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Valuation and Risks in Venture Capital Investing

Compared to a traditional project or company with an established business model, valuing a venture capital project is quite difficult.

Even though some of the popular valuation methods can be used to value such a project, the difficulty in assessing the future cash flows of these projects make the results of the valuation models unreliable.

Even though investments in venture capital projects pose significant risks, the investors are motivated by huge expected returns from at least some of the projects. The ratio of success to failure is very low, but the companies that succeed cover up their losses in other investments.

Unlike other businesses, venture capital projects also pose other risks such as inexperienced entrepreneurs, innovative ideas, and uncertain time to success.

However, venture capital funds invest in many projects and the risk of the entire portfolio will be lesser compared to individual investments due to diversification.

There are three key factors while valuing a venture capital project:

1. Expected payoff at the time of exit, if venture succeeds

2. Time to exit

3. Probability of failure

Let’s take a simplified example to understand the payoff.

An investor is considering investing $1 million in a new project. he expected that if the project succeeds it will pat $10 million at the end of five years.

However, the risk is that the project may daily in any of these five years. The investor’s cost of equity is 15%, and he has the following estimates for the project failure in the next 5 years:

Year	Prob. of Faulire
Year 1	30%
Year 2	25%
Year 3	20%
Year 4	20%
Year 5	20%

First we need to calculate the project will succeed, i.e., the project will survive to the end of 5 years. This can be calculated as follows:

= (1-0.30)*(1-0.25)*(1-0.20)^3 = 26.88%

The next thing we want to calculate is the NPV if the project is a success and earn $10 million for the investor. The NPV can be calculated as follows:

NPV if the Project Succeeds

= -$1 million +$10 million/(1.15)^5

= $3.97

NPV if the Project Fails: -$1 million

The expected NPV of the project will be:

=0.2688*$3.97 million + 0.7312*(-$1 million)

=$335,936

Since the expected NPV is positive, the recommendation is the aspect the project.

Exit Strategies for Venture Capital Funds

By Sheeba

An important aspect of venture capital investing is the exit strategies. Venture capital funds primarily invest with an exit in mind after a few years. After successfully funding at seed, pre-production, production and expansion stages, a venture capitalist will start assessing exit strategies. The exit in the form of disinvestment or liquidation is the last and final stage of the venture capital funding. The key types of liquidation/disinvestment are trade sales, sale of quoted equity post initial public offering (IPO), and write-offs. Let’s look at each of these in detail:

Trade Sales: In this type of strategy the private company is sold or merged with an acquirer for stocks, cash, or a combination of both.

IPO: If the company has done well, the venture capital investors will take the IPO route, by issuing shares registered for public offering. An example is the upcoming Facebook IPO, which is expecting to raise about $15 billion through IPO and is valued at approx. 100 billion. The venture capital investors and other private investors will get their portion of shares who can put them in the open marketplace for trading after an initial lock-in period.

Write-offs: These are voluntary liquidations that may or may not result in any proceeds.

Apart from the above three types of disinvestment, there are a few other options:

Bankruptcy: The company may just go bankrupt.

Buy-back: In this method the entrepreneur buys-back the investment share from the venture capitalists and takes it back to being a privately held company.

Investors who invest in a venture capital fund get distributions of public stock or cash from realized venture capital investments. Sometimes the fund may require further investments from limited partners. At other times, they may make cash or share distributions at random times during the lifetime of the fund. Investors can sell their interests to another buyer if they find one.

In a bad case scenario, some funds find themselves with highly illiquid, barely there companies. In a good scenario, they have good investments, which they disinvest from at a stage and find new investments to fund.

Characteristics of Venture Capital Funding

By Manish

Venture Capital Funding can be of different kinds. Early stage funding could be at the stage of ideation, initial production and marketing. Expansion funding is done during commercial production, marketing and growth (For more information refer to the article – Stages of Venture Capital Funding). Different funds focus on different types of funding and sectors. There are however some unifying characteristics of venture capital funds.

