Daymas Ryan Dipo

Contents
Venture Capital Business, The Conception ........................................................................... 2 Venture Capital Business From Time to Time ....................................................................... 3 Venture Capital Business and its Differences ....................................................................... 4 Venture Capital Business, The Mechanism ........................................................................... 4 Venture Capital Business, Profile and Logic of The Deal ..................................................... 6 Reference ................................................................................................................................. 7

Venture Capital Business

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Daymas Ryan Dipo

Daymas Ryan Dipo 19009141 Mid-Term Exam Venture Capital Business 13 May 2012

Venture Capital Business, The Conception

Viewed from its very basic function, venture capital business is a financial service company that invests its money in high risk start-up businesses with no collateral, in exchange for high return on investment. With this definition in mind, then venture capital business is one of the sources of funds for small investor that does not have access to formal financial services because lack of collateral (hard asset) and credit worthiness. The fact that venture capital does not need a collateral for the funds invested, makes this business fills the gap between formal financial firms (bank) with micro finance. Venture capital is different from banks in terms that they are willing to take more risk, a certain thing that formal banks could not do because of government imposed regulation that regulates on how much the maximum interest rate they should charge to a loan. The very basic nature of Start-up Company is that they do not have a large number of collateral and they lack of credit worthiness, when this nature is met with bank criterion, bank needs to charge higher interest rate that of course is impossible because of government regulations. This is where the venture capital steps in, they could offer sources of fund without those limitations, and thus, this is where the high return on investment is rationalized within the venture capital firm. The nature of venture capital that needs high return on investment makes them selective in choosing their start up. Theres several myth that states venture capital invest in good ideas and good people, but this myth is busted in Bob Zider paper, How Venture Capital Works stated that historically, venture capital invest in good industries. The reason is that growing a business within high-growth industries is much easier than in low-growth one. In addition, the most important thing that venture capital firm in selecting a start-up is an exit strategy, this is how they are going to realize the profit gained from growing such start-up. Exit strategy is usually done via initial public offering (IPO) and management buyout/leveraged buyout. Without these strategy available in hands, venture capital would not be able to reap the capital gain.

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Venture Capital Business From Time to Time

Venture capital can be traced back from its origin, that is, in the history of private equity that started in 1930s. At that time, there was a problem in financing in United States and United Kingdom as they wanted to provide funding for small caps company. The problem was, they did not have the correct funding mechanism that could contain all the risk that existed. The first seed money invested happen in the World War II as some wealthy family invested their money in young company and hired professional to evaluate them. The road for venture capital seems brighter when ARDC (American Research and Development Corporations, a company established by Harvard Business School faculty member, General Georges Doriot. ARDC opened up many investors eyes with its success story, that is when its $70.000 investment in equity of Digital Equipment Corporation, become $350 million within 14 years time periods. This success created a new incentives for other investors to invest their money on venture capital business. Following ARDC success, in the 1970s there were many new venture capital businesses around the world trying to do the same thing as ARDC does. The outcome is quite miserable, many of those company failed because the lack of expertise, infrastructure, and the most important, entrepreneurs. This failure lead to the birth of new financial entity called private equity, a firm that share basic nature of venture capital, but operates focusedly on buyouts and bridge financing, as well as stock and some start ups. Following the story, not all off the countries that imitated US Venture capital were failed. As the boom and bust cycle needed for venture capital to work emerges, in this case internet boom, United Kingdom and Israel started to become the center of venture capitalist in 1990s. The demand for internet company was very high at that time, creating more incentives to investor to invest their money. However, in the early 2000s tha internet boom finally go bust, wiping down the start up company as well as venture capitalist. Despite of this scenario, some venture capitalist still proved its impressive return on investment, making this sector to become more attractive to investors. In the past year, several venture capital success story has flourished over the news, there are Amazon, Ebay, Google, Facebook, and etc. All of them were an internet start up at their time. The latter (Facebook) is now opt for IPO that revise its valuation to more than $100 Billion.Nowadays venture capitalist always see an opportunity, a good industry to begin with, so that it could be easier to manage or crate growth.

