FINANCE: VENTURE CAPITAL PART II

In a previous article we studied what is Venture Capital.   In this article, we shall take a look at how it works.

How It Works:  Adam Kowalski is a Polish immigrant to U.S.A.   He is one of those millions of to-be-legends that came to New York with less than 50 Dollars in his pocket, and a brilliant idea in his mind.   Back in Warsaw, Poland, Adam was fascinated with cars, as a child.   But one thing that bothered him about cars was the fumes they spewed, that made him sick.   So he resolved, one day, to do something about it.   That ’something’ took the shape of a chemical treatment process for the car’s silencer that could reduce carbon monoxide emissions by about 25%!  

 The silencer is the last part of the machine from where the carbon monoxide laden fumes exit into the atmosphere.   Adam’s process cleansed the fumes before they ejected into the atmosphere, thereby reducing the carbon monoxide content by about 25%.   He conducted several experiments in his modest ‘lab’ in Warsaw, and was convinced that he was on to something with great potential.   The problem was how to get if off the lab table and into the real world.   That would be the real test for his ‘baby’.

So Adam, like millions around the world, packed his bags, and landed in New York, and started working to realize his dream.   To cut a long story short, Adam came in touch with one Mr. John Anderson, who ran a Venture Capital firm by name, Jack, Jones, and Associates.   The firm had contributors drawn from wealthy individuals, and a few mid size firms based in New York.  

 Anderson realized that Adam’s idea was brilliant, and had great potential for growth and profits.   However, it was equally risky.   In effect, this tecnology would mean, that every eleven cars on the road would spew out carbon monoxide equal to that of only ten cars.  That meant one car off the road for every ten fitted with this mechanism, in terms of carbon monoxide emissions.

But there were hurdles to be crossed before this product could see the light of the day.   It depended on how the car manufacturers would receive the new product, that  would mean investing additional dollars into the manufacture, and consequently increasing the cost of the machine to the consumer.   While an average car buyer would appreciate technology that would give him better mileage and save him some dollars,  to convince him to pay more for the car to ’save’ the environment was quite another thing.  

Moreover the political environment was also not favorable.   The Bush Administration was opposed to the Kyoto Protocol on Climate Change, and generally not in favor of any legislation, that was against the ‘American way of life’.   But Anderson knew that this technology had a lot of promise for growth and profits.   And the Bush Administration was on its last legs.   Soon there would be a change and things would look up, and cleaner and greener technologies would get a boost from the new Administration.

So, Anderson decided to back the project and helped set up a company called Greener America, and committed 50 million dollars of his V.C. firm’s money to it.    In return, he got a 50% share in the new venture, apart from say in the most important decisions of the new company, especially those related to finances, and recruitment.

As it so happened, the Bush Gang got a drubbing in the ensuing elections, and soon America was treading a new, uncertain path that held great promise, and potential, but was equally risky.   Just the kind of situation for a Venture Capitalist, in politics!

Anderson patted himself on the back for a wise decision taken.   He estimated that the new company would break even in about 2 year’s time, and thereafter, it would be ripe for either a sale, or public equity.

This is an example of how venture capital works.   To sum up, venture capital fills a need for financing of new ventures that are not mature enough for either Bank financing or public participation through IPOs.   Though the entreprenuer may not get the best deal possible, at least his idea becomes a reality, and brings him glory and money.

                                                                               Concluded                                       

 

FINANCE: VENTURE CAPITAL PART I

What is Venture Capital:    Venture Capital may be defined as capital infused in ventures that are new, untested and risky, but with high potential for growth and profits.   Venture Capital is financing of untested technologies, processes, systems, or products that have no guarantee of success, but tip the scales in favor of investing in them, on account of their high potential for growth and profits.  

Attraction and  Scope:  Success in a venture of this kind holds the promise of capturing the whole, or at least a good part of the market, for that particular product or service.   It is this tantalizing  prospect of cornering the market, and consequently driving away the gravy car home, that persuades a Venture Capitalist to risk his money on these ventures.   Of course, the prospect of such high growth and profits naturally begets with it, the risk of losing it all.   All or Nothing is a common feature of venture capital financing.  

Venture capital is akin to private placement.   The players involved here are high networth individuals, or institutions, who contribute or pool together their resources for investment through the medium of specialist investment firms.   These investment firms look out for opportunities of high returns against high risk, and identify projects that are relatively new and yet to establish themselves.   And because they are not established players, these new projects or ventures are not in a position to either raise Bank loans on favorable terms, or go in for public subscriptions(IPOs). 

This vulnerability of the venture attracts the Venture Capitalist, who offers to take a stake in the company on profit and loss basis.   That is, the Venture Capitalist is prepared to bear a loss also in the event of the venture not doing well, which is not the case with traditional financiers like Banks.  For the new venture, that has a brilliant idea to work on, but not in a position to crystallise the same on account of want of funds, this offer of the Venture Capitalist is irressistible.   However, there is also a flip side to it.   The Venture Capitalist also demands a significant control on the decisioin making within the venture.   This is, of course, in addition to his control over the ownership of the venture(to the extent of his investment).   This poses a classical dilemma to the inventor, or entreprenuer who is willy nilly forced to accept the proposition of the venture capitalist.

The Venture Capitalist, who may be a individual or a firm, pools finances from interested persons or companies, and invests in new ventures as discussed above, with the objective of making a neat profit by providing crucial and much needed financial support to the new venture when it needs such assistance most.   In return for taking the trouble and the risk of associating with a venture that is struggling to find its feet, the Venture Capitalist hopes to end up with his pot of gold, when the venture is either sold off, or goes public.   Of course he is prepared to lose his investment in the process.   But for the venture capitalist, it is a fair gamble.

Apart from providing finances, the Venture Capitalist may also contribute managerial and technical expertise to the venture.   This is to ensure that there is a reasonable chance for the venture to succeed.   Often, and especially, technically brilliant people lack the managerial and financial acumen to make their venture a commercial success.   They come up with a product that perfectly fills a void in that particular area, but inablility to handle the commercial aspects of the venture, be it financing, or marketing can prevent the venture from realizing its full potential, if not end up a flop.

In the next part of the article, we shall see how the V C system works.

                                                                                    To be continued.