Illiquidity: Easy liquidity by cashing out in the short-term is not an option for venture capital funding. An IPO or buyout of a venture is how venture capitalists disinvest. A premature IPO could undermine an otherwise successful company. Alternatively an IPO released in a poor IPO market could also stall possibilities of cash out.
Long-term commitment: Venture capital funds need to be latched in for a period of few years before disinvestment. Investors who do not prefer illiquidity will attach a premium to their funds, also known as liquidity risk premium. Therefore an investor who can wait out the time horizon will benefit from this premium. University endowments who seek VC funds to invest in are an example of such investors.
Difficulty in determining current market values: It is difficult to evaluate the current market value of the portfolio of a VC.
Limited historical risk and return data and limited information: Venture capital funds more often than not invest in new and cutting edge industries of a sector, where there is little historical data or continuous trading data. It is also difficult to estimate cash flows or the probability of success.
Entrepreneurial/management mismatches: Entrepreneurs may face difficulties when there is dilution of ownership and control. Bad management choices may scuttle a good venture. Entrepreneurs sometimes find it difficult to step up as the venture gains size.
Fund manager incentive mismatches: Investors interested in well performing rather than large sized funds need to find managers who match their investment objectives.
Knowledge of competition: As we discussed earlier since most business’ that are funded are from nascent industries it is difficult to assess the competition, than say in established industries. A complete competitive analysis is therefore difficult to undertake for a VC fund.
Vintage Cycles: Economic conditions vary from year to year. During some years venture capital funding is plenty and therefore returns for them low. In poor or stressed market condition, even good firms find it difficult to find VC funding.
Extensive Operation Analysis and Advice: Venture capital funds that plan to invest in technology companies may not have the required expertise to assess them. Financial investment knowledge alone is not sufficient. Good fund managers therefore require both operating and financial analysis and advising skills. A fund manager who does not understand the business will impede rather than improve it.

Stages of Venture Capital Funding

By Manish

Venture Capital Funding is a form of private equity wherein the investor has a minority interest in the business. Typically it extends over a few years from ideation to exit.

Let us take a case study of Simply Switch, an online price comparison tool, where a user can switch to the best bargain for electricity, gas, credit card, broadband, etc. In 2002, after assessing Simply Switch’s growth potential, a venture capital firm called Bridges Ventures injected £125,000 pounds at the time when the company had just started. Over a period of three and a half years it totally spent 345,000 pounds. It sold its stake in 2006 for 22 million pounds returning £7.5 million pounds, resulting in an IRR of 165%. Bridges Venture chaired the company initially before placing an industry expert as chair. It undertook new market entry and growth strategies. The venture capitalist provided strategic and financial advice and ascertained the optimum time for exit. (Source: bvca.co.uk).

Clearly there are different stages to venture capital funding of a business. Schilit review offers an understanding into the various stages of venture capital investing. Funding varies from stage to stage. Given below is a table of the stages.

Stage	Details
Stage 1: Seed stage	A business idea is funded. This initial funding is used for product development and market research.
Stage 2: Early stage financing	Funding is provided for initial operation before commercial production ensues and sales begin.
Stage 3: Formative funding	This includes seed stage and early stage funding.
Stage 4: Later stage funding	Funding provided for commercial operation and sales, but before an initial public offering (IPO).

Early stage funding can be either start-up or first stage funding. In start-up financing capital is provided for initial operations and testing. This would include product development and initial marketing. First stage funding is provided for initial commercial production and sales.

Under the later stage funding there can be second stage, third stage and mezzanine funding.

The second stage funding is provided to the company for expansion even though it is not profitable despite commercial production and sales.

In third stage funding, capital is provided for major expansion, for example, in Simply Switch’s case for aggressive marketing of its service for awareness and adoption.

Mezzanine as the name suggests is a kind of bridge funding that will help the company prepare for its journey between its expansion of capacity and the IPO. Simply switch might have availed this between gathering more adopters and having its stake acquired by Daily Mail and General Trust.

Financing through all stages, seed funding to mezzanine, is referred to as balanced stage financing.

Overview of Private Equity

By Manish

An equity investment in a business, which is not traded on the capital market, is referred to as private equity. Individuals or private institutions invest in companies with growth potential, without managing the business on a day to day basis through portfolios of private equity projects. They take the private equity route through limited partnerships, which allows them to invest in the portfolio projects while maintaining limited liability. Private equity experts involved in such a portfolio, called general partners, are usually involved with management decisions of the companies that form part of the portfolio. The general partners usually belong to the private equity company or the private equity division of a financial institution.

The limited partnership is referred to as the fund. Sometimes several private equity funds pool their funds together. Investors, private and institutional, can also invest in such ‘fund of funds’.

