Chapter 10

Section C : Chapter 12 Business Financing

Financial management is an integral part of business administration and ranks equally in importance with other key result areas such as production and marketing. The fundamental objectives of any venture are survival and growth, though there could be other social objectives too. It could, however, be said that all objectives too. All objectives center on the economic objectives, which` means maximization of profits. Financial Management plays a major role in fulfilling the above and includes functions like analyzing and forecasting financial needs, managing working capital, planning the capital structure, etc.

Short Term and Long Term Finance

Financial resources can be categorized into short term and long term. While short term finance is utilized for short term requirements, long term finance is deployed to meet both long term and short term uses.

The sources of short-term finance include:

a. Sundry creditors

b. Bank borrowings for working capital

c. Deposits / borrowings from friends, relatives and others

d. Advances received from customers

The sources of long-term finance include:

i) Equity/owners capital and deposit

ii) Term loans from financial institutions and banks

iii) Seed capital, margin money and subsidy from Government and financial institutions.

Besides the above external sources, there is an internal source of funds that is generated by the industry itself through retention of profits or conversion of assets into funds. For sound financial health of any industry, it is essential that short-term finance be utilized for acquisition of current assets only which are normally converted into cash within one year. Long-term finance, on the other hand, is utilized for acquiring fixed assets as also partly for financing current assets, that is, for meeting margin on working capital.

The application for loan or say a short-term finance always needs the backup of a Project Report, is essential when the Small-Scale wants to apply for the loan for monetary support.

Management of working capital

Working capital is defined as that part of the capital which is invested in the working or current assets like stock of raw materials, semi-finished goods, Sundry debtors, bills receivables etc. this capital is also known as circulating capital or revolving capital. Working capital is used for financing current assets i.e. the day-to day business needs. It is also used for purchasing raw-materials. A major portion of the working capital lies in the business in the form of semi-finished, finished goods and cash. Working capital is also required for payment of wages and salaries, overhead expenses like power, rent, taxes, repairing and upto date maintenance of machinery etc. The amount in respect of goods sold on credit (Sundry Debtors) represents a vital portion of the working capital.

Classification of working capital

1)Regular Working capital meeting continuous day-to-day business needs of the firm, changes its form, it is invested and reinvested in the business called as fixed or regular working capital.

2)Variable Working capital not regular, not static, required to meet the requirements of a rise in the total quantity of goods produced during certain seasons in the year, this additional capital is called variable or seasonal working capital.

3)Special working capital needed on special occasions viz. increasing prices of raw materials, business recession, strike, failure of the machinery, fire, etc. Special working capital is needed to finance the firm on such occasions.

Working capital is often classified as gross working capital and networking capital. The former refers to the total of all the current assets and the latter is the difference between total current assets and total current liabilities. Ongoing review of gross working capital is essential for efficient management of current assets. However, for a long-term view, we have to concentrate on net working capital. The net working capital of a healthy unit should have a positive rule. A periodic study of the causes of changes that take place in the net working capital is necessary. Changes in net working capital can be measured in terms of value as also in percentages by comparing current assets, current liabilities and working capital over a given period. this involves the basic approach to working capital analysis.

Deployment of working capital is best explained by what is called the operating cycle.

Fig. 10.1 Operating Cycle

Any manufacturing organization is characterized by a cycle of operations consisting of purchase of raw materials, converting the raw materials, converting the raw materials into finished goods and realizing cash. It is diagrammatically represented above.

This operating cycle is also called the cash to cash cycle indicates how cash is converted into raw materials, work-in-process, finished goods, bills and finally back to cash. Working capital is the total cash that is circulating in this cycle. It also becomes clear that working capital cash be turned over, or reused after completing the cycle.

Essentially. Management of working capital will mean, apart from finding out the source of meeting capital requirements by reducing the cycle time for optimum results.

The following factors are pertinent for having an overall view of the forces affecting working capital needs:

1. Nature of business;

2. Production policies;

3. Manufacturing process;

4. Growth and expansion of business;

5. Business cycle fluctuations;

6. Terms of purchase and sales;

7. Withdrawals by promoters, etc.

It may be noted that, for any industry, there are likely to be periodic changes in any or all of the above. Therefore, management of working capital becomes a dynamic activity.

Raising working capital

Working capital requirements of a unit are met by internal as well as external sources. The major external source is the banking system. Banks offer various types of credit facilities for meeting the financial requirements of their customers. Their approach is normally flexible particularly towards small-scale sector. Credit facilities are granted by banks against the inventory holdings, book debts and bills receivables, for export oriented units by way of export finance (pre-shipment credit and post-shipment credit) etc. Certain contingent facilities like issuing letters of credit and guarantees are also offered by them.

