CLASSIFICATION OF PRIVATE EQUITY

Venture Capital (VC) 

Introduction 

Fertile brains can generate ideas – Venture capitalists provide the money to fuel these ideas and innovations to reality. Simply put ‘venture capital’ is the capital provided to especially new startups and entrepreneurship enterprises to stand up and deliver. 

A venture capitalist is the institutional investor who has the access to liquid funds and is ever willing to part it with talented startups and innovative enterprises that require that extra bit of hand holding. Note the word used ‘ever willing’ will essentially be the distilled result of a strict selection criteria based evaluation of the startup, its promoters, its vision and of course, the numbers in terms of estimated cash flows, breakeven point, and a whole lot of similar parameters that we would see shortly. 

Some of the most successful ideas in the new age world have got the momentum and the trajectory all but thanks to venture funds – WhatsApp, Spotify, Facebook – all had venture capitalists helping them to get the much required capital as well as to get them to get on to the big stage of mergers and takeovers by larger entities. 

A venture capital fund, as opposed to a venture capitalist, is a firm that works as an investment fund having pooled resources from various self styled and serious venture capitalists, and is seeking private equity stake in startups and innovative enterprises. 

VCs usually invest as either ‘early stage’ funds or ‘late stage’ funds. Early stage would mean the VC is taking a more riskier approach of investing in startups exhibiting ‘raw potential’, whereas later stage would mean the less riskier way of investing in firms having proven their business viability and are wanting to expand their operations. 

Who stand to gain from Venture Capital (VC) funding? 

1. Startups 

2. Innovative enterprises who are still in the early stages of their growth 

3. High risk – high reward business lines

1. Niche business segments, etc. 

In the Indian scenario, the e-commerce segment has seen sustained interest for funding by VCs, for example: 

1. Online services like Makemytrip, Taxi For Sure etc. 

2. Online marketing portals like Bookmyshow,Myntra, etc. 

3. Online health care segments like Practo, etc. 

Business Model for a VC 

So, what is the business model for a VC? The first and the foremost step will be to identify a startup or a diverse idea that can become a revenue generator and hence warrants capital funding. And this is the toughest part of the job. The selection matrix can involve a whole battery of parameters, the critical ones listed as below: 

(i) The fundamental ‘idea’ or the ‘business model’ of the company 

(ii) The ability to generate customer interest thereby increasing the possibility of a successful business manifold – which explains why e-commerce companies in India are able to garner a largesse of the VC funds 

(iii) The breakeven point – obviously the shorter the time frame the better 

(iv) The future prospect of the startup to be taken over by a bigger entity. 

Apart from the revenue perspective, a smart VC also looks into the possibility of how much can a startup create ‘brand recall value’ – the higher the possibility the more is the prospect of a valued takeover deal. For example, WhatsApp, in which VCs had strategic stake, had so correctly marketed the concept that it got the attention of Facebook.Its acquisition by Facebook has brought smiles to everyone involved – the VC got a good price, and so did the founders of the company, and Facebook have its customer connect significantly enhanced. 

The next important step would be to measure the exact amount of capital to be provided to the venture. This would entail the need to check the background of the promoters, business culture, current and future growth prospects, cash flow estimates, breakeven point analysis, and the brand value creation. This whole process can also be called as ‘due diligence’ process, and finally the VC will make an exhaustive report of the same, to justify the decision to finance the venture / enterprise or otherwise. 

And the last step would obviously be the exit point of the VC from the enterprise. It’s very important to appreciate the fact the primary objective of any VC is to provide funds with a clear cut time frame for returns on investment. Once the desired returns are achieved, the VC exits out of the enterprise, either through a stake sell-out, or through outright merger with an outside enterprise. 

The following is a pictorial representation of the basic VC investment cycle:

As stated earlier, once the target returns are achieved, the VC would like to exit out to realize the gains and move on to another investment. This brings us to the concept of ‘private equity’. 

Types of Funding by a VC 

A VC will fund typically in the following ways: 

1. Seed Capital 

2. Startup funding 

3. Early stage funding 

4. Interim funding - Bridge financing , mezzanine 

5. Expansion funding 

Let’s analyze each of these in detail: 

1. Seed Capital: This is the preliminary source of fund provided to the startup for either acquiring fixed assets of startup like computers, machineries etc; or for leasing out premises and such other operational setups. The seed capital is usually limited, and just enough for the startup to shore up its capital assets. In the recent times, there are ‘incubators’ who have specialized into this type of funding purely for seed capital, and seek to exit out once other investors find value. 

2. Startup funding: This funding is given usually for the purposes of executing sales orders, in terms of product development and sales, doing sales promotional activities and the like.

1. Early stage funding: This is typically the Series A funding where the VC provides the funds for setting up the entire plant / site / services line which may also include the infusion of working capital.