The most well- known form of private equity investing is venture capital funding. This is also considered the most traditional form of private equity. Venture capital funding has founded several technological successes and failures. In this form of private equity a business is funded from incubation, through set-up, R&D, production and an exit strategy through a buy-out or an initial public offering (IPO). The time frame of such investment is for several years at a time. Venture capitalists usually have several hits and misses in their portfolio. A big success however makes it viable for the investor to invest in further businesses.

Another form of private equity and possibly the largest category in it is the Leveraged Buy Out. Unlike a venture capitalist that has a minority interest in the company of choice, a leverage buyout investor has a majority stake in the company it is buying out. Usually these companies are publicly traded, but once the buy-out happens they usually become privately held. These buyouts see the private equity firm putting 20-40% of its own funds and borrowing the rest, hence the term leveraged buyout. The private equity firm then adds value to the company by involving itself in management and re-engineering it. It then puts up the firm up for sale either privately or through an IPO.

A variant of the leveraged buyout is the management buyout. In this format the managers of the acquired company become large investors in it. Large buyouts usually exceed $10 billion. There are however usually mid-size companies taken into the portfolio. A lot hinges on value addition when the company goes private. Private equity comes from across the globe. An acquired firm usually adds value with the help of its managers, hence management buyouts, to ensure a higher rate of success.

Yet another form of private equity is called distressed investing or vulture investing. Here private equity players zoom in on companies in financial distress. They then buy them out cheaply and restructure them. Any positive accruals made initially first go to debtors.

Additional Resource (Video): Private Equity Model-how private equity firms help businesses.

Types of Market Structures

By Sheeba

There are four basic market structures: perfect competition, monopoly, monopolistic competition and oligopoly.

In a perfect competition market structure several firms are present who all produce identical products and are all sold at market price. The entry barriers to this market are low and the only factor determining sales is price. Since no one producer can affect prices, the demand curve for such a market is horizontal i.e. perfectly elastic. An example of this could be onions produced from a certain region.

On the other end of the spectrum is the monopoly market structure. In such a market there is usually just one seller. The entry barrier is very high to this kind of market. The cost of investment, copyright or holds over resources are some examples of high entry barrier. The railway network of any country is an example of a monopoly.

When it makes natural sense to have one firm produce a product it is called a natural monopoly. Public utilities, electronic defense equipment are government sponsored natural monopolies.

Covering the middle ground of market structure in one form is monopolistic competition. In this scenario firms do not produce identical products. There exist in the products difference in features, price, branding and so on. The shampoo market demonstrates this. Despite the same end use, i.e., cleaning hair and scalp, the firms producing them market their differences. Removal of dandruff, stopping hair fall, more luster are some of the differentiators they advertise. Consumers are loath to shift unless there is a very high (>10%) increase in price.

In an oligopoly market there are a few players who need to keep an eye on each other’s strategy. The cement industry or airline manufacturing industry are good examples. In both these industries the economies of scale are very high making entry barriers in these segments high. The different firms differentiate on the basis of some features, their offerings being good substitutes to each other. In this market structure demand elasticity is more than that of a monopoly.

The following table highlights and compares the features of these four types of market structures.

	Perfect Competition	Monopolistic Competition	Oligopoly	Monopoly
Number of Sellers	Many	Many	Few	One
Barriers to Entry	Very Low	Low	High	Very High
Type of Substitute Products	Very good	Good substitutes but differentiated	Very good differentiated substitutes	No good substitutes
Nature of competition	Price only	Marketing, features and price	Marketing, features and price	Advertising
Pricing Power	None	Little	Little to significant	Significant

Role of International Organizations (IMF, World Bank, and WTO)

By Manish

This article explains the role of the three important international organizations, namely, World Bank, the International Monetary Fund, and the World Trade Organization in facilitating trade.

The excerpts of the functions and objectives are taken from their respective websites.

International Monetary Fund (IMF)

The purposes of the IMF are clearly expressed in Article I of its constitution, the Articles of Agreement:

To promote international monetary cooperation
To facilitate the expansion and balanced growth of international trade
To promote exchange stability
To assist in the establishment of a multilateral system of payments
To give confidence to members by making the general resources of the Fund temporarily available to them under adequate safeguards
To shorten the duration and lessen the degree of disequilibrium in the international balances of payments of members

World Bank

The World Bank is a vital source of financial and technical assistance to developing countries around the world.