Though banks have flexible schemes for financing working capital needs, larger units with working capital requirements above Rs. 10 lakhs are required to comply with the norms laid by the Tandon Committee and Chore Committee accepted by Reserve Bank of India.

Tandon Committee

The important features are:

1. Classification of industry and fixation of inventory/receivables norms: The Committee classified certain industries into distinct groups and fixed inventory/receivables norms for 15 industry groups.

2. Application of margin and eligibility for borrowing. In order to avoid double financing, the Committee recommended that only a part of the working capital gap (current assets minus current liabilities excluding bank borrowings) be financed by banks. The Committee suggested three months for computing the maximum permissible level of bank borrowings.

Method 1: This method stipulates that banks would finance 75 percent of the working capital gap the remaining 25 percent to come from long term sources such as owned funds of term borrowings.

Method 2: this method stipulates that the borrower should provide for 25 percent of the gross current assets through long term sources and the rest to be provided by trade credit, other current liabilities and the bank.

Method 3: This method is similar to method 2, only if further stipulates that the core current assets should be taken out from the total current assets separately funded from long-term sources.

The above speculations are to be applied progressively.

3. Suggested reporting system for follow-up of bank credit: The committee has also recommended submission of periodic statements regarding operations of the units for the purpose of effective monitoring and supervision by banks.

Chore Committee

The important recommendations are:

1. The borrowers enjoying aggregate working capital limits of Rs.50 lakhs and over would require to conform to second method of lending prescribed by Tandon Committee which would give a minimum current ratio of 1.33;

2. The borrower would be required to submit to the bank his quarterly requirement of funds on the basis of his budget and provide periodical information of the actual performance vis--vis the estimates.

FINANCIAL FORECASTING

Financial Forecasting follows a systematic projection of the expected actions of the management in the form of financial statements, budgets, etc. The process involves use of past records, funds flow statement, budgets etc. the process involves use of past records, funds flow behavior, financial ratios and expected economic conditions in the industry as a whole as well as in the unit. It is a sort of working plan formulated for a specific period by arranging future activities.

The activities of financial forecasting are varied:

It enables optimum utilization of funds

It helps in planning the units growth and in setting performance goals.

It is used to anticipate the financial needs and it reduces ad hoc and emergency decisions.

It serves as a good basis not only for negotiating confidently with banks/financial institutions.

Financial statements meant to display the effects of future circumstances are described as Performa statements. Since business, decisions are based on the judgement or the influence of future needs on a units financial position, these projected statements provide an important base for financial forecasting and planning. They are prepared on certain assumptions and expectations and give a reasonable estimate of revenues, costs, profits, taxes, other uses and sources of funds.

Projected profit and loss statement

This statement begins with the estimate of the expected sales for the forecast period and is an important step in financial forecasting. The purpose of this statement is to have a fair and reasonable estimate of expected revenue, costs, profits, taxes, etc.

Projected Balance Sheet

It is a forecast of expected funds flow of each item therein to be expected accordingly. Various items of assets and liabilities of the projects balance sheet are explained below:

Assets

1. Cash: Usually there is an assumption for a minimum level of cash or liquid funds desired at the end of the period of forecasting. It can also be a balancing assets and liabilities.

2. Trade Debtors: Magnitude of debtors is closely linked to sales. Based on the past trend/ performance expected credit policy and the pattern of future clientele, a certain number of days debtors or receivables is expected to be outstanding. Thus, to forecast trade debtors, one has to study historical data about the industry as a whole as also the unit, market conditions, and nature of customers.

3. Inventories: The estimate of inventories is prepared on the basis of past operating data together with an examination of future policies. It involves an analysis of the additions to opening stocks, purchases and production of goods during the period and reduction therein through use and sale.

4. Fixed assets: Outlays for factory building, plant and machinery are generally planned in advance. Adjustments, however, have to be made for additions and sales of old assets. Adequate provision for depreciation should be made year-by-year to generate funds for replacement of the relative assets.

5. Liabilities

Trade creditors Creditors can be estimated by analyzing schedules of purchases payments maturing during the period or by calculating the ratio of accounts payable to purchases.

Loans and advances this is usually the balancing figure to equalize assets and liabilities.

Accrued liabilities these are arrived at by analyzing the pattern of wage payments, the tax & dues, interest obligations arrives these at and repayment of loans.

Provision for taxes closing balance of the provision will be found by starting with the opening balance of the provision for taxes, adding the new provision for taxes and deducting the actual payment of taxes.

