ACQUISITION AND EXIT STRATEGIES FOR VENTURE CAPITAL INVESTORS
Introduction
Venture capital was introduced in 1988, it was after the economic liberalisation in India. IFC, ICICI, and IDBI were the few organisations that established venture capital funds and targeted corporations. The formalisation of the Indian VC market started only after 1993.
As of 2019, the total value of venture capital deployed throughout India was worth $10 billion. This is an increase of 55% compared to the previous year and is currently the highest.
VC is a long-term risk capital generally invested in order to finance high risk projects in the form of shareholding. These projects have a potential of growth in future. In order to assist new entrepreneurs in their initial phase of the project, venture capitalists invest their fund, resources and managerial abilities in the start-up. When the project reaches the stage of a boom, they sell their shares at a high premium to others and earn a profit from it.
A venture capital is “a financing institution which joins an entrepreneur as a co-promoter in a project and shares the risks and rewards of the enterprise”.
Financial venture capital can be offered by:
. Venture capital firms;
- Investment banks and other financial institutions;
- HNIs (Angel investors), etc.
In venture capital firms we see that a pool of money is collected from other investors or companies which form the venture capital funds. The firms also invest from their own funds to show commitment to their clients.
Based on the stage at which funds are invested, VC can be categorised under:
- Seed funding: Capital invested to aid start ups at the initial stage.
- Start-up capital: Capital invested to create product prototype or hire crucial management etc.
- First stage, or series A: Capital invested for the business to start marketing, promotion, or commercial manufacturing of a product.
- Expansion funding: Capital invested to expand the operations of the company to create new products, tap into new markets, invest in new equipment and technology, or even acquire a new company etc.
- Late-stage funding: Capital invested in businesses that have achieved great success in commercial manufacturing and sales. Companies at this stage may have tremendous growth in revenue but not show profit.
- Bridge funding: Capital invested to help short term investments which is necessary for IPO (initial public offering) when the business is approaching the boom stage.
Significance/need of the same
The process of VC funding starts with gathering funds (from investors, financial institutions, and individuals), then they are invested in selected companies carrying out due diligence, evaluation, and investment contacts. Then the investee company is nurtured and supported by monitoring business management and improving their value. Next the capital gains are evaluated, and the invested funds are distributed to the investors.
The motive of the process is to build businesses that not only deliver outstanding financial value but also emerge as category leaders.
It provides some advantages as venture capital helps new entrepreneurs inculcate business expertise. The individuals supplying VC have significant experience to help the owners in decision making, especially human resource and financial management to help the business grow and gain more revenue. Moreover, the entrepreneurs or business owners are not obligated to repay the invested sum. Even if the company fails, they will not be liable for repayment to the original investors.
It should also be noted that the VC investors are sometimes HNIs who can help the business build more connections and improve the market. This can be of immense help in terms of sales and promotion.
VC investors seek to infuse more capital into a company for increasing its valuation. To do that, they can bring in other investors at later stages. In some cases, the additional rounds of funding in the future are reserved by the investing entity itself.
VC can supply the necessary funding for small businesses to upgrade or integrate new technology, which can assist them to remain competitive.
Although VC funds invest in risky ventures, they do have some criteria to decide in which entities they are going to make the investment and to what extent. They may be generally investing into start-ups, but they can also be investing in established businesses where these are a new area.
Regulations
Venture capital funds are now regulated by the Securities and Exchange Board of India (AIF) Regulations, 2012 (Alternative Investment Funds Regulations). The former regulations applicable to venture capital funds were the SEBI (VCF)Regulations, 1996 which were repealed, and the funds were then required to be registered under the AIF Regulations. The AIF regulations define VC funds as AIFs which invest primarily in unlisted activities or a new model.
Process of acquisition through VC
- Deal origination: This is the first step of VC investment. A stream of deals is necessary; however, such deals may have various sources. One such source is the referral system where deals are referred by business partners, parent organizations etc.
- Screening: In this stage all the projects of the undertaking are scrutinised and categorised as market scope, technology or product, size of investment, geographical location, stage of financing etc. Entrepreneurs may also be invited for face-to-face discussion.
- Evaluation: Important documents to evaluate the project capacity and ability to meet such claims are thoroughly evaluated. Various factors like the profile of the company, the efficiency of the business model is evaluated. After putting into consideration all the factors, thorough risk management is done which is then followed by deal negotiation.
- Deal Negotiation: Deal negotiation is a process by which the terms and conditions of the deal are so formulated so as to make it mutually beneficial. Both the parties put forward their demands and a way in between are sought to settle the demands.
- Post Investment Activity: After the finalization of the deal, rights and duties are granted to the VC. The VCs have representations in the board of directors to ensure the company is following up the plans.
- Exit Plan: The last stage of VC investment is to draw up an exit plan keeping in mind the nature of investment, extent of financial stake etc. VC may exit through IPOs, acquisition by another company, purchase of the venture capitalists shares by the promoter or an outsider depending on which provides minimal losses and maximum profits.
Exit strategies for VC funding
Since we know that VC investors invest capital with the motive to exit after a few years, deciding exit strategies becomes crucial. VC investors usually fund at seeding, pre-production or expansion stage and start determining exit strategies before the boom stage. Exit strategies can be formed through liquidation or disinvestment by IPO (initial public offering), mergers and acquisitions, sale to other investors or shares buy back etc. Some of the exit strategies are explained below:
IPO: If the company produces good results, the VC investors issue shares registered for public offering. The original investors here make a profit as the new stock is worth much more than the original investments.
Share buyback: In this case the entrepreneur buys back the shares from the VC investor at predetermined price and thus the company becomes private. Such exit option is opted for when the entrepreneurs have funds to buy back equity help by the VC investors.
Sales in OTC market or stock exchange: The shares of the company may be registered on a national market such as NASDAQ or the NYSE. The client may buy the shares.
Sales to strategic investors: VC sells their shares to strategic buyers who may already own a business or have plans to enter the industry. In this case the VC would be able to sell most of the stock of the company and the acquirer may or may not retain the management team but substantial changes in the company’s operations would not take place.
Mergers and Acquisitions: The company may be acquired by a larger company through merger.
In acquisitions, the acquiring company makes a tender offer to all shareholders to purchase their shares, often in cash at a premium over what investors paid.
Management Buyouts: In this scenario the company’s management team purchases the assets and operations of the business they manage. a company can go private in an effort to streamline operations and improve profitability. The transition of managers from being employees to owners, comes with significantly more responsibility and a greater potential for loss. However, it is appealing to professional managers to reap greater potential rewards from being employees to the owner of the business. Since they are the existing managers, there is a much better understanding and moreover, the company’s debt load would be lower providing financial flexibility.
Conclusion
There are some cons that entrepreneurs have to give up an ownership stake in their business during VC. Sometimes it turns out that the company requires more funding than initially estimated. In such cases there is a huge probability of the original owners losing the majority stake of the company along with the decision-making powers too.
These venture capital investors have representation in the business as a chair among the board of members as a way of having control over the stake of the start-up. This can often give rise to conflict of interests between the owners and investors, which can hinder decision making. Moreover, the funding of the start-up may be delayed due the in-depth analysis of its profile by the venture capital investors by conducting due diligence and assessing the feasibility of a start-up before going ahead with the investment. This process can be time-consuming as it requires excessive market analysis and financial forecasting, which can delay the funding.
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