The convention of Task Force for SME Development was
held in Lahore at SMEDA office on November 21, 2004. Senior bankers and
finance experts including the famous banker Mr. Shoukat Tarin, who is
also a president of Union Bank, attended the meeting. They emphasized to
encourage and incorporate venture capital fund for SMEs in Pakistan.
It is an attempt to give a brief introduction of
venture capital investment and give some suggestions in connection with
the possibility of venture capital for SMEs in Pakistan.
Before introducing venture capital in Pakistan, an
aggressive awareness campaign for venture capital should be launched
through media to attract foreign as well as indigenous investors to
incorporate a venture capital fund and venture capital association in
Pakistan that are two basic requirement of the venture capital. Though
the basic work on possibility of venture capital in Pakistan has been
done with the help of Asian Development Bank (ADB). But yet more work is
required to be done because the proposal has not yet been materialized.
The overriding concern of writing this article is to
have a general or mental sketch of venture capital over all. Penguin
Dictionary of Economics defined venture capital, "Medium-Long term
funds invested in enterprises particularly subject to risk". We
should also consider the definition of Dr. Neil Cross, a Senior
Executive with 3i, one of the world's largest and longest established
venture capital companies, and a former Chairman of the European Venture
Capital Association. He defined, "The provision of risk bearing
capital, usually in the form of a participation in equity, to companies
with high growth potential. In addition, the venture capital company
provides some value-added in the form of management advice and
contribution to overall strategy. The relatively high risks for the
venture capitalists are compensated by the possibility of high return,
usually through substantial capital gains in the medium term." Let
us consider another definition to elaborate venture capital more which
appeared in the Quarterly Bulletin of Bank of England of 1984, 'an
activity by which investors support entrepreneurial talent with finance
and business skills to exploit market opportunities and thus obtain
long-term capital gains.'
For the general reader, venture capital is a form of
investment finance which is invested to have a high return subject to
risk. It has some major themes as under:
* It is equity finance
* Require hands-on management;
* Provides superior return through capital gain;
* Require patience.
One should be clear and can distinguish between debt
and equity to understand venture capital. Debt is repayable on a date
certain, it bears interest, and tends to be passive. Ordinary equity, on
the other hand, affords the holder certain rights and privileges, which
make him an active participant in the ownership, management, and profit
Debt Finance is a loan often from bank or a building
society like House Building Finance Corporation. These financial
institutions lend a sum of money to a borrower on contractually agreed
interest. Like House Building Finance Corporation advances home loan for
20 to 20 years on certain interest rates.
Equity Finance is a form of percentage share in the
enterprise or investment in the enterprise subject to risk. Nowadays,
the rates of property in Karachi or major cities of Pakistan are growing
rapidly. People like to invest in the property business subject to
reasonable profit in the future. Suppose, a group of five people wish to
purchase a bloc of flat in Karachi with a view to getting profit in near
future. They purchase this bloc of flat on amount agreed. Each person
will contribute 20% amount and will get 20% profit in the future. It
means each individual shared 20% equity of this bloc of flat. This is
the form of equity finance. Typically, a venture capitalist may seek
between 20% and 49.9% of the common shares in a company. The size of the
stake must be large enough to allow the venture capitalists to influence
his fellow shareholders (in particular the entrepreneur manager) while
not so large as to loose sight of the fact the venture capitalists are
investors not operator. Majority control is rarely sought. The share
exchanged in return for the financial injection allow the venture
capitalist to share in the company's profits, to exercise all of the
other rights and privileges that a co-owner or partner might enjoy.
