12 April 2004	Monday	21 Safar 1425

Venture capital financing (VCF) is an activity by which investor supports entrepreneurial talent with finance and business skill to exploit market opportunities and thus obtain long-term capital gains.

The provision of risk bearing capital, usually in the form of participation in equity to companies with high potential growth. It is an amalgamation of managerial skills of entrepreneurs with high potential innovative business ideas with fund raising and management capabilities of 'visionary risk' money managers.

There is a common misconception that venture capital financing is confined to the provision of seed and startup financing in high technology industry only. As is evident from the above definition venture capitalists generally participate in a broad range of business development financing from providing seed-financing to an entrepreneur to develop a new business concept, idea or products, to financing leveraged/management buy-outs.

Venture capital financing plays an important role in providing financial assistance to entrepreneurs, particularly where the entrepreneur lacks adequate collateral to secure conventional credit facilities from financial institutions such as commercial banks and finance companies.

Venture capital also contributes toward increasing the availability of funds for entrepreneurs involved in innovative projects that carry high degree of risk but have attractive growth prospects.

As an equity-based form of finance, venture capital will be expected to bring the investor a higher yield than debt. In return for this desired higher yield the investor will be expected to take greater investment risk and back his capital injection with advice and guidance.

Key features: The key features of the VFC are that it is, (a) equity finance; (b) requires hands-on management; (c) provides superior return through capital gain and (d) requires patience also.

The VFC is defined as "equity finance" and as such it stands as an alternate or complement to other forms of corporate finance which a financial institution may provide or which entrepreneur may seek.

Due to high risk and less certain return the traditional vetting procedure adopted by bank and financial institutions for debt finance may not necessarily be appropriate while vetting any proposal of venture capital financing.

Greater reliance in such a situation has to be placed upon the quality of management, the capacity of earning growth and the expected value of the equity upon realization of the investment.

The VCF requires hand-on management the investor and investees must have close relationship in managing and guiding the development of a project. The financial skill and expertise of the providers of "venture capital" may not be necessary in the day-to-day management and control but such skills and expertise can best be brought to bear at board level.

Active board participation is seen as essential in monitoring and guiding the investment to its fruitation. Hands-on management may entail conflict of interest which can best be avoided and minimized by establishing appropriate control and administrative procedures.

The VCF investment provides superior return through capital gain. Unlike providers of debt capital, venture capital investor provides finance to mostly innovation projects with high risk potential as such the return in capital invested is higher than a normal low risk investment.

Empirical evidence in north America suggest that return on investment average 20 to 30 per cent per annum while most U.K. venture capital firms claim 30 per cent per annum return, the expected rate of return in both countries is 40 per cent per annum.

The VCF patience. This is due to the fact that venture capital investment is generally directed towards project with longer gestation or fruitation period, which may range from 3 years to 5 years and some time even 10 years. Recent evidence regarding realization show that average term to fruitation in U.K. is 3.5 years, whereas in North America it tends to be longer.

Funding process: The VCF process (life cycle) generally consist of the following stages: (a) Seed capital; (b) start-up capital; (c) early stage finance; (d) second round finance; (e) expansion capital; (f) management buy-outs and buy-ins; (g) mezzanine finance (bridge finance).

Seed capital can be defined as the finance of initial product development or the capital provided to an entrepreneur to prove the feasibility of a project and qualify for start-up capital. Its characteristics might be:

* absence of a ready market for the product;

* absence of a complete management team;

* a product or process which is still in the research or development stage.

Seed capital project, by their very nature, require a relative small amount of capital and the financing has the distinction of being the earliest and as such the riskiest stage of venture capital investment.

Start-up capital may be defined as the capital needed to finance the product development, initial marketing and the establishment of product facilities. The characteristics of a start-up venture might be: * establishment of a company; * establishment of some - but not all - of the management team; * development of a business plan and a proto type product or fully developed idea; * absence of trading record. Start-up capital investment has less risk to the venture capitalist than does seed capital investment.

