Compensation to the Venture Capitalists

The mode of compensation to the venture capitalists is determined before undertaking the venture financing. In general, a venture capital company is paid compensation in the form of an annual management fee. This covers the normal operating expenses, such as salary and allowances of employees, administrative expenses and all expenses related to the selection of investments, as well as disinvestments, but exclude legal expenses and professional fee related to investment portfolio, which are reimbursed separately. It is generally 2 to 3 percent of the Net Asset Value (NAV) or the capital of the fund.

Forms of Organization:

The structural aspects of venture capital companies greatly determine their profitability and their contributors and participants. While designing the structure of such companies, objectives such as limited liability of investors, simple operation of funds, tax transparency of the fund in the sense that double taxation is avoided, tax exemption of the carried interest defined as the extra incentive/profit to the managers over and above the share attributed to their capital contribution and the management fee, maximum tax benefits to investors etc are considered. A brief description of the generally adopted forms of organizations by the venture capital companies is presented below:

Limited Partnership:

Although the partnership form of business organization carries unlimited liability, limited liability partnership has evolved to cater to the needs of the venture capital industry in the USA. It is their most favored method of structuring a venture capital company. The two types of partners in a limited partnership are general and limited. The liability of the general partner is unlimited, and that of the limited partner, is limited. The limited partner does not participate in the actual operations of the business. It is the general partners who actively participate in the affairs of the investee company by carrying out functions such as business identification and development, investment appraisal and investigation of potential investment, negotiation and closing of deals, investment monitoring, advice and assistance to investee companies, arrangement for sale of shares at the exit time, and other fund management functions.

Investment Company:

Investment Company is a simple form of organization of venture capital companies. The investment company manages the portfolio of its investments in a wide range of undertakings. Both the venture capital company and the investee company attract taxation.

Exit Mechanism:

Every venture capital investment is usually liquidated after accomplishment of the purpose of the venture investment. Capital gains are usually made by the venture capitalists since they are in a position to sell their units at a fabulous price in the capital market. The time of exiting is decided in advance, sometimes even at the time of financing the ventures companies. Several factors are taken into account before deciding the exit, such as nature of the venture, the extent and type of financial stake, the state of actual and potential competition, market condition, the style of functioning, as well as perception of the venture capital companies etc.

Methods of Exit:

Following are the methods used by the venture capital companies to exit from the venture assistance in terms of equity investments:

IPO method: IPO (Initial Public Offering), also known as Going Public or Floatation, is a method of exit adopted by a venture capital company, whereby exiting takes place through a public issue of capital. It is the most popular exit route. The chief advantage of this method is that it facilitates liquidity of investments through listing on stock exchanges. Besides, the method commands benefits such as higher price of securities as compared to private placement, better image and credibility with the public, managers, customers and financial institutions. An important requirement for venture companies resorting to this method is the adoption of reporting requirements, stock exchange regulations, disclosure requirements etc. The chief drawback of this method is the higher issue costs, increased accountability to shareholders etc. Venture capitalists can also approach the OTCEI as a public issue for exiting, whereby bought out deals are struck with the members of the OTCEI, who would in turn offer the shares thus acquired, to the public at a future date.

Sale of shares method: Under this method, sale of shares is undertaken by the venture capitalists to entrepreneurs who have promoted the ventures. The entrepreneurs, through employees, can also acquire shares by forming an employee stock ownership trust. The sources of the trust include contribution by the employees/company and borrowings financial institutions and banks.

Puts and calls method: Under this method, the exit takes place through puts and calls. For this purpose, venture capital companies enter into a formal exit agreement with the entrepreneurs at a price based on a predetermined formula.