VENTURE CAPITAL REQUIRES HANDS-ON MANAGEMENT
People of Europe and USA or other advanced countries
are aware of venture capital. It is important to stress that venture
capital is not necessarily or of itself a panacea for unemployment and
does not in itself create jobs, encourage entrepreneurship, or stimulate
research and development. Rather, the majority of venture investment is
directed towards existing, profit making, or soon-to-be-profit making
It is wrong perception that venture capital investing
is an injection of equity into identified growth businesses. Venture
capital investment is characterized by its hands-on, as opposed to
arms-length, nature. The distinguishing features of hands-on investment
are the time and effort which the investor is prepared to put into each
transaction, and the after-management of each investee company within
the portfolio. The venture capital firm may take between 20% to 49.9% of
a company's voting equity. In some cases this will mean that the venture
capital firm will be the minority shareholder, behind the entrepreneur's
controlling stake. Equally likely, however, the venture capital firm's
holding will make it the largest individual shareholder where two or
more entrepreneurs, other investors such as employee and non-Executive
Directors, or even another venture capital firm has taken equity in a
company. The venture capital portfolio manager cannot therefore be
content to receive a regular flow of information from his client firm,
but must become personally involved in the firm's activities.
PROVIDE SUPERIOR RETURN THROUGH CAPITAL GAIN
Given the risks inherent in providing equity as
opposed to debt, it follows that those in the business of providing
venture capital must do so only if the expected value of their return on
investment is sufficiently high to justify those risks. Debt financier,
such as banks, whose range of possible returns can be narrowed, can lend
to borrowers promising only moderate returns. The venture capitalist
must offset his risk by confining his investment to venture exhibiting
potential for above average returns on equity. The figure normally cited
is for a return of approximately 40% per annum, compounded. Phased
differently, many venture capitalists refer to 'a three times return
after three years' or 'a five time return after five years'.
In seeking individual investments with above average
returns, the vast majority of venture capital firms accept that some
proportion of their portfolio will in fact yield only a marginal or no
return at all. A survey was conducted in UK and it was contented that
two out of ten venture capital investment had failed altogether. A
further six investment out of ten, the bulk of the venture capital
investment portfolio, were expected to yield no more than the market
rate of return. These would provide a steady, but unremarkable income,
which would sustain the portfolio. Only two investments in ten are
expected to yield the extraordinary returns, which will raise the
overall return of the portfolio. This phenomenon is known in the
industry as the rule of 2:6:2, indicating the relative occurrence of
outright losers, acceptable investment and clear winners in any venture
In becoming an equity investors, the venture capital
firm exposes itself to the widest possible range of returns. This is the
nature of the venture capitalist's risk: not a lower expected return but
a greater, and less certain range of return.
VENTURE CAPITAL REQUIRES PATIENCE
As venture capital is well developed in the Europe
and USA. The world follow the American model of venture capital, which
was first introduced between the 1960s and 1970s, and later on after
1980s in UK. They are aware of the maturity period and they can wait.
Venture capital requires patience because it needs
long time to maturity. Ultimately the reward from venture capital
investing come when the venture capitalist sells his shares to another
buyer. Typically the payoff will come through one of four means of
realization or exit:
* Trade Sale
* Earn Out
* Take Out
Which ever is the exit mechanism, the prospective
venture capital investor must be prepared to recognize that none of them
will come quickly. Venture capital investment take a long time to
mature. Given their focus on sometimes small, usually unlisted firms,
venture capital investment lack the liquidity of an investment in a
listed firm. The industry tends also to be cyclical, its fortunes
fluctuating with the initial placement market. These factors highlight
the need for patience.
In establishing an illiquid, long-term portfolio, an
investor must recognize two prerequisites. One, which lies within the
control of the portfolio manager, is the need for patience. The second,
which lies outside the control of the portfolio manager, is the need for
a political economy that is sympathetic and conducive towards long-term
SEVEN STAGES OF VENTURE CAPITAL FUNDING
Venture capital investment is a homogeneous product:
i.e. all long-term equity investment made by professional investors are
made in the same kinds of companies, or the same kind of reasons, and
with the same sorts of expectations concerning risk, maturity, and
In a spectrum of lending from the local Pakistani
banks, we can distinguish between a large variety of loan products, for
example, credit cards, car loan (which might have a maturity of 3 to 5
years), and home mortgage (which have a maturity of 20 to 25 years).