2. Interim funding: Once the enterprise breaks even, the immediate focus will be on having stable cash flows. In the meantime, the management may also seek additional capital to ramp up its’ operations model to its full capacity. This can be done in different ways –

a. The management can seek a ‘bridge loan’ that is essentially a plank provided for stepping up to ramp up / reach the full capacity. Bridge loan, being a short term financing loan, is an ideal way for enterprises to get a temporary source of funds before it can get replaced with a larger or a longer time frame based loan.

b. The management can seek a ‘mezzanine’ financing which is typically a hybrid of debt and preferred stock finance. In some cases, the mezzanine is purely a debt form of finance. In both cases, the repayment schedule gets tailored to the enterprise’s cash flows thereby exhibiting flexibility to the management. However, the fund comes at a price – the VC gets a direct stake in the equity of the enterprise post the conversion of preferred stock, which may make some managements uncomfortable for this sort of an arrangement. There are variants of mezzanine funding with some VCs who estimate that if the enterprise has high future potential, it can forego the requirement for a collateral value altogether or at leastkeep it to minimal levels; whereas some VCs would like to have an asset-backed security for the debt component. The equity component also gives the VC a say in the management affairs of the enterprise, which makes this route quite attractive to them. From the borrowers’ point of view, this may be the costliest form of funding as the rate of interest would be quite high, to recognize the risks getting carried in the form of uncollateralized debt. This can leave the management with a huge refinance cost; however, as stated earlier the VC would also take care of this in the tailoring of the repayment schedule.

3. Expansion funding: Once the enterprise is running full steam, and has managed to create its own space in the market in terms of brand recall value, the VC will surely be interested to provide additional funding in terms of long term finance for future growth prospects. This may also put the enterprise ‘on the block’ for potential buyers, especially large sized companies who regularly scout for smaller niche enterprises for adding further variety to their developed shelf of products and services.

The following is a pictorial representation of the VC funding stages:

Angel Investor 

An angel investor is a multi-millionaire who has the funds, usually idle with him or her, and wants to take a share of risk to promote a startup by investing into the same. In return, they usually get an ownership stake or a preferred stocks and board rights. Seldom do they settle for subordinated debt, unless the case for investment is too strong to an opportunity to be missed. The biggest pitfall for an angel investor is that they need to bear extremely high risks, and hence their rate of returns is also the highest. Usually angel investors are retired fund managers and successful entrepreneurs themselves who have a knowhow of the particular segment that they would like to invest in, and rely a bit more on intuition and gut feel about a particular investment. After all it’s their own funds, as compared to VC funds who manage other’s funds. It is not uncommon to find angel investors having common segment interest to team together, such as two investors having a liking for e-retailing space would definitely approach for an assessment of a particular enterprise together. This has also given rise to a new concept called ‘equity crowd sourcing’ – online social media like Facebook, LinkedIn have been fuelling this concept of crowd sourcing or crowd funding, however given the fact that the gullible investors can fall prey to fly-by-night operators;US has brought the JOBS Act (the acronym JOBS is abbreviated for ‘Jumpstart Our Business Startups Act’), which has been conditionally adopted by the US regulatory authority which is Securities Exchange Commission (SEC). 

Buyouts for a PE 

A PE would have a horizon estimate put to its investment. However, usually they are actively assessing for obtaining a good value informally within their business circles, at times, even a year before the planned exit date. There are two popular ways of buyouts getting executed – Leveraged Buyouts (LBOs) and Management Buyouts (MBOs). 

Leveraged Buy Outs (LBOs) 

The increasingly complex nature of commerce and its applications have given rise to a new category of ‘strategic investors’ – private equity (PE) firms who scout for enterprises in the ‘rough’, acquire the same using a clever mix of debt and equity (typically at 70:30 debt to equity), and then targeting to sell the same within a medium term period, say 3 to 5 years. In the process, they leverage on the debt and create value (both perceived and real) and then they either spin off the management control to another entity for a price, or go for an outright sale. 

Some of the examples of a successful LBO deal include the buyout by Tata Steel of UK’s Corus, and the acquisition of SLI Sylvania by Havells India. 

Management Buy Outs (MBOs) 

The classic MBO represents the buyout made by the entity’s managers themselves. The logical reasoning is that they are best placed to run the operations efficiently. However the other side to this is that the managers of the entity may not be the best of the lot to bring in additional clients. Similarly, they may be on the conservative side when it comes to risk taking.However with changing times, MBOs are also getting attention from PEs themselves. In an article published in The Hindu Business Line print edition dated July 10, 2008, explaining on the emerging features of MBOs - ‘Traditionally, Management Buy Outs (MBOs) involved the management wanting to purchase a controlling interest in the company and working along with financial advisors to fund the change of control. Today, MBO activities involve promoters divesting their stake in a firm by selling out to PE players willing to finance the asking price. The PE players are flexible enough to enter into a partnering relationship with the existing management. This sort of arrangement is basically just a stake buyout and not a classical MBO. It is common in scenarios where owners want to hive off entities with poor results and the management lacks funds to hold on to the entity (and their jobs) and are, in turn, bailed out by the PE firm’. This means that the PE brings in the finance as well as their clout in the market to attract additional business lines. Once the expected IRR is achieved, or the estimated cash- on-cash multiple is attained, the PE may also chose to exit out.One of the good examples of MBO in India is the purchase of Intelenet Global Services by Blackstone.

