In the previous article we discussed VC Financing as the vehicle for creating a ready source of finance for meeting the needs of high-risk innovative projects with potential for large returns. We also discussed the reluctance of conventional financiers to extend such finance. What are the genuine problems in dealing with financing of such projects? And how to overcome them? Such an analysis will help efforts by both the investors and the finance-seeker to appreciate each other's point of view and come to a meeting point.

Most high technology entrepreneurs are convinced that they have exciting and dramatic ideas. At the same time the skepticism with which the potential investors approach their concept and their demand for substantial equity are quite disturbing to entrepreneurs. What most entrepreneurs do not see clearly are the risks facing the business. There are certain fundamental problems that make them difficult to finance.

Focussing on this feature, Gompers and Lerner, the authors of "The Money of Invention : How Venture Capital Creates New Wealth" first focus on the four basic questions financiers must resolve before committing capital to a venture. These should be of special interest to startups and emerging ventures:

1. Uncertainty about the future

   1. Technological uncertainty

   2. Financial uncertainty

2. Information gaps

   1. Innovators' informational advantages

   2. Investors' informational advantages

3. "Soft" assets

   1. Patents and trademarks

   2. Human capital

   3. Future investment opportunities

4. Volatility of current market conditions

   1. Financial-market flaps

   2. The product-market pendulum

"Uncertainty arises due to the array of potential outcomes for the company or project. The wider the dispersion of the potential outcome the greater the uncertainty. The distinction between unknowability and uncertainty is critical. A careful analysis of a particular entrepreneurial project can identify key phases of uncertainty and provide an assessment of the likelihood of those various outcomes. This kind of thoughtful review constitutes the first step in determining a project finance alternative. While it is relatively easy to point out the various forms that uncertainty takes, it is far more difficult to quantify the financial implications. Uncertainty affects investors' willingness to contribute capital. By their nature young and restructuring companies are associated with significant levels of uncertainty."¹

"Due to his day-to-day involvement with the firm an entrepreneur knows more about his company's prospects than investors. This results in the information gaps between the entrepreneur and the investor. The problems that arise from information gaps inhibit many traditional investors from funding entrepreneurial ventures. For example, the entrepreneur may undertake a riskier strategy than initially suggested or may not work as hard as the investor expects. The entrepreneur might also invest in projects that build up his reputation at the investor's expense."¹

"The third factor affecting the firm's corporate and financial assets are soft assets. These assets include intangible assets like patents, trademarks and the collective ability of company's employees, referred to as human capital. It is much more difficult for an investor to estimate the value of soft assets such as trade secrets than hard assets such as plant and machinery."¹

Market conditions also play a key role in determining the difficulties of financing firms. Both the financial and product market may be subject to substantial variations. The ability of a young company to grow rapidly and respond swiftly is a key source of its competitive advantage. When this advantage is hindered by the above-mentioned factors the steps that can be taken to overcome these obstacles are getting a better sense of the risks in the industry, enumerating and setting clear goals to reduce information gaps, communicating clearly the firm's assets especially the soft assets and thinking clearly about financial and product market cycles."¹

"Entrepreneurs' most important task is to provide their prospective investor(s) with realistic and educational answers to these questions -- proactively. Both parties grow through this process. Entrepreneurs should welcome the intense scrutiny of the venture capitalist with the same appreciation as the intense scrutiny of one's physician; the questions and answers may not always be what we hope to hear, but an open and responsive "partnership" can lead to our best long-term health.

"Then looking at the venture capital side of this relationship, The Money of Invention emphasizes that "... Good investment strategies should utilize:

1. "Detailed due diligence and deal screening based on intensive industry knowledge and important networks of experts.

2. "Staging of investments to explicit milestones that are carefully thought out to correspond to the resolution of uncertainty.

3. "Syndication of investments to gather more information and diversity risk.

4. "Equity ownership and incentive compensation for senior management to directly link the interests of investors and the entrepreneur.

5. "Selective use of covenants and restrictions in critical areas that limit the potential conflicts that may arise.

6. Carefully thought out boards of directors that provide oversight, strategic advice, and credibility to the company."²

"On their part Venture Capital Financing Firms realize that they make money by identifying promising innovations early, investing capital to build their venture and aid the entrepreneur in growing the business. Unlike traditional lending institutions venture capital firms specialize in collecting and evaluating information"¹

Start-ups and Growth Companies

"The venture capitalist has a specific set of techniques that manage risk and encourage success. These techniques include a thorough screening and due diligence process that takes place before the decision is taken to invest. The next step is the staged financing, which is contributing financial support in discrete stages over time. Then syndication of investment, which involves bringing in other venture capitalists and diversifying commitments. The fourth step involves compensating contracts, which includes the use of stock grants and options, particularly convertible preferred equity that aligns investors and management incentives. The fifth step is providing for the covenants and restrictions that protect new venture firms' potentially damaging decisions by entrepreneurs and the last step involves the strategic composition of investors' boards and directors." ¹

[¹"Analyst" August 2002 - Book Review -"The Money of Invention : How Venture Capital Creates New Wealth"
²The Business Forum OnlineŽ Book Review "The Money of Invention - How Venture Capital Creates New Wealth" by Paul A. Gompers and Josh Lerner]

"The basic principal underlying venture capital - invest in high-risk projects with the anticipation of high returns. These funds are then invested in several fledging enterprises, which require funding, but are unable to access it through the conventional sources such as banks and financial institutions. Typically first generation entrepreneurs start such enterprises. Such enterprises generally do not have any major collateral to offer as security, hence banks and financial institutions are averse to funding them. Venture capital funding may be by way of investment in the equity of the new enterprise or a combination of debt and equity, though equity is the most preferred route.

"Since most of the ventures financed through this route are in new areas (worldwide venture capital follows "hot industries" like infotech, electronics and biotechnology), the probability of success is very low. All projects financed do not give a high return. Some projects fail and some give moderate returns. The investment, however, is a long-term risk capital as such projects normally take 3 to 7 years to generate substantial returns. Venture capitalists offer "more than money" to the venture and seek to add value to the investee unit by active participation in its management. They monitor and evaluate the project on a continuous basis.

"The venture capitalist is however not worried about failure of an investee company, because the deal which succeeds, nets a very high return on his investments - high enough to make up for the losses sustained in unsuccessful projects. The returns generally come in the form of selling the stocks when they get listed on the stock exchange or by a timely sale of his stake in the company to a strategic buyer. The idea is to cash in on an increased appreciation of the share value of the company at the time of disinvestment in the investee company. If the venture fails (more often than not), the entire amount gets written off. Probably, that is one reason why venture capitalists assess several projects and invest only in a handful after careful scrutiny of the management and marketability of the project.

"To conclude, a venture financier is one who funds a start up company, in most cases promoted by a first generation technocrat promoter with equity. A venture capitalist is not a lender, but an equity partner. He cannot survive on minimalism. He is driven by maximization: wealth maximization. Venture capitalists are sources of expertise for the companies they finance. Exit is preferably through listing on stock exchanges. This method has been extremely successful in USA, and venture funds have been credited with the success of technology companies in Silicon Valley. The entire technology industry thrives on it.