Venture finance, conceptually being risk finance, should be available in the form of equity or quash-equity (conditional or convertible loans). A straight or conventional loan, involving fixed payments, would be unsuitable form of providing assistance to a new, risky venture. New ventures have the problem of cash flows in the initial years of their development; hence they are not able to service debt. However, the requirement for this kind of assistance could still arise in a few cases, particularly during the second stage of financing after the venture has taken off. Venture capital financing in India in the past took three forms: equity, conditional loans and income notes. Conventional loan has been a quite popular source of funds made available by VCFs in India in the past.
All VCFs in India provide equity. Generally, their contribution may not exceed 49 per cent of the total equity capital. Thus, the effective control and majority ownership of the firm may remain with the entrepreneur. When a venture capitalist contributes equity capital, he acquires the status of an owner, an becomes entitled to a share in the firm’s profits as much as he is liable for losses. VCFs buy shares of an enterprise with an intention to ultimately sell them off to make capital gains. The advantage of the equity financing for the company seeking venture finance is that it does not have the burden of serving the capital, as dividends will not be paid if the company has no cash flows. The advantage to the VCF is that it can share in the high value of the venture and makes capital gains if the venture succeeds. But the flip side is that the VCF will lose if the venture is unsuccessful. Venture financing is a risky business.
A conditional loan is repayable in the form of a royalty after the venture is able to generate sales. No interest is paid on such loans in India, VCFs charged royalty ranging between 2 and 15 per cent gestation period, cost-flow patterns, risk and other factors of the enterprise. Some VCFs gave a choice to the enterprise of paying a high rate of interest (which could be well above 20 per cent) instead of royalty on sales once it becomes commercially sound. Some funds recovered only half of the loan if the venture failed.
A unique way of venture financing in India was income note. It was a hybrid security which combined the features of both conventional loan and conditional loan. The entrepreneur had to bay both interest on royalty on sales, but at substantially low rates. Some venture funds provided funding equal to about 80 percent of a project’s cost for commercial application of indigenous technology adapting imported technology to wider domestic applications. Funds were made available in the form of unsecured loans at a lower rate of interest during development phase and at a higher rate after development. In addition to interest charges, royalty on sales could also be charged.
Other financing methods
A few venture capitalists, particularly in the private sector introduced innovative financial securities. The participating debenture; is an example of innovative venture financial. Such security carries charges in three phases: in the start-up phase, before the venture attains operations to a minimum level, no interest is charged. After this, a low rate of interest is charged up to a particular level of operation. Once the venture starts operating on full commercial basis, a high rate of interest is required to be paid. A variation could be in terms of paying a certain share of the post-tax profits of royalty.
VCFs in India provide venture finance through partially or fully convertible debentures and cumulative convertible preference share (CPP). CPP could be particularly attractive in the Indian context since CPP shareholders do not have a right to vote.
In developed countries, like the USA and the UK, the venture capital firms are accustomed to using a wide range of financial instruments. They include.
1. Deferred shares: – where ordinary share rights are deferred for a certain number of years.
2. Convertible loan stock: – which is unsecured long-term loan convertible into ordinary shares and subordinated to all creditors.
3. Special ordinary shares: – with voting rights bit without a commitment towards dividends.
4. Preferred ordinary shares: – with voting rights and a modest fixed dividend right and a right to share in profits.
Venture capital funds abroad also provide conventional loans, hire-purchase finance, lease finance and even overdraft finance, but the overall financial package is always tilted in favour of equity component.