Hurdle rate 

The minimum rate of return that is required by the investor before the sharing of profits – for e.g. a hurdle rate of 15% would mean for the PE that this should be the minimum return to be generated before sharing of profits start. In other words, the hurdle rate is the minimum guaranteed return for the Limited Partners before sharing the gains with the General Partners, as per the carried interest arrangement. Carried interest or simply stated as ‘carry’ is the share of profits of the General Partner in excess of the investment made by him in the portfolio. 

Paid in Capital 

Paid in Capital is the amount of capital contributed by the shareholders. It is amount of capital "paid in" by investors during the issue of equity shares to the public, including the par value of the shares themselves. Paid in capital represents the funds raised by the business from equity, and not from ongoing operations." "Paid-Up Capital is shown in the ‘equity’ section of the balance sheet. It represents the amount of money shareholders have paid into the company by purchasing shares. It basically involves two accounts, the par value of the shares and the excess over par value. 

Term Sheet 

The term sheet is the agreement copy that the VC hands over to the management, which contains the terms and conditions, fee structure, payout terms, liquidation rights, anti-dilution provisions, pre-emptive rights, exit terms etc. 

Critical Terms that appear in a Term Sheet: 

(i) Fee structure: The VC will have two types of fee income it earns – a management fee that is based on a fixed percentage, and a ‘carry’. The management fee will vary from 1% to as high as 5%, the normal standard being 2% of the total invested funds in the particular venture. It is not unusual to also find a tapering clause in the fee structure after a specific period, say three years, post which the fee percentage starts shrinking to the harvest year. On the other hand, a ‘carry’ clause would mean a 

‘carried interest’ in the profits of the venture either for a certain pre-determined number of years, or till harvest. The GP (General Partner) usually stands to earn a portion of both management fee as well as carry. Carried interest gets payable after the hurdle rate is achieved.

(i) Harvest year: The year projected to be the exit year for the PE/VC.

(ii) Down round: This would mean that the investors pay a lower per share price than what previous investors paid, which indirectly implies that the investors have valued the VC at a lower value in the current round than the previous round. This decline is called as ‘down round’. For example, if the initial round of financing earned INR 1 Crore for an entity, and the round two has obtained a value of INR 0.7 Lacs, then this means that the investors have valued the entity lower in the second round, causing a ‘down round’. Down round causes a dilutive effect of original investor rights.

(iii) Methods for computing anti-dilution rights: To avoid a possible dilution to a ‘down round’ situation, the term sheet will usually contain an anti-dilutive clause. This is achieved either by a ‘full ratchet’ method or a ‘weighted average’ method, and the preferred method is mentioned in the term sheet. In a rare case where it is not explicitly stated, the weighted average method is usually adopted.

Illustrative example on the application of anti-dilutive clause:

The position of holding in a VC before the second round (Series B) -

                                                                                                                                                                                                                                           

	Number of Shares	Per share	Value	% holding
Common Stock	600,000	1.00	600,000	60%
Series A investor	400,000	1.00	400,000	40%
	1,000,000	1.00	1,000,000	100%

Now, in Series B an investor has given a down round value of only INR 6, 00,000. Without an anti- dilution clause, the revised stake-holding would be as:

Common Stock	300,000	0.60	180,000	30%
Series A investor	200,000	0.60	120,000	20%
Series B investor	500,000	0.60	300,000	50%
	1,000,000		600,000	100%

You would note that the share of Series A investor has gone down, whereas the late entrant Series B investor has an upper hand.

Now, say if there was an anti-dilutive clause which stated to protect Series A investor against a down round – the revised sheet would look as below –

	Number of Shares	CP	Value	% holding
Common Stock	100,000	0.60	60,000	10%
Series A investor	400,000	0.60	240,000	40%
Series B investor	500,000	0.60	300,000	50%
	1,000,000		600,000

(i) Up round: The opposite of down round where the successive round of investment has valued the venture at a value higher than the earlier round. 

(ii) Break Fee: A fee typically payable to the investor if the company declines the investment described in the Term Sheet or if the company or founders breach exclusivity or other binding provisions in the Term Sheet. 

(iii) Exclusivity Agreement: A kind of non-compete period during which the company cannot negotiate for investments with outsiders for additional investments in the company. This is to protect the holding rights of the PE.