Financial Markets & Services

Module -2 Venture Capital

Venture capital (VC)
Venture capital (VC) is a form of private equity funding that is generally provided to start-ups and
companies at the nascent stage. VC is often offered to firms that show significant growth potential and
revenue creation, thus generating potential high returns.
Venture capital is a way for investors to help finance startup companies. It can be defined as –
“Long-term minority and temporary investment, by specialized capital investment companies, in small
and medium-sized companies with great prospects for profitability and/or growth.”
It is a type of financing granted to private businesses by investors in exchange for a partial portion of
the company.

The main characteristics of venture capital –

1. Venture capitalists take a share in the company’s capital stock by purchasing shares.
2. It is a way of channelling savings.
3. The receiving company is limited to letting the investment company enter its shareholding.
However, it is normal for the receiving company to bear the costs caused by the investment
company’s entry into that capital.
4. Venture capitalists invest in small and medium-sized companies because they can offer the
greatest possibilities for expansion and development.
5. Investment is usually directed to new economies.
6. The investment is mainly for companies in the growth or start-up phase.
7. The investment company assumes greater risks than those that a credit institution is normally
willing to assume.
8. For venture capital investors, the main benefit is obtaining high capital gains from the interest
Rates.

Types of Venture Capital

The term venture capital or private equity is often used interchangeably to refer to any investment not
traded on a regulated market. However, there are more exact terms to define these investments
according to the development phase of the company to which they are addressed:
1. Seed Capital
Seed capital is required before a business’s launch to conduct market research and start forming
a company. Investors acquire a part of the capital of companies in their early stages.
2. Growth Capital
This type of private equity investment focuses on acquiring minority stakes in mature
companies seeking financing for their expansion or restructuring plans.
3. Startup & Early-Stage Capital
This type of capital is used to recruit key management, conduct additional research, and prepare
a product or service for the market. After launch, early-stage capital can help the business
increase sales to reach the break-even point and increase efficiency.
4. Expansion and Late-Stage Capital
Such funding expands a company’s production to other products or sectors and also increases
market efforts for new products.
5. Bridge Financing
Bridge financing is capital that can be offered to help a company reach an important milestone,
such as an initial public offering or a merger.

The steps involved in venture capital financing:

1. Deal origination
The origination of a deal is the first step in venture capital financing. Deal flow is crucial to
venture capital. When approaching a venture capital firm, it is necessary to submit a business
plan, which includes elements such as:
executive summaries of business proposals
analysis of the competitive landscape and opportunities and the market potential
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Module -2 Venture Capital
detailed financial projections, description of the company's management
2. Screening
Venture capitalists screen all potential projects before investing. They classify projects based
on several factors, including the size of the investment, the technology involved, the location,
the investment size and the stage of financing. Entrepreneurs who wish to participate in the
screening process can provide a brief outline of their venture or be a part of an in-person
meeting for clarifications.
3. Evaluation
An evaluation of the proposal follows a preliminary screening. The assessment considers
factors such as the project profile, market potential, technological feasibility and profitability.
In addition to the entrepreneur's skills, manufacturing, marketing and technical knowledge are
also part of the evaluation. Risk management entails considering these factors followed by deal
negotiation.
4. Deal negotiation
Having found the project to be beneficial, the venture capitalist negotiates the deal. Deal
negotiations are the process of creating a deal that is mutually beneficial for VCs and founders.
Ideally, both parties reach an agreement on their demands. Venture capitalists and entrepreneurs
negotiate a number of factors, including how much investment they would make, the percentage
of profits they share and their rights.
5. Post investment activity
The venture capitalist becomes a partner and collaborator of the enterprise once it receives the
funding. Venture capital firms typically participate in the enterprise through representation on
the board of directors or improving the quality of marketing, finance or other managerial
functions. Risky financial situations usually call for the involvement of capitalists.
6. Exit plan
When a business or investment venture achieves its profit objectives, an exit strategy may also
be implemented. Exit planning for venture capital investments is based on the extent of
investment and the financial stake. Exit plans aim to minimise losses and maximise profits. The
venture capitalist may exit through an initial public offering, an acquisition by another firm or
by selling their shares to the promoter.

Lease
A 'lease' is a temporary transfer of property from the owner to another person for a certain period of
time and for consideration (i.e. for payment or value). The 'lessor' is the person giving the property on
lease and the 'lessee' is the person receiving the property on lease. Rent, premium, consideration, fees,
etc.
A lease refers to a legal contract or agreement between a property owner, known as the landlord or
lessor, and another party, referred to as the tenant or lessee, that allows the latter to use and occupy the
property for a defined period in exchange for regular payments.
Leases commonly apply to real estate, such as apartments, houses, and commercial spaces, but they can
also be used for assets like vehicles and equipment.

Types of Leases
1. Operating Lease
In an operating lease, the lessee uses the asset for a period significantly shorter than its useful
life. The lessor retains the risks and benefits of ownership, and the lease expenses are treated
as operating expenses on the lessee's income statement.
2. Finance Lease
Also known as a capital lease, a finance lease is a longer-term lease in which the lessee
essentially acquires all the risks and rewards of ownership, even though the legal title may
remain with the lessor.
The leased asset and the corresponding lease liability are recorded on the lessee's balance sheet.
3. Sale and Leaseback
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Module -2 Venture Capital
In a sale and leaseback arrangement, an asset's owner sells the asset to another party and then
leases it back. This arrangement allows the original owner to continue using the asset while
freeing up capital.
4. Direct Lease
In a direct lease, a lessor who is not the manufacturer or the seller of the asset purchases the
asset and leases it to a lessee. The lessor acquires the asset specifically for the lease agreement.
5. Leveraged Lease
A leveraged lease involves a lessor, a lessee, and a lender. The lessor borrows funds from the
lender to purchase the asset, which is then leased to the lessee. The lender is repaid from the
lease payments.