CASH MANAGEMENT

A cash flow statement will forecast the probable time of receiving cash from sales and estimates the time after which the bills are paid. The projected cash flow statement shows all cash receipts from every source as they are expected to be received and of cash payments by the business as they are to be made. While the projected profit and loss is recorded in the monthly profit and loss statement at the time, the services are provided; as the sales are recorded in the cash flow statement only at the time when the cash payments for the services are received.

Importance of Cash Flow Statement

Managing cash flow is one of the most important tasks business owners face. It is an essential tool for a good cash management.

Cash flow gives the following:

A list of bills giving details on how much is due and when it is due.

A schedule of anticipated cash receipts.

A schedule of priorities for the payment of accounts

An estimate of the amount of money needed to borrow in order to finance day-to-day operations. This is perhaps the most important aspect of a complete cash flow projection.

A format for planning the most effective use of your cash(cash management)

A measure of the effects of unexpected changes in circumstances i.e. loss of many bids, bankruptcy of general contractor or a developer, strikes, poor estimates, etc.

An outline to show the financier the sufficient cash to make loan payments, if there are any plans to borrow money on a long-term basis.

Preparing a cash Flow Statement

The preparation of a Cash Flow Statement involves six basic steps:

Estimate cash receipts for the budget period.

Estimate cash disbursement for the budget period.

Calculate the net cash inflow (or outflow)

Add in cash on hand at the beginning of the month.

Compute cash balance (or shortage)

Project amount of loans necessary.

A cash flow statement is normally prepared for twelve months.

It is computed on an on-going basis and is revised as the situation changes. It assists in financial planning, inventory purchases and formulating credit and collection policies. It also serves as an early indicator when expenses are getting out of line. It is one of the most important tools an owner/manager has to control his or her business.

Estimating your Operating Cash Requirements

The cash flow statement is to estimate the amount of money required to be borrowed in order to finance the day-to-day operations. When the cash flow statement is ready we realize how much operating capital must be injected into business by doing the following calculations:

1. Identify your initial bank loan balance or overdraft, before the start of the year, if applicable.

2. Proceeding month by month, add the increase or deduct the decrease in your operating bank loan to determine the monthly operating loan balance.

3. Identify the highest operating balance; this represents the minimum operating loan or line of credit that should be obtained.

The operating cash requirements are the funds you will need to keep your business running during the first year without a major cash crisis. Unless your projections are unrealistic or unexpected circumstances arise, you need not modify your projections.

Break-Even Analysis

Break-even analysis also called cost-volume-profit analysis helps in finding out the relationship of costs and revenues to output. The analysis can be done only after calculating the break-even point (BEP) .The BEP is defined as that level of sales at which the total cost equals total revenue, i.e., the sales level at which there is no profit or no loss. The BEP is calculated using the formula:

BEP = Fixed Expenses/Contribution per unit where contribution is sales minus variable costs per unit.

The BEP thus obtained will be in number of units(pieces).

A different way of calculating BEP is BEP= Fixed Expenses*Sales/Total contribution where contribution is the total sales minus the total variable expenses.

In this case the BEP will be in Rupees. Graphically BEP is presented as below:

For calculation of BEP, therefore, it is essential to classify the expenses into fixed expenses and variable expenses. The break-even point as mentioned shows the level of sales at which there is no profit or loss. This information itself is of immense use to units because it gives the minimum level at which the unit should operate, at given cost and price, to start generating profit. However, apart from this the break-even analysis is useful inter alia in the following areas:.

Determining product mix. This is done by knowing the contributions of different products and choosing the products in such a way that the total contribution is maximized.

Make or buy decisions. If the variable cost is less than the price that has to be paid to an outside supplier, it may be better to manufacture than to buy.

Knowing profits at given sales volume and finding the effects of changes in fixed and variable costs to profits.

In the case of SSI units it is essential that the break-even point is as low as possible. This can be ensured by minimizing the fixed expenses or by increasing the contribution. However, since contribution is largely dependent on market conditions it is essential to keep the fixed expenses at the minimum level.

ESTIMATION OF GROSS FIXED ASSETS/CAPITAL:

Land, building, plant and machinery these are by and large, met out of market borrowings or term loans from financial institutions, including banks.

Estimation of Gross Fixed Assets/Capital

A. LAND

1. Location

2. Area

3. Whether freehold or leasehold

4. Purchase price of land, if owned

5. Rent in case of leased land

6. Terms of lease

7. Ground rent payable per year

B. BUILDING

1. Location

2. Whether owned or leased

3. Purchase price of Building, if owned

4. Rent in case of leased/ rented premises

5. Terms of lease

Structure Type of Structure Dimensions Area Actual Date of

(whether temporary) Sq. mts. Cost/Rs. Erection

1. Workshop

2. Godown

3. Administrative

4. Other buildings

C.. COST OF EXISTING MACHINERY RS.