Because different verities of loan involve different sets of risks,
rewards and different expectation, lending institutions sometimes
specialize in different products, or become the dominant suppliers of
these products. While the distinctions between banks and building
societies are rapidly becoming blurred.
Following are the seven stages of venture capital
life cycle in the approximate order in which an investee company would
require each form of finance. They range from an investment type which
may take eight years or longer for realization (seed capital) to one
which, by its very nature, is intended purely as bridge finance
* Seed capital
* Start up capital
* Early stage finance
* Second round finance
* Expansion capital
* Management buy-outs and buy-ins
* Mezzanine finance
The rationale for providing seed capital investment
is that from tiny acorns mighty oak trees grow. Seed capital is
investment into the gem of an idea, or a concept — as opposed to a
business. European Venture Capital Associations defines seed capita, the
financing of the initial product development or the capital provided to
an entrepreneur to prove the feasibility of a project and qualify for
start-up capital. The following are the characteristics of seed capital:
* The absence of a ready to market product;
* The absence of a complete management team;
* A product or process which is still in the research or development
Typically, seed corn enterprises lack the asset base
and/or the track record to obtain debt from conventional sources
(working capital lines or bank term loans) and are largely dependent
upon the entrepreneur's personal resources. Moreover, seed capital
investment may take from 7 to 10 years to achieve realization.
This is the second stage of venture capital
investment cycle. At this stage the business concept has been fully
investigated, and the business risk now becomes that of turning the
concepts into a product. In this scenario the investee moves closer
towards the establishment of a going concern. The European Venture
Capital Association (EVCA) defines start-up capital as:
Capital needed to finance the product development,
initial marketing and the establishment of product facilities. (P. De
Vree, as quoted in the Proceedings of EVCI, No.,1, 1988)
It has the following characteristics:
* the establishment of a company; whether by
incorporation or partnership;
* the establishment of some — but not all — of the management team;
* the development of a business plan, and a prototype product or fully
* the absence of a trading record.
The time horizon for a start-up capital investment
will typically be some 6 to 8 years.
EARLY STAGE FINANCE
With the passage of time, the company matures and it
becomes less risky investment for the would-be (a person who desires)
provider of equity capital. As it passes through the start-up and into
the early success stage of its life cycle, a proven management team will
have been put into place, a range of products will have been established
and an identifiable market will have been targeted. British Venture
Capital Association defines early stage finance as:
Finance provided to companies that have competed the
product development stage and require further funds to initiate
commercial manufacturing and sales. They will not yet to be generating
profit. (Report on Investment Activity, 1986).
It has the following characteristics:
* Little or no sales revenue.
* Cash flow and profits are still negative.
* A small but enthusiastic management team which
consists in most cases of entrepreneurs with a technical or specialist
background and with little experience in the management of a growing
* Short term prospects for dramatic revenue and
Early stage investment might typically have a four to
six year time horizon to realization.
SECOND ROUND FINANCE
The would-be venture capitalist should recognize that
owner-manager is looking for a partner with a strong balance sheet, a
generous supply of patience, and the willingness to ride out the
inevitable set-backs. It is stressed that venture capital investing
often, and as a matter of course, may call for a second and sometimes
third injection of capital. The provisional need for an investor
prepared to dig into deep pockets will therefore drive many
entrepreneurs to seek larger, better capitalized investors.
We can define second round finance as 'follow on'
that is the provision of capital to a firm which has previously been in
receipt of external capital but whose financial needs have subsequently
Following are the characteristics of the second round
* a developed product on the market;
* a full management team in place;
* sales revenues being generated from one or more products;
* losses on the income statement or, when it is breaking even, a
negative cash flow.