Early state finance may be defined as the finance provided to companies that have completed the product development stage and require further funds to initiate commercial manufacturing and sales. Characteristics of an early finance might be: * little or no sales revenue; * cash flow and profits are still negative; * small but enthusiastic management team with a technical or specialist background; * short-term prospects for dramatic revenue and profit growth.

Second round finance may be defined as the provision of capital to a firm which has previously been in receipt of external capital but whose financial needs have subsequently expanded. A firm requiring second round finance will have: * a developed product in the market; * a full management team; * sales revenue being generated from one or more products; * losses on the income statement or when it is breaking even.

Expansion capital may be defined as the finance provided to fund the expansion or growth of a company, which is breaking even or trading at a small profit. It will be used to finance increased production capacity, market or product development and/or to provide additional working capital.

The two broad characteristics of expansion capital can be identified: (1) investment in companies that substantially self financed since foundation and are seeking outside equity for the first time and (2) provision of second round finance to a company that has already received at least one round of early stage capital from other sources.

The return from investment is realized sooner and will tend to be lower than for earlier stage due mainly to comparatively lesser risk.

A Management buy-out (MBO) involves the acquisition of a company for the shares in that company) from the existing owners by a team of existing management/employees. MBO is a very late stage form of venture finance. As such, it involves less risk than some other stages. It is a corporate finance in the form of equity and is an investment into the management of the investee firm.

An MBO involves bringing in a management team of outsiders, strangers to the company, as opposed to buy-out where they were part of the existing team. It is a process of providing funds to enable a management or group of managers from outside the company to buy-in the company.

Mezzanine finance is a half-way stage finance between equity and loan capital in terms of risk and return and is of ten the last financing supplied to a private company in the final run-up to a trade sale or public flotation. It may be supplied either as a debt or as high-ranking equity with low risk and bringing in lower rate of return.

Legal process: When all goes well with the investment, voluminous legal documents have to be prepared, agreed to and signed by various interested parties such as investors, management, vendors, lenders, employees etc. Legal documents address a host of questions and interest of every concerned group is protected and well defined, their rights and liabilities, sharing of profits and loss, contribution to the pool are determined.

The most appropriate form in which a venture capital company may be organized or floated is a public limited company, it is also due to the reason that above a certain limit of paid-up capital a company must be converted into a public limited company and shares issued to the public.

A venture capital company may also be registered as a banking company or finance company under the relevant laws. It is not essential that providers of venture capital may form a separate company. The providers can form a syndicate or consortium to finance a business proposal.

The VCF in Pakistan in its absolute terms as prevalent in industrialized countries is almost non-existent but banks and DFIs do provide equity support, bridge-financing and expansion capital.

It can play major role in the development of micro economic sectors of the economy especially in the field of computer software, vendors services sector for automobile industry, innovative ideas developed and created by PCSIR & other research institutions in the public sector and individual inventions and ideas leading to creation of jobs and increase in export revenue.

If for example we pick-up only one sector of computer soft ware experts estimate that Pakistan within a short period of two to there years can increase its software exports amounting to $3 billion.

Similar opportunities exist in others areas as explained above which apart from creating favourable balance of payments can solve employment problems and help in the industrialization of the country.

In order to encourage venture capital financing in Pakistan the government should offer attractive tax and other incentives to the private sector and may also form joint venture with the private sector to establish "Venture Capital Financing" institutions.

Major providers of venture capital in UK and North America is the financial sector like pension funds, insurance companies, banks and fund managements group whose total contribution average from 67 in 1992 to 79 per cent in 1966 and the balance was provided by private individuals, industrial corporations and others.

The VCF financing holds great potential as a source of finance for rapid industrialization in Pakistan especially in the field of innovative and high-tech industries. There is a great need of encouraging and supporting this form of financing by the government in the form of appropriate fiscal and financial incentives and provide a conductive legal framework for its growth and development.