In case the assets have been revalued or written off at any time during the existence of company, furnish full details of such revaluation together with the reason therefore.

EVALUATION OF PRE - OPERATIVE EXPENSES

Cost already Proposed to be Total incurred incurred

Pre-operative expenses

a) Establishment

b) Rent, rates and taxes

c) Traveling expenses

d) Miscellaneous expenses

e) Interest and commitment charges on

borrowings (details of calculations)

f) Insurance during construction including

erection insurance

g) Mortgage expenses (stamp duty, registration

charges and other legal expenses)

(.% of loan of Rs lakhs)

h) Interest on deferred payments, if any.

Table 3.1 EVALUATION OF WORKING CAPITAL REQUIREMENTS

1ST year of operation2ND year of operation 3RD year of

operation

1. CURRENT ASSETS

i) Raw materials (including stores and other

items used in the process of manufacture)

Imported (Months consumption)

Indigenous (Months consumption)

ii) Other consumable spares(excluding those included

under item (i) above)

iii) Stock-in-process (Months cost of production)

iv) Finished goods (Months cost of sales)

v) Receivables other than export and deferred

receivables (including bills purchased and

discounted by bankers)

(Months domestic sales excluding deferred

payment sales)

vi) Export receivables (including bills purchased

by bankers) (Months export sales)

vii) Advances to suppliers of raw materials and stores/

spares consumable

viii) Other current assets including cash and bank balances

and deferred receivables due within one year

(major items to be specified individually)

Total current assets (I)

II. Current Liabilities

Other than bank borrowings for working capital)

i) creditors for purchases of raw materials and sores and

consumables spares (Months purchases )

ii) Advances from customers

iii) Accrued expenses

iv) Statutory liabilities major items to be specified individually

a

b

c

Total current liabilities (II)

III. Working capital gap(I minus II)

IV. Margin on working capital (25% of III/25% of I)

V. Bank borrowings (III-IV)

i. The periods to be shown should be in relation to the annual projection for the relative

item during that year.

ii. If the canalized item form a significant part of raw material inventory, they may be shown separately.

iii. Spares not exceeding 5% of total inventory or those expected to be consumed within 12 months, whichever are lower, may be shown against item I (ii).

iv. Other current liability item II (v) will include installments of term loans/ liabilities due within one year.

Planning for working capital is very crucial. It is generally observed that entrepreneurs assess the WC requirements in their own way. There are often three forms and recast working capital requirements according to their forms.

The forms are :

Form for WC requirement less than Rs. 25000

Form for WC requirement less than Rs. 25000 Rs. 200000

Form for WC requirement greater than Rs. 200000

This limit changes as per the government regulation and the banks policy.

Financial Statements

There are various financial statements but the key one are Balance Sheet and the Profit and Loss account

1. Balance Sheet: it is the statement of the financial position of business enterprise as on a particular date. It indicates the total assets and a liability of the enterprise on that date or in other words, describes the sources from which the business entity obtained funds and the uses that have been made of these funds.

Format of Balance Sheet is given on the following page:

Projected Balance Sheet as on 31st March

(In Rupees 000s omitted)yPrevious Year ActualCurrent

Year ProjectedNext Year

Projected AssetsPrevious Year ActualCurrent Year

ProjectedNext Year Projected

Current

Bank

Sundry Creditors

Other Statutory Loans

Other Liabilities

Income Tax Current

Cash and Bank

Investments

Inventory

Sundry debtors

Stores

Others

Tax

Deferred

Friends and Relatives

Term LoanFixed

Balance

Add

Less: Depreciation

Capital and Surplus

Capital

General Reserves

Investment Allowance

Other Reserves and SurplusMisce-llaneous

Long Term Advances

Others

Total Total

Projected Profit and Loss Account (Format)

Previous yearCurrent yearNext Year

i) Sales Realisation

ii) Variable Expenses Raw Materials consumed

Wages

Power and Electricity

Consumables

Repairs and Maintenance

Interest on Working Capital

Selling Expenses

iii) Contribution ( i - ii)

iv) Fixed Expenses Salaries

Interest on Loan

Depreciation

Administrative Overheads

v) Total Expenses ( ii + iv)

vi) Profit before Tax (i-v)

Venture Capital

Invention and innovation drive the US economy. What's more, they have a powerful grip on the nations collective imagination. Tales abound of against-all-odds success stories of Silicon Valley entrepreneurs. In these sagas, the entrepreneur is the modern-day cowboy, roaming new industrial frontiers much the same way that earlier Americans explored the West. At his side stands the Venture Capitalist, a trail-wise sidekick ready to help the hero through all the tight spots - in exchange, of course, for a piece of the action.

