fund;
Along with its connected persons, the fund manager shall not hold more than 25% (twenty five percent) of the units of a fund at any point of time.
The sponsor(s) shall maintain a continuous investment of not less than 2.5% (two and half percent) of the fund corpus. An alternative investment fund shall declare, to the unit holders, cash dividends only. All investments in a fund shall be locked in for a period of 03 (three) years from the date of issuance of units.
How it works
Timing is everything. More than 80% of the money invested by venture capitalists in USA goes into the adolescent phase of a companys life cycle. In this period of accelerated growth, the financials of both the eventual winners and losers look strikingly similar. Picking the wrong industry or betting on a technology risk in an unproven market segment is something Venture Capital avoids.
By investing in areas with high growth rates, Venture Capital primarily consign their risks to the ability of the companys management to execute. Venture Capital investments in high-growth segments are likely to have exit opportunities because investment bankers are continually looking for new high-growth issues to bring to market. The issues will be easier to sell and likely to support high relative valuationsand therefore high commissions for the investment bankers.
As long as venture capitalists are able to exit the company and industry before it tops out, they can reap extraordinary returns at relatively low risk. Astute venture capitalists operate in a secure niche where traditional, low-cost financing is unavailable. High rewards can be paid to successful management teams, and institutional investment will be available to provide liquidity in a relatively short period of time.
Profile of the Ideal Entrepreneur
From the perspective of venture capitalists, the ideal entrepreneur: tells a compelling story and is presentable to outside investors, has a good reputation and can provide references that show competence and skill, understands the need for a team with a variety of skills and therefore sees why equity has to be allocated to other people, works diligently toward a goal but maintains flexibility, gets along with the investor group, understands the cost of capital and typical deal structures and is not offended by them, is sought after by many VCs, has realistic expectations about process and outcome., recognizes the need for speed to an IPO for liquidity,
The Return of Investment
All the stakeholders of Venture Capital get benefited. The fund registered under these Rules shall pay an annual fee @ of 0.05% of NAV of the fund to the Commission.
Trustee also gets commission for his part of role in maintaining fiduciary duties.
Entrepreneur shall get desired capital. As per BSEC rule, investors shall get a hurdle rate of return on investment of a fund as disclosed in the constitutive documents.
Finally the Fund Manager, who engineers everything, get management fee and receives profit from the invested fund. As per Bangladesh Securities and Exchange Commission (Alternative Investment) Rules, 2015, Fund management fee given below.
The fund manager shall be entitled to an annual fund management fee up to 4% (four percent) of NAV of the fund for managing an impact fund, up to 3% (three percent) of NAV of the fund for managing a venture capital fund and up to 2 per cent) of NAV of the fund for managing a private equity fund.
The fund manager may share up to 20% of the net annual profit of a fund, if the fund can achieve the hurdle rate as per terms and conditions disclosed in the Constitutive document.
Investment Fund Manager will receive cash dividend as per its own investment of the fund. (i.e. 2 % to maximum 25% investment of the fund)
As per Bangladesh Securities and Exchange Commission (Public Issue) Rules, 2015, Alternative Investment Fund Managers and Alternative Investment Funds can invest as Intuitional Investors. As a result Fund Manager and Alternative Investment Funds can earn: a) Dividend and b) Capital Gain.
Risk Associated with Venture Capital
Success rate in Venture Capital is not very high. On average, good plans, people and businesses succeed only one in ten times. The best companies may have 80% probability of succeeding.
A typical breakout of portfolio performance per 1,000 invested is shown below:
Length of Investment
Venture capitalists will help companies grow, but they eventually seek to exit the investment in three to seven years.
An early stage investment may take 5-7 years to mature, while a later stage investment may only take a few years. Venture capital investing is high-risk long term and illiquid in nature and should always be made with careful diligence and full appreciation for the risks.
As per Bangladesh Securities and Exchange Commission (Alternative Investment) Rules, 2015, Life of the fund shall be established for a specific period from 05(five) to 15 (fifteen) years which shall be disclosed in the constitutive documents
Conclusion
Bangladesh is a densely populated country of having roughly 30% younger generation who are dynamic and possess innovative ideas. As a result Bangladesh can achieve this demographical dividend for at least next 20yeas.
In near future, innovative ideas backed by finance from Venture Capital will spark and vibrate our economy and it is not impractical for our country to be role model of the world by capitalizing on youth spirit through venture capital.
Reference
(The write-up has been prepared with the help of Bangladesh Security and Exchange Rules and Harvard Business Review on Venture Capital.)
The write is the director of Athena Venture Capital Ltd.