We are not a bank in the ordinary sense but a unique partnership to reduce poverty and support development. We comprise two institutions managed by 188 member countries: the International Bank for Reconstruction and Development (IBRD) and the International Development Association (IDA). The IBRD aims to reduce poverty in middle-income and creditworthy poorer countries, while IDA focuses exclusively on the world’s poorest countries. These institutions are part of a larger body known as the World Bank Group.

Together these two institutions provide low-interest loans, interest-free credits and grants to developing countries for a wide array of purposes that include investments in education, health, public administration, infrastructure, financial and private sector development, agriculture, and environmental and natural resource management.

World Trade Organization (WTO)

The World Trade Organization (WTO) is the only international organization dealing with the global rules of trade between nations. Its main function is to ensure that trade flows as smoothly, predictably and freely as possible.

Where countries have faced trade barriers and wanted them lowered, the negotiations have helped to open markets for trade. But the WTO is not just about opening markets, and in some circumstances its rules support maintaining trade barriers — for example, to protect consumers or prevent the spread of disease.

At its heart are the WTO agreements, negotiated and signed by the bulk of the world’s trading nations. These documents provide the legal ground rules for international commerce. They are essentially contracts, binding governments to keep their trade policies within agreed limits. Although negotiated and signed by governments, the goal is to help producers of goods and services, exporters, and importers conduct their business, while allowing governments to meet social and environmental objectives. The system’s overriding purpose is to help trade flow as freely as possible.

Trading Blocs, Common Markets, and Economic Unions

By Manish

Countries often enter into different types of agreements with respect to their trade policies. The objective of such agreements is to reduce the trade barriers among countries.

These types of agreements are generally referred to as trade blocs or regional trading agreements (RTA), under which a group of countries agree to reduce or eliminate trade barriers.

These agreements will have internal rules that the members of the group follow for behavior among themselves. They will also have external rules that the members follow for dealing with non-members.

Types of Trade Blocs

There are different types of trade blocs depending on the levels of commitments and arrangement between the members.

Preferential Trade Areas

Preferential trade areas have the lowest level of commitment to the reduction of trade barriers. Here the members lower the trade barriers but do not eliminate the barriers among themselves. Such an agreement does not address how individual members will deal with the non-members.

Free Trade Area

The next level of commitment is the free trade area where all the trade barriers among the members are removed. So, all members are free to import and export goods and services among themselves. These members will continue to maintain independent trade policies with non-member countries. An example of a free trade agreement is NAFTA (North American Free Trade Agreement) under which Canada, Mexico and the US have agreed to eliminate the barriers among themselves. However, each member maintains independent policy while dealing with other countries.

Customs Union

This is the third type of trade bloc, under which the member countries not only eliminate internal trade barriers, but also adopt common policies on how to deal with non-member countries. An example is Customs union of Russia, Belarus and Kazakhstan, which was formed in 2010. These countries are eliminating trade barriers among themselves but have also agreed to some common set of policies for dealing with nonmember countries.

The above three types of trade blocs only addressed trade barriers related to goods and services. The following trade blocs, apart from these trade barriers, also address other factors such as flow of resources.

Common Market

In a common market, the members eliminate internal trade barriers, adopt common external trade barriers and allow free movement of resources, for example labor, among member countries. Examples include Mercosur (Southern Cone Market), East African Common Market, and West African Common market.

Economic Union

In an economic union, members eliminate internal barriers, adopt common external barriers, allow free movement of resources, and adopt a uniform set of economic policies. The European Union is an example of an economic union. With one currency, they adopted one monetary policy.

Full Integration

The final level is the full integration of the member states. The example is the United States.

[Image Map: www.pbs.org]

Balance of Payments Accounts

By Manish

To buy foreign goods and services, the firms and individuals need to buy the currencies of the foreign countries. Similarly they need to purchase the currency of domestic country while paying for goods and services to foreigners.

The balance of payments is the method used by countries to monitor all their international transactions.

The Federal Reserve Board (FRB) defines a country’s balance of payments as the record of transactions between its residents and foreign residents over a specified period. Any transaction that causes money to flow into a country is a credit to its BOP account, and any transaction that causes money to flow out is a debit.