As with most myths, theres some truth to this story. Arthur Rock, Tommy Davis, Tom Perkins, and other early venture capitalists are legendary for the parts they played in creating the modem computer industry. Their investing knowledge and operating experience were as invaluable as their capital. But as the venture capital business has evolved over the past 30 years, the image of the cowboy with his side-kick has become increasingly outdated. Today's venture capitalists look more like bankers, and the entrepreneurs they fund look more like MBAS.

The U.S. venture capital industry is envied throughout the world as an engine of economic growth. Although the collective imagination romanticizes the industry, separating the popular myths from the current realities is crucial to understanding how this important piece of the U.S. economy operates. For entrepreneurs (and would-be entrepreneurs), such an analysis may prove especially beneficial.

Venture Capital Fills Voice

Contrary to popular perception venture capital plays only a minor role in finding basic innovation. Venture capitalists invested more that $10 billion in 1997, but only 6% or $600 million, went to start-ups. Moreover, it is estimated that less than $1 billion of the total venture-capital pool goes to R&D. The majority of that capital went to follow-on finding for projector, originally developed through the far greater expenditures of governments ($63 billion) and corporations ($133 billion).

Where venture money plays an important role is in the next stage of the innovation life cycle the period in a company's life when it begins to commercialize its innovation. It is estimated that more than 80% of the money invested by venture capitalists goes into building the infrastructure required to grow the business - in expense investments (manufacture & marketing & and sales) and the balance sheet (providing fixed assets and working capital).

Venture money is not long-term money. The idea is to invest in a company's balance sheet and infrastructure until it reaches a sufficient size and credibility so that it can be sold to a corporation or so that the institutional public-equity markets and step in and provide liquidity. In essence, the venture capitalist buys a stake in an entrepreneurs idea, nurtures it for a short period, and then exits with the help of an investment banker.

Venture capital's niche exists because of the structure and rules of capital markets. Someone with an idea or a new technology often has no other institution to turn to. Laws limit the interest banks can charge on loans - and the risks inherent in start-ups usually justify higher rates than allowed by law. Thus bankers will only finance a new business to the extent that there are hard assets against which to secure the debt and in today's information-based economy, many start-ups have few hard assets.

Further-more, investment banks and public equity are both constrained by regulations and operating practices meant to protect the public investor. Historically, a company could not access the public market without sales of about $15 millions assets of $10 Trillion and a reasonably profit history. To put this in perspective, less than 2% of the more than 5 million corporations in the United States have more than $10 million in revenues. Although the IPO threshold has been lowered recently (through the issuance of development-stage company stocks), in general the financing window for companies with less than $10 Union in revenue remains closed to the entrepreneur.

Venture capital fills the void between the sources of funds for innovation (chiefly corporations, government bodies, and the entrepreneurs friends and family) and traditional lower-cost sources of capital available of ongoing concerns. Filling that void successfully requires the venture capital industry to provide a sufficient retain on capital to attract private equity funds, attractive return for its own participants, and sufficient upside potential to entrepreneurs to attract high-quality ideas that will generate high returns. Put simply, the challenge is to earn a consistently superior return on investments in inherently risky business ventures.

Profile of the ideal Entrepreneur

From a venture capitalists perspective, the ideal entrepreneur:

Is qualified in hot area of interest.

Delivers sales or technical advances such as FDA approval with reasonable probability.

Tells compelling story and is presentable to outside investor.

Recognizes the need of an IPO for liquidity.

Has a good reputation and can provide reference that shows competence and skill.

Understand the need for team with variety of skill and therefore sees why equity has to be allocated to other people.

Works diligently towards the goal but maintains flexibility.

Gets along with investor group.

Understands the cost of capital and typical deal structures and is not offended by them.

Is sort after by many VCs.

Has realistic expectation about process and outcome.

Sufficient Returns at Acceptable Risk

Investors in venture capital funds are typically very large institutions such as pension funds, financial firms, insurance companies, and university endowments - all of which put a small percentage of their total funds into high-risk investments. They expect a return of between 25% and 35% per year over the lifetime of the investment. Because these investments represent such a tiny part of the institutional investors' portfolios, venture capitalists have a lot of latitude. What leads these institutions to invest in a fund is not the specific investments but the firms overall record of accomplishment, the funds story and their confidence in the partners themselves.