In the venture capital life cycle, second round
financing will typically come after the start-up and early stage
funding, and should be expected to have a shorter term to maturity.
The American and European refer to themselves as
'development' rather than 'venture' capital provider. It is a means
showing where their activities lie in terms of the venture capital life
cycle. Expansion and development are here used as synonymous term.
Expansion can be defined that expansion capital refers to the finance
provided to fund the expansion or growth of a company which is breaking
even or trading at a small profit. Expansion or development capital will
be used to finance increased production capacity, marker or product
development and/or to provide additional working capital.
It has the following characteristics:
* Investment in companies that have been
substantially self-financed since foundation, and are seeking outside
equity for the first time.
* The provision of second round finance to a company
that has already received at least one round of early stage capital from
Companies seeking development finance for the first
time will typically be more mature than those seeking second round
finance, and sales of proven products normally tend to be at a higher
level. These companies may well able to continue without an injection of
external capital, but the entrepreneur is perhaps attracted by the
possibility to accelerate the company's growth or, in certain
circumstances, to realize a part of his own equity. Firms of this nature
may lend themselves easily to a trade sale. However, an initial
placement on a public exchange may produce a better price.
MANAGEMENT BUY-OUTS AND BUY-INS
One may confuse to hear management buy-outs and
buy-ins. Penguin Dictionary of Economics defines it as —
The acquision of all or part of the equity capital of
a company by its directors and senior executive, usually with the
assistance of a financial institution. In a management buy-ins an
outside team of managers acquires a company in the same way.
The management buy-out has much in common with, and a
number of difference from, other form of venture finance such as
start-up or development capital. The common aspects of MBOs and other
form of venture capital finance are:
* MBOs are corporate finance, in the form of equity,
in situation where the ability to obtain debt may be constrained due to
the high level of gearing that would occur.
* MBO finance is above all else an investment into
the management of the investee firm.
* MBOs require the surrender of a portion of
management's equity, in return for finance from the venture capitalist.
Although the venture capitalist may be supplying some debt component to
the acquision, it is through the equity that he hopes eventually to make
The MBO is a very late stage form of venture finance.
As such, it typically involves less risk than some other stages. In
assessing MBO opportunities, venture capital investors typically seek
three characteristics of the investee firm:
* Proven management.
* A history of profitability.
* A history of market share.
MBOs, unless followed by a period of asset stripping
by the new owners, will typically take two or three years to fruition.
The last stage of equity related funding is so-called
mezzanine finance. The term mezzanine is used for two reasons:
* it is a half-way stage between equity and loan
capital in terms of risk and return;
* it is often the last financing supplied to a
private company in the final run up to a trade sale or a public
Mezzanine financing is supplied as a layer which
makes behind secure lending but before ordinary share capital. Thus,
mezzanine funding may be supplied either as debt (high coupon bonds) or
as high ranking equity (preference share). To compensate for the greater
risk attached to unsecured lending, or the lack of voting power in
preference share recipients of mezzanine financing must offer a higher
rate of return than to secured lenders. Typically, mezzanine funds
expect to earn 300 to 400 basis point more than secured loan or senior
Supplier of mezzanine finance point to the following
characteristics of mezzanine capital which distinguish it from
investments in ordinary share capital, and which make it more attractive
as venture capital investment:
* when structuring an MBO, the provision of mezzanine
finance allow management a greater share of business than would
otherwise be afforded;
* being lower risk than ordinary share capital, it
requires a lower rate of return;
* if provided by way of debt, it has tax advantages;
* it can be secured.
Mezzanine financing is intended as a form of bridge
finance. Typically, therefore, it is expected to have a maturity of less
than two years.
AMERICAN MODEL OF VENTURE CAPITAL
The American are the inventors of Venture Capital and
it was first introduced in USA in between 1960s and 1070s. There have
always been people willing to start business, and other people willing
to back them and share the risks and rewards of enterprise, so that in a
sense there has always been enterepreneurship and venture capital. What
is distinctive about American venture activity is that it represents a
successful attempt to institutionalize entrepreneurship, and
particularly enterpreneurship associated with technical innovation.