Components of a Lease
A lease agreement is composed of several key components.
1. Lessor and Lessee: The lessor is the legal owner of the asset and the party that leases the asset
to the lessee. The lessee is the party that obtains the right to use the asset in exchange for lease
payments.
2. Lease Term: The lease term is the duration for which the lease agreement is valid. During this
period, the lessee has the right to use the asset under the terms specified in the lease agreement.
3. Lease Payments: Lease payments are the regular payments that the lessee makes to the lessor
for the use of the asset. The amount and frequency of these payments are detailed in the lease
agreement.
4. Residual Value: The residual value is the estimated value of the leased asset at the end of the
lease term. It plays a crucial role in determining the lease payments.

Advantages and disadvantages

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Module -2 Venture Capital

Factoring
Factoring – also known as invoice factoring or accounts receivable financing – is the process in which
businesses receive advances against their accounts receivables. There are three parties when it comes
to factoring: the debtor (buyer of goods), the client (seller of the goods), and the factor (the financier).
This type of financing is often utilized to manage book debt.
Forfaiting
Forfaiting is a financing option exporter use to receive immediate cash. How it works: The exporter
sells its claim on medium and long-term trade receivables to a forfaiter at a discounted rate to receive
fast access to cash. The benefit: Exporters minimize the risk of factoring by selling without recourse,
which means the exporter is not liable when the importer fails to pay the receivables.
What is the Difference Between Factoring and Forfaiting?
The main difference between the two is that factoring can be used in domestic and international trade,
whereas forfaiting only applies to international trade financing.
Here are eight additional key differences between factoring and forfaiting:
1. The process
Factoring: a financial arrangement where business owners sell their pending invoices (accounts
receivables) to a third party (factoring companies, lenders, or banks) in exchange for fast cash.
Forfaiting: belongs under export financing in which an exporter sells their rights of trade receivables to
a forfaiter to acquire immediate cash payment.
2. Timing
Factoring: deals with short-term accounts receivables, which typically falls due within 90 days or less.
Forfaiting: deals with medium- to long-term accounts receivables.
3. Sale of receivables
Factoring: the sale of receivables is usually on ordinary products or services.
Forfaiting: the sales of receivables are on capital goods.
4. Percentage of financing received
Factoring: business owners usually get 80% to 90% financing.
Forfaiting: funds exporters with 100% financing of the value of exported goods.
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Module -2 Venture Capital
5. Negotiable instruments
Factoring: deals with negotiable instruments, such as promissory notes and bills of exchanges.
Forfaiting: does not deal with negotiable instruments.

Types of Factoring
Here are the primary types of factoring:
1. Recourse Factoring:
In recourse factoring, the business is responsible for collecting accounts receivable. If a customer does
not pay the invoice, the business must buy back the invoice from the factoring company. This form of
factoring is often less expensive for businesses but carries more risk.
2. Non-Recourse Factoring:
Non-recourse factoring transfers the risk of non-payment to the factoring company. If a customer
defaults, the factoring company absorbs the loss. Non-recourse factoring is generally more expensive
for businesses due to the added risk protection.
3. Full-Service Factoring:
Full-service factoring involves a comprehensive arrangement where the factoring company not only
advances funds against invoices but also manages credit checks, collections, and other accounts
receivable services. This option provides businesses with extensive support in managing their accounts
receivable.
4. Spot Factoring:
Spot factoring, also known as single-invoice factoring, allows businesses to choose specific invoices to
factor rather than committing to factoring all their invoices. This flexibility can be useful when only a
portion of invoices needs immediate cash flow support.
5. Bulk Factoring:
Bulk factoring involves factoring a large group or batch of invoices simultaneously, which can provide
significant working capital in a single transaction. This type of factoring is often used for seasonal
businesses or businesses with large volumes of accounts receivable.
6. Invoice Discounting:
Invoice discounting, often used by businesses with established credit control procedures, allows a
company to retain control over the collections process. The factoring company advances funds against
invoices, and the business is responsible for collecting customer payments.
7. Export Factoring:
Export factoring is tailored for businesses involved in international trade. It provides financing for
invoices related to exports. Export factoring companies may offer services such as currency conversion,
credit protection, and assistance in dealing with foreign customers.
8. Construction Factoring:
Construction factoring is designed for businesses in the construction industry. It addresses specific
challenges, such as slow payments and the need for cash flow to cover labour and material costs.
9. Medical Factoring:
Medical factoring is designed for healthcare providers, including medical practices and hospitals. It
helps these businesses manage cash flow and meet financial obligations while waiting for payments
from insurance companies and patients.

Guidelines on Factoring.
1. Any assignor may, by an agreement in writing, assign any receivable due and payable to him
by any debtor, to any factor, being the assignee, for a consideration as may be agreed between
the assignor and the assignee and the assignor shall at the time of such assignment, disclose to
the assignee any defences and right of set off that may be available to the debtor.
2. On execution of agreement in writing for assignment of receivables, all the rights, remedies and
any security interest created over any property exclusively to secure the due payment of
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Module -2 Venture Capital
receivable shall vest in the assignee and the assignee shall have an absolute right to recover
such receivable and exercise all the rights and remedies of the assignor whether by way of
damages or otherwise, or whether notice of assignment as provided in clause 6 below is given
or not.
3. Where an assignment of receivables constituting security for repayment of any loan advanced
by a creditor and where the assignor, with the written consent of such creditor, has given notice
of such encumbrance to the assignee, on acceptance of such assignment, the assignee shall pay
the consideration for such assignment to the creditor.