How do venture capitalists meet their investors' expectations at acceptable risk levels? The answer lies in their investment profile and in how they structure each deal.

The investment profile.

One myth is that venture capitalists invest in good people and good ideas. The reality is that they invest in good industries - that are industries that am more competitively forgiving than the market as a whole. In 1980, for example, nearly 20% of venture capital investments went to the energy industry. More recently, the flow of capital has shifted rapidly from genetic engineering specialty retailing & computer hardware to CD-ROMS, multimedia, telecommunication, and software computers. Now, more than 25% of disbursements are devoted to the Internet 'space". The apparent randomness of these shifts among technologies and industry segments is misleading; the targeted segment is each case wasgrowing fast, and its capacity promised to be constrained in the next five years. To put this in context, it is estimated that less than 10% of all U.S. economic activity occurs in segments projected to grow more than 15% a year over the next five years.

In effects venture capitalists focus on the middle part of the classic industry S-curve. They avoid both the early stages, where technologies are uncertain and market needs are unknown, and the later stages, when competitive stakeouts and consolidations are inevitable and growth rates slow dramatically. Consider the disk drive industry. In 1983, more than 40 venture-funded companies and more and 80 others existed. By late 1984, the industry market value had plunged from $5.4 billion to $l.4 billion. Today only five major players remain.

Growing within high-growth segments is a lot easier than doing so in low, no, or negative growth Ones, as every businessperson knows. In other words, regardless of the talent or charisma of individual entrepreneurs, they rarely receive backing from a VC if their businesses are in low growth market segments. What these investment flows reflect, then is a consistent pattern of capital allocation into industries while most companies are likely to look good in the near term.

During this adolescent period of high and accelerating growth, it can be extremely hard to distinguish the eventual winners from the losers because their financial performance and growth rates look striking similar. At this stage, all companies are struggling to deliver products to a product-starved market. Thus, the critical challenge for the venture capitalist is to identify competent management that can execute - that is, supply the growing demand.

Picking the wrong industry or betting on a technology risk in an unproven market segment is something VCs avoid. Exceptions to this rule tend to involve "concept stocks, those that hold great promise but take an extremely long time to succeed. Genetic engineering companies illustrate this point In that industry, the venture capitalist's challenge is to identify entrepreneurs who can advance a key technology to a certain stage - FDA approval, for example - at which point the company can be taken public or sold to a major corporation.

By investing in areas with high growth rates, VCs primarily consign their risks to the ability of the companys management to execute. VC investments in high-growth segment are likely to have exit opportunities because investment bankers are continually looking for new high growth issues to bring to market. The issues will be easier to sell and likely to support high relative valuations - and therefore high commission for the investment bankers. Given the risk of these type of deals, investment bankers, commissions are typically 6% to 8% of the money raised through an IPO. Thus, an effort of only several months on the part of a few Professionals and brokers can result in millions of dollars in commissions.

As long as venture capitalists are able to exit the company and industry before, it tops out, they can reap extraordinary return at relatively low risk. Astute venture capitalists operate in a niche where traditional, low-cost financing is unavailable. High rewards can be paid to successful management teams, and institutional investment will be available to provide liquidity in a relatively short period of time.

The logic of the deal.

There are many variants of the basic deal structure, but whatever the specifics, the logic of the deal is always the same: to give investors in the venture capital fund both ample downside protection and a favorable position for additional investment of the company proves to be a winner.

In a typically start-up deal, for example, the venture capital fund will invest $3 million in exchange for a 40% preferred-equity ownership positing although recent valuations have been much higher. The prefer-red provisions offer downside protection. For instance, the venture capitalists receive a liquidation preference. A liquidation feature simulates debt by giving 100% preference over common shares held by management until the VCs $3 million is returned. In other words, should the venture fail, they are given first claim to all the company's assets and technology. In addition, the deal often includes blocking rights or disproportional voting rights over key decisions, including the sale of the company or the timing of an IPO.

The contract is also likely to contain downside protection in the form of anti-dilution clauses, or ratchets. Such clauses protect against equity dilution if subsequent rounds of financing at lower values take place. Should the company stumble and have to raise more money at a lower valuation the venture firm will be given enough shares to maintain its original equity position - that is, the total percentage of equity owned. That preferential treatment typically comes at the expense of the common shareholders, or management as well as investors who are not affiliated with the VC firm and who do not continue to invest on a pro rata basis.

Alternatively, if a company is doing well, investors enjoy upside provisions, sometimes giving them the right to put additional money into the venture at a predetermined price. That means venture investors can increase their stakes in successful ventures at below market prices.