The essence of American-style venture activity is
simple. A venture firm will raise money and use it to fund companies
started by entrepreneurs. Many of these companies will use advanced
technology; some will have been formed specifically to exploit a
technical development. The investment will take the form of share
capital. The firm will buy the shares of the enterprise, and so become,
together with the entrepreneurs and other investors, its joint owners.
If the enterprise fails, the venture capital firm will lose its money.
If the enterprise is successful, then the venture capital firm will sell
the shares and take its profits.
But this simple formulation is in many ways
deceptive. Venture activity can only take place in certain conditions.
There have, for example, to be investors who are willing to take great
risks, and wait for many years before they see any return on their
money. The venture capitalists who mange this money have to have
considerable technical expertise and business experience. There has to
be a large pool of entrepreneurs, willing to risk their careers and
perhaps their personal savings. Not only must the entrepreneurs be
technically qualified; they have also to be skilled mangers, capable of
bringing a company into existence and directing its growth. Venture
activity depends also on number of markets: a labour market from which
the people needed for a new company can be taken in; markets for the
technically advanced products and services the new companies offer; and
a market for the shares of companies, so that the investors can
eventually realize their gains. Political stability is another important
precondition: the period between investment and return is likely, after
all, to take several years. And the incidence of taxation — especially
capital taxation — has to be sufficiently light not to discourage
investors and entrepreneurs from taking risks.
These conditions have rarely been met satisfactorily,
even in the United States. They did not obtain there during the 1960s
and early 1970s, when venture capital activity was subdued. But
administration of pension funds, large amount of money began to flow
into the venture capitalist grew extremely rapidly. Their success
attracted even more investment.
These American development soon came to the attention
of governments and business organizations in other industrial countries.
Many of them sent missions to the United States to study venture
capital. These came away impressed by the way in which a few hundred
venture capitalists had been able, by placing money with the right
entrepreneurs, to bring thousands of new business into being. Some of
these business were rapidly becoming formidable industrial companies:
Apple computer, Computervision, Data General, Digital Equipment, Intel,
Prime, ROLM, Tandem. Many of the enterprises backed by venture capital
were using techniques such as genetic engineering, or producing goods
and services, like microprocessors and computer aided design, which
scarcely existed outside the United States. And the cumulative effect of
venture activity was that entire regions.
INVESTMENT METHOD AND RETURNS
There are perhaps 125 major venture capital firms in
the US — though there are several hundred regional and minor firms.
Some are divisions of large corporations like General Electric. Others
are offshoots of financial institutions such as banks and securities
houses. But most venture capital firms are partnerships.
A partnership consists usually of three or four
individual partners and a similar number of associates, who come
together in order to raise money from large financial institutions and
invest it in new and rapidly growing companies. The partners and
associates of the more famous firms are nearly always businessmen of
great ability. Usually one or two of the partners in any partnership
will have been entrepreneurs themselves. Other will have been seniors
managers in outstanding companies, such as Hewlett Packard. Several of
them will have technical qualification. One or two will probably have
worked in Wall Street. The partners may invite a number of well-known
industrialists and entrepreneurs to join a Board of Advisors, partly to
confer prestige on the firm, and partly to help bring in business and
help review investment proposals.
The Recent Latin American Case (The Brazilian Case of
The following survey of venture investment in Brazil
has been released by Thomson Venture Economics at their website. This
shows the case of developing countries. If such investment introduced in
Pakistan it will not take many years to grow because of the rapidly
growing economic activities in Pakistan where in every field there is a
profit and has less chances of loss.