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Venture Capital Business and its Differences

Unlike bank, venture capital is different from another formal financial institutions, in terms that venture capital offer source of funding without the need of collateral. This nature, however, is offset by high return on investment needed by venture capital. Bank and other financial institution needs collateral when lending their money, when this requisition is not met, bank would opt to charge higher interest rate, that is, risk free rate plus risk premium of the business covering all the risk. However, with a tight government regulation on bank, the maximum interest rate that they could charge is limited, and thus could not offset all the risk that emerges from a new start up company. To put it into another perspective, according to Bob Zider, venture capital usually expect ten times return on capital for five years in return of one to two years of financing, that is, if converted into banks interest, would sum up to 58% annual compound interest. A very expensive source of financing, but rationalized by venture capitalist perspective of very high risk profile. In start ups perspective, this source of fund is extremely expensive, but is offset by the advantages it will create such as attract talented people, protection for their own money, and the pay structure on venture capital that has no such caps.

Venture Capital Business, The Mechanism

Venture capital get its money from investors, either private or institutional. Institutional investor often comes from pension funds, financial firms, insurance companies, and university endowment. Each of these entities put small amount of their portfolio into high risk investment that expected to generates a return of 25% - 35% per year over the investment horizon. The deal in the money invested on start-up is usually to divide the money given into several stages which is: Seed, this stage is the first stage of venture capital financing, the capital provided at this stage is often modest, and is used to finance the research and development before the commercial operation. Seed stage venture capitalist usually will participate in later stage as its expansion. Early stage, this stage implies that the start-up is able to begin operation, but not yet in the stage of commercial operation. At this stage, costs usually increase with a vast amount of growth. Formative stage is where venture capitalist includes in their financing the seed and early stage money

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Later stage includes third stage, expansion stage, and mezzanine stage. In this stage, capital is provided after commercial manufacturing and sales but before IPO. This stage could be the bridge that finance a start-up to fill the IPO, that is to provide capital needed for going public The idea here is that capital is given to several stages to protect the investors against the vulnerability to risks. In assessing the valuation of a start-up, venture capitalist usually uses several method to value them. Most used is Discounted Cash Flow Valuation (DCF) and Relative Valuation. In DCF, venture capitalist discount future cash flow generation by some amount of rates, which usually is their cost of capital or expected return. With DCF valuation, venture capitalist could value the start up with the following formula:

Where: DPV is the discounted present value of the future cash flow (FV), or FV adjusted for the delay in receipt; i is the interest rate, which reflects the cost of tying up capital and may also allow for the risk that the payment may not be received in full; d is the discount rate, which is i/(1+i), i.e. the interest rate expressed as a deduction at the beginning of the year instead of an addition at the end of the year; CF is the expected cash flow generated at year n n is the time in years before the future cash flow occurs. The other tools to measure the value of a start-up is to use relative cash flow. In this method venture capitalist compare the start-up with another start-up that has been operating to set a benchmark. There is several formula used in relative valuation, one of them is PEG ratio (Price to earnings growth ratio) which is:

Where: Price/Earning is market Price divided by earning per share Annual EPS growth is year to year growth of the earning While PEG ratio is quite easy to use, there are some limitations, which is, if the company has not been operating, then venture capitalist could not calculate the price/earnings and EPS growth.

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Venture Capital Business, Profile and Logic of The Deal

From the statistic point of view, venture capital businesses usually invest in a good industries, that is, industries that have high growth and competitive advantage compared to another industries. The trend for venture capital is, according to Bob Zider, at 1980s they invest at energy industry and then moved to genetic engineering, specialty retailing, computer hardware to CD-ROMs, multimedia, telecommunications, and software companies. While continuously searching for good industries, these venture capitalist creates boom and bust cycle along its way, take internet boom for example. Investing in a high growth start-up company is favorable for venture capitalist, because it gives them the flexibility to go through exit opportunities. This is because bankers usually keep looking for a high growth issues because of their nature that is easy to sell (IPO) The deal used for these venture capitalists is consisted of downside protection and favorable upside contract if the start-up is winner. Downside protection is the contract that gives provision to venture capitalist to get the first claim of the start-up in case of bankruptcy, so in the event of liquidation, venture capitalist could reduce the risk. Upside provisions could be done if the start-up is proved to be a success, with this way, a venture capitalist could add up its portion of investment in a start-up company with lower price than market price.

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Reference
Solnik, Bruno. Global Investments Sixth Edition, CFA Publication, 2011. Levin, Jack S. Structuring Venture Capital, Private Equity, and Entrepreneurial Transactions. Little, Brown and Company, 2000. Bartlett, Josph W. Fundamentals of Venture Capital. Madison Books, 1999 Crisp, Peter. Winning Angels. Pearson Education Limited, 2001 Zider, Bob. How Venture Capital Works. Harvard Business Review November 1998: 9. Kenney, Martin. Note on Venture Capital. International Encyclopedia of the Social and Behavioral Science 2000: 10.

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