Venture capital investment is generally made in new enterprises that use new technology to produce new products, in expectation of high gains or sometimes, spectacular returns.
Venture capitalists continuously involve themselves with the client’s investments, either by providing loans or managerial skills or any other support.
Mode of Investments:
Venture capital is basically an equity financing method, the investment being made in relatively new companies when it is too early to go to the capital market to raise funds. In addition, financing also takes the form of loan finance/convertible debt to ensure a running yield on the portfolio of the venture capitalists.
The basic objective of a venture capitalist is to make a capital gain on equity investment at the time of exit, and regular return on debt financing. It is long term investment in growth-oriented small/medium firm. It is a long term capital that is injected to enable the business to grow at a rapid pace, mostly from the start up stage.
Hands on Approach:
Venture capital institutions take active part in providing value added services such as providing business skills, etc to investee firms. They do not interfere in the management of the firms nor do they acquire a majority/controlling interest in the investee firms. The rationale for the extension of hands-on management is that venture capital investments tend to be highly non-liquid.
High Risk return Ventures:
Venture capitalists finance high risk return ventures. Some of the ventures yield very high return in order to compensate for the heavy risks related to the ventures. Venture capitalists usually make huge capital gains at the time of exit.
Nature of Firms:
Venture capitalists usually finance small and medium sized firms during the early stages of their development, until they are established and are able to raise finance from the conventional industrial finance market. Many of these firms are new, high technology oriented companies.
Liquidity of venture capital investment depends on the success pr otherwise of the new venture or product. Accordingly, there will be higher liquidity where the new ventures are highly successful.
Methods of Evaluation:
The evaluation of venture capital investments are generally idea based and growth based, in contrast with the conventional investments, which are asset based. Venture capitalists employ the following methods in order to evaluate their investments:
1) Conventional Method
2) First Chicago Method
3) Revenue Multiplier Method
Under this method of valuation, venture capitalists take into account the time at which the investee companies start the venture and the time at which such companies exit their investments. The exit takes place in the form of sale to public/ third party and so on. The value of the venture for the purpose of investment involves the following computations:
1) Annual revenue: The annual revenue at the time of liquidation of the investments is calculated as follows: Present annual revenue in the beginning, compounded at an expected annual growth rate for a certain holding period.
2) Expected earnings level: The expected level is computed as follows: Future earning level x After tax margin percentage at the time of liquidation.
3) Future market valuation: The future market valuation of the venture capitalists is ascertained as follows: Earnings levels x Expected P/E ratio on the date of liquidation
4) Present value of VC: The present value of the venture capital using a suitable discount factor is determined.
5) Minimum percentage of ownership: The minimum percentage of ownership required is calculated as follows:
= Finance sought x 100 / Calculated present value of the venture capitalists