VC firms also protect themselves from risk by co-investing with other firms. Typically, there will be a lead investor and several "followers". It is the exception, not the rule, for one VC to finance an individual company entirely. Rather, venture firms prefer to have two or three groups involved in most stages of financing. Such relationships provide further portfolio diversification - that is, the ability to invest in more deals per dollar of invested capital. They also decrease the workload of the VC partners by getting others involved in assessing the risks during the due diligence period and in managing the deal. And the presence of several. VC firms adds credibility. In fact, observes have suggested that the truly smart fund will always be a follower of the top-tier firms.

Attractive return for the VC

In return for financing one or two years of a companys start-up, venture capitalists expect a ten times return of capital over five years. Combined with the preferred position this is very high-cost capital: a loan with a 58% annual compound interest rate that cannot be prepaid. However, that rate is necessary to deliver average fund returns above 20%. Funds are structured to guarantee partners a comfortable income while they work to generate those returns. The venture capital Partners agree to return all the investors' capital before sharing in the upside. However, the fund typically pays for the investors annual operating budget - 2% to 3% of the pools total Capital - which they take as a management fee regardless of the funds results. If there is a $100 million pool and four or five partners, for example,, the partners are essentially assured salaries of $200,000 to $400,000 plus operating expenses for seven to ten year.

The real upside lies in the appreciation of the portfolio. The investors get 70% to 80% of the gains; the venture capitalists get the remaining 20% to 30%. The amount of money any partner receives beyond salary is a function of the total growth of the Portfolios value and the amount of money managed per partner.

Thus for a typical portfolio - say, $20 million managed per partner and 30% total appreciation on the fund - the average annual compensation per partner will be about $2.4 million per Year, nearly all Of which comes from mutual fund appreciation.

What part does the venture capitalist play in maximizing the growth of the portfolios value?

In an ideal world, all of the firms investments would be winners. However, the world isnt ideal; even with the best management, the odds of failure for any individual company high.

On average, good plans, people, and businesses succeed only one in ten times. To see why, consider that there are many components critical to a company's success. The best companies might have an 80% probability of succeeding at each of them. But even with these odds, the probability of eventual success will be less than 20% because failing to execute on any component can torpedo the entire company.

These odds play out in venture capital portfolios: more than half the companies will at best return only the original investment and at worst be total losses. Given the portfolio approach and the deal structure VCs use, however, only 10% to 20% of the companies funded need to be real winners to achieve the targeted return rate of 25% to 30%. In fact, VC reputations are often bruit on one or two good investments.

Those probabilities also have a great impact on how the venture capitalists spend their time. Little time is required on the real winners - or the worst performers. Instead, the VC allocates a significant amount of time to those middle portfolio companies, determining whether and how the investment can be turned around and whether continued participation is advisable. The equity ownership and the deal structure described earlier give the VCs the flexibility to make management changes, particularly for those companies whose performance has been mediocre.

Most VCs distribute their time among many activities. They must identify and attract new deals, monitor existing deals, allocate additional capital to the most successful deals, and assist with exit options. Astute VCs are able to allocate their time wisely among the various functions and deals.

The popular image of venture capitalists as sage advisors is at odds with the reality of their schedules. The financial incentive for partners in the VC firm is to manage as much money as possible. The more money they manage, the less time they have to nurture and advise entrepreneurs. In fact, virtual CEOs" are now being added to the equity pool to counsel company management, which is the role that VCs used to play.

The Upside for Entrepreneurs

Even though the structure of venture capital deals seems to put entrepreneurs at a steep disadvantage, they continue to submit far more plans than actually get funded, typically by ratio of more than ten to one. Why do seemingly bright and capable people seek such high cost capital?

Venture-funded companies attract talented people by appealing to a 'lottery' mentality. Despite the high risk of failure in new ventures, engineers and businesspeople leave their jobs because they are unable or unwilling to perceive how risky a start-up can be. Their situation may be compared to that of hopeful high school basketball players, devoting hours to their sport despite the overwhelming odds against turning professional and earning million-dollar incomes. However, perhaps the entrepreneurs behavior is not so irrational.

Consider the options. Entrepreneurs - and their friends and families - usually lack the funds to finance the opportunity. Many entrepreneurs also recognize the risks in starting their own businesses, so they shy away from using their own money. Some also recognize that they do not possess all the talent and skills required to grow and ran a successful business.

Most of the entrepreneurs and management teams that start new companies come from corporations or, more recently, universities. This is logical because nearly all basic research money, and therefore- invented comes from corporate or government funding. But those institutions are better at helping people find new ideas than at turning them into new businesses. Entrepreneurs recognize that their upside in companies is limited by institutions pay structure. The VC has no such caps.