The accounts are grouped into three major categories: current account, capital account, and financial account. The current account measures the flow of goods and services, the capital account consists of capital transfers and the acquisition and disposal of non-produced, non-financial assets; and the financial account records investment flows.

Let’s look at the components of each of these accounts.

Current Account

The current account is composed of four sub-accounts:

Merchandise and Services: Merchandise consists of all raw materials and manufactured goods bought, sold or given away. Services include tourism, transportation, engineering and business services, such as law, management consulting and accounting, fees from patents and copyrights on new technology, software, books and movies.

Income receipts: Foreign income derived from ownership of assets, such as dividends on holdings of stock and interest on securities.

Unilateral transfers: One-way transfers of assets, such as worker remittances from abroad and direct foreign aid. In the case of aid or gifts, the capital account of the donor nation is debited.

Capital Account

The capital account has two sub-accounts:

Capital transfers include debt forgiveness and goods and financial assets accompanying migrants as they leave or enter the country. It also includes the transfer of title to fixed assets and the transfer of funds linked to the sale or acquisition of fixed assets, gift and inheritance taxes, death duties, uninsured damage to fixed assets and legacies.

Acquisition and disposal non-financial assets: This includes the sales and purchases of non-produced assets, such as the rights to natural resources, and the sales and purchases of intangible assets, such as patents, copyrights, trademarks, franchises and leases.

Financial Account

The financial account is made up of two sub-accounts:

U.S.-owned assets abroad: Include official reserve assets, government assets and private assets. These assets include gold, foreign currencies, foreign securities, reserve position in the International Monetary Fund, U.S. credits and other long-term assets, direct foreign investment and U.S. claims reported by U.S. banks.

Foreign-owned assets in the United States: Include foreign official assets and other foreign assets in the United States. These assets include U.S. government, agency, and corporate securities; direct investment; U.S. currency; and U.S. liabilities reported by U.S. banks.

Deficit and Surplus

The current account should balance with the capital plus the financial accounts, and the sum of the balance of payments statements should be zero. In each account, there can be surplus or deficit. For example, when the United States imports more goods and services than it exports, there will be a current account deficit. The difference must be financed by borrowing, or by selling more capital assets than it buys, which will lead to a capital account surplus.

If a country has a persistent current account deficit, it is, in effect, exchanging capital assets for goods and services. A large trade deficit means that the country is borrowing from abroad.

Trade and Capital Restrictions

By Manish

Trade Restrictions

In many countries governments will impose trade restrictions that will restrict foreign companies from supplying goods to these countries. Below are the main reasons for imposition of trade restrictions.

Protect new industries: The government may want to protect any new industry from competition till it grows to a certain level.
National security: The government may want to protect industries that produce goods required for national security. It’s crucial that such goods can be procured locally during crisis.
Protect jobs: When you allow foreign players to enter in your country, it will lead to job loss. The government may want to protect its labor. However, economists do not support this reason because there will be more job creation in other industries and also the prices of the imported products will be cheaper.
Protect domestic industries: Many domestic industries may use their political influence to protect themselves from foreign competition.
Anti-dumping: Domestic producers may argue that foreign firms are exporting products below their cost in order to drive competitors to bankruptcy, with the intention of later raising prices.

Methods of Trade Restriction

Country may attempt to limit trade through the following policies:

Tariffs – Government levies taxes on imported products.
Quotas – Government imposes limitations on the amount of a product that can be imported
Voluntary Export Restraints – This is a case where trading partners mutually agree to limit the amount of a product that will be exported
Export subsidies: The governments may provide subsidies to companies that export certain goods.
Minimum domestic production: Government may impose requirement that certain percentage of goods must be domestic.

Effects of Trade Restriction

Trade restrictions have the following common impact:

Domestic price of the good increases
Quantity imported decreases
Quantity supplied domestically increases.
Domestic producers gain
Foreign exporters lose
Government gains (tariff revenue, import licenses, etc.)

All methods except quotas and tariffs will decrease national welfare. In a large country, tariffs and quotas can increase welfare under certain conditions.

Capital Restrictions

Some countries may restrict the flow of capital across borders. This can come in the form of:

Prohibiting or restricting foreign investment in a country or specific industries
Prohibiting or taxing income earned on foreign investments
Restrictions on repatriation of earnings of foreign entities

Capital restrictions decrease economic welfare, however they tend to help developing countries in the short-term.