Introduction to Venture Capital
I am sure that many visitors to this site have projects that require extra funds and additional investments and are interested in understanding how you could acquire the funds required. Obviously, if you have existing monies use this money or if you have enough collateral, call up your banker and have him forward the cash that you require by pledging in the collateral as guarantee. However, if you do not have these two possibilities, as is the case with most entrepreneurs, then you need risk capital, also known as Venture Capital.
Projects requiring extra funding vary considerably. They can be of the type that make you say "ahhh I need money for this as this is the great project of the century that will provide returns of 10 times in a short time!" The probabilities of having this realized realistically are little if not zero. There are projects also where the entrepreneur says and thinks he knows it all and believes he needs no external advice or expertise but only money to develop the project. This is also again usually unrealistic as generally no one person, no matter how talented they are, has an in depth understanding of all that is required. Companies are usually built by strong teams which bring together their efforts for success. It is money which facilitates this process.
Venture capital is smart money invested into high growth potential projects that can offer significant returns to the investors. These investors can also bring in value added skills which sometimes are more important than cash / investments alone in the project. Venture Capital investments therefore are strong partnerships between ambitious, talented and honest entrepreneurs and the set of additional skills and cash brought in by the investors for high growth potential projects and companies.
Venture Capital is not suitable for all types of projects and only those who fulfill certain criteria will benefit from this type of investment. Some of the key criteria used for venture capital investment are as follows;
Entrepreneur & the management team behind the project
Venture Capital is invested in people’s vision and skills first and then in the project. A hardworking and talented management team with experience, ambitions and drive can make a not so exciting project highly successful. Whilst a not so capable team will hinder, or at worst, destroy even the best project in the world.
High Growth Potential of the Project
The project should be able to grow fast and expand largely within a time frame of a few years. This means that projects that are slow to grow or may take more than 5 - 7 years to grow to their full potential are not suitable. Normally high growth potential companies grow very little in their first 1-2 years, then after that time frame their growth rate is around 25 % at least annually and can go to even 200% or more per year depending upon individual factors.
Investment time horizons of 3-7 Years
Venture Capital investments are limited in their time frame of involvement and are usually set for a time period starting from 3 years to a maximum of 7 years . The project therefore should be able to realize its full potential within that time frame.
Higher ReturnsVenture Capital investors demand a higher return than usual returns. Such high returns are seen as compensation for the amount of risks taken and skills brought into the new company in which they have invested. Venture Capital investors expect returns of at least 3 - 5 times their initial investments. The minimum rate of return of investments that venture capitalists look for is 30 % return per annum.
Equity Partnership / Share ownership in the company and Active involvementVenture Capital investors are not passive investors who will write a check and then sit back. They are real partners who bring in not only cash but also value added skills that are often required by young companies. In return, they take equity participation in the company and are actively involved. This involvement varies from Investor to investor. For example they may facilitate the hiring of key people or bring in executives with a large network of contacts that the company may need to sell their products and /or services.
Venture Capital investors ‘exit’ after, and if the company has realized its full potential within the given time frame. It is through the ‘exit’ that investors realize the returns on their investments, mostly by capital gains. For ‘exiting’ the company, there are several possibilities. The classic method is listing in the stock market through IPO. Other methods are sales to a large industrial group, their shares being purchased out by other investors and/or management.
So let us see how this works with a hypothetical example. Suppose investors have invested 1 Million $ in a company for 25 % shares and equity. That means that company was worth in total 4 Million $ (1 Million $ for 25%). Now suppose this company grew very well and after 5 years the company is either listed on the stock market or sold to a large investors group for about 20 Million $. The investor’s 25 % shares will therefore be worth 5 Million $. So, the investment of 1 Million $ has grown to 5 Million $ over a 5 year period as the company has developed. By the selling of shares at that time, the ‘exiting’ investors have realized the returns on their investments. Such exits are very important for investors, as no matter what the value of the shares are on paper it is not worth that much if there are no buyers who are willing to pay for it. It is also a fact that most young innovative companies do fail due to the high degree of risk they carry.
Islamic Finance applied to Venture Capital. As you will see that the venture capital deals can be structured in an Islamic way specially as ‘Musharakah‘ transaction. Depending upon the type of the deal it can be Permanent or Diminishing Musharakah.
In this case, the investors participates in the equity of a company and receives an annual share of the profits on a pro rata basis. The period of termination of the contract is not specified. This technique is also referred to as continued musharakah.
Digressive or diminishing musharakah is a special form of musharakah which ultimately culminates in the ownership of the asset or the project by the client. It operates in the following manner: The investor participates as a financial partner, in full or in part, in a project with a given income forecast. An agreement is signed by the partner and the investor through which the investor receives a share of the profits as a partner. However, the agreement also provides payment of a portion of the net income of the project as repayment of the principal funds invested in by the investors. The partner is entitled to keep the rest. In this way, the investors share of the equity is progressively reduced and the partner eventually becomes the full owner.
Allah’s Blessing to all.
This article has provided you with some basic information about venture capital issues and hopefully has clarified any issues you may have had. Should you require further clarification or have any questions, please feel free to contact me.