Downsizing and re-engineering have scattered the historical security of corporate employment. The corporation has shown employees its version of loyalty. Good employees today recognize the inherent insecurity of their positions and, in return, have hide loyalty themselves.

Additionally, the United States is unique in its willingness to embrace risk-taking and entrepreneurship. Unlike many Far Eastern and European cultures, the culture of United States attaches little, if any, stigma to trying and failing in a new enterprise. Leaving and returning to a corporation is often rewarded.

For all these reasons, venture capital is an attractive deal for entrepreneurs. Those who lack new ideas, funds, skills, or tolerance for risk to start something alone may be willing hired into well-funded and supported venture. Corporate and academic training provides many of the technological and business skills necessary for the task while venture capital contributes both the financing and an economic reward structure well beyond what corporations or universities afford. Even if a founder is ultimately demoted as the company grows, he or she can still get rich because the value of the stock will far outweigh the value of any foregone salary-

By understanding how venture capital actually works, astute entrepreneurs can mitigate their risks and increase their potential rewards. Many entrepreneurs make the mistake of thinking that venture capitalists are looking for good ideas when, in fact, they are looking for good managers in particular industry segments. The value of any individual to a VC is thus a function of the following conditions:

The number of people within the high-growth industry that are qualified for the position;

The position itself (CEO, CFO, VP of R&D);

The match of the personal skills, reputation, and incentives to the VC firm

The willingness to take risks; and

The ability to sell oneself.

Entrepreneurs who satisfy these conditions come to the table with a strong negotiating position. The ideal candidate will also have a business record of accomplishment, preferably in a prior successful IPO, that makes the VC comfortable. His reputation will be such that the investment in him will be seen as a prudent risk. VCs want to invest in proven, successful people.

Just like VCs, entrepreneurs need to make their own assessments of the industry fundamentals, the skills and funding needed, and the probability of success over a reasonably short time frame. Many excellent entrepreneurs are frustrated by what they see as an unfair deal process and equity position. They do not understand the basic economics of the venture business and the lack of financial alternatives available to them. The VCs are usually in the position of power by being the only source of capital and by having the ability to influence the network. However, the lack of good managers who can deal with uncertainty high growth and high risk can provide leverage to the truly competent entrepreneur. Entrepreneurs who are sought after by competing VCs would be wise to ask the following questions:

Who will serve on our board and what is that persons position in the VC firm?

How many other boards does the VC serve on?

Has the VC ever written and funded his or her own business plan successfully?

What, if any, is the VCs direct operating or technical experience in this industry segment?

What is the firms reputation with entrepreneurs who have been fired or involved in unsuccessful ventures?

The VC partner with solid experience and proven skill is a true "trail-wise sidekick. Most VCs, however, have never worked in the funded industry or have never been in a down cycle. In addition, unfortunately many entrepreneurs are self-absorbed and believe that their own ideas or skills are the key to success. In fact, the VCs financial and business skills play an important role in the company's eventual success. Moreover, every company goes through a life cycle- each stage requires a different set of management skills. The person who starts the business is seldom the person who can grow it, and that person is seldom the one who can lead a much larger company.

Thus, it is unlikely that the founder will be the same person who takes the company public.

Ultimately, the entrepreneur needs to show the venture capitalist that his team and idea fit into the VCs current focus and that his equity participation and management skills will make the VCs job easier and the returns higher. When the entrepreneur understands the needs of the funding source and sets expectations properly, both the VC and entrepreneur can profit handsomely.

Although venture capital has grown dramatically over the past ten years, it still constitutes only a tiny part of the US economy. Thus in principle, it could grow exponentially. More likely, however, the cyclical nature of the public marketing, with their historic booms and busts, will check the industry's growth. Companies are now going public with valuations in the hundreds of millions of dollars without making a penny. Moreover, if history is any guide, most of these companies never will.

The system-described here works well for the players it serves: entrepreneurs, institute investors, investment bankers, and the venture capitalists themselves. It also serves supporting cast of lawyers, advisers, and accountants. Whether it meets the needs of investing public is still an open question.

Stage 1

CASH

Stage 2

Raw Materials

Stage 3

Stock-in-process

Stage 5

Sundry Debtors

(Receivables)

Stage 4

Finished Goods

Fig 10.2 Break-Even Analysis

Variable Cost Line

Total Cost Line

Sales Revenue Line

Break-Even

Point

Fixed Cost Line

Cost and sales Revenue (Rs.)

Volume of Output (units)