PUBLIC MARKET INDEX
COMPARISON AS OF 12/08/2004
1 day chg
1 day % rtn
YTD % rtn
1 yr % rtn
3 yr % rtn
APPLICATION OF VENTURE CAPITAL IN PAKISTAN
The Pakistan economy in the recent years is showing
marvelous grading and is comparable with any growing economy. It is also
showing resilience from shocks. The recent trend of investment in
Pakistan is growing fast and reached almost over US $ 900 millions in
2004-2005. Apart from the industrial investment, the foreign investors
shown keen interest in other sectors of the economy like agriculture,
mining, oil and gas, iron and steel, real estates, associates of
building of dams, many foreign banks as well as local banks are
increasing their portfolios, the emergence of consumer baking in
Pakistan is opening new avenues for banking sectors in Pakistan.
Recently, a Saudi Arabian Group agreed to invest in real estate to
provide houses and flats to 60,000 people in Pakistan. In short the
economic activities accelerated to a considerable numbers that is an
emerging paradise, which is waiting for foreign investors so the new
horizon of venture investment in Pakistan.
Not only the SMEs but also the big enterprises may
take advantages from venture investment fund.
THE INCORPORATION OF VENTURE CAPITAL FUND
The Security Exchange Commission of Pakistan may be
assigned a job to find out the possible means of incorporating Venture
Capital Fund in Pakistan according to the state and the need of SMEs in
Pakistan. However, Venture Capital may be formulated on the lines of
British Venture Capital Fund. The venture capital in UK was introduced
in 1980s and the early stage of this fund was as follow that is to have
a mental picture of the fund:
UK Pension Funds
UK Insurance Companies
Fund Management Groups
Sub-Total: Financial Sector
Sub-Total: Non Financial Sector
Sources of publicly raised venture
capital in the UK 1982 and 1986 (Figure from Venture Economics)
THE STATE OF SMES IN PAKISTAN
In Pakistan, SMEs are defined in terms of employment
generated and productive assets. SMEs primarily based on the number of
personnel employed in the enterprise. Small enterprise is defined as
having 10-35 employees with mere 2 to 20 million assets, and medium
enterprise having 36-99 employee mere 20 to 40 million assets.
In Pakistan SMEs provide employment to 65% of the
work force in industrial sector. They contribute to gross domestic
product (GDP) around four times as much as the large scale industries.
According to the Economic Survey of Pakistan 1998-99,
SMEs with a mere 20% investment and resources to less than 10% of the
total formal credit, generated 80% of the country's total employment.
In short, this sector has the potentials to absorb
venture capital fund. The following should be done:
* SMEDA should manage a data along with their
business profile of SMEs at Pakistan level so that the actual figure and
the state could be known.
* SMEDA for the first few years at the door of SMEs
should give free consultancy on the book keeping, taxation, and their
business records and accounts etc.
* SMEDA has already done extensive study on the
possibility of venture capital in Pakistan with the help of Asian
Development Bank (ADB). So the need of composition of venture capital
fund should be on priority agenda.
* Free book lets and pamphlet on the venture capital
investment in Pakistan should be published extensively and distributed
at national and international level like Foreign mission abroad etc to
aware the foreign as well as indigenous investors the factual position
and the possibility of venture capital investment in Pakistan.
INCORPORATION OF PAKISTAN VENTURE CAPITAL ASSOCIATION
Government of Pakistan may encourage private and
foreign investors to incorporate venture capital association to assist
the SMEs as well as big enterprise to secure financing from the fund.
SECP be assigned a job to formulate policy on the subject without
further delay as the competition on the horizon of WTO regime is
critical. Now, the time is to take decision to boost the economic
activities in Pakistan, where the main focus is SMEs.
HOW SMES IN PAKISTAN CAN SECURE FINANCING FROM
VENTURE CAPITAL FUND?
Once the Venture Capital Fund is developed, the SMEs
would have more chances to benefit from the fund. However, it is
important to note that the venture capitalists prefer growing business
if properly maintained. By the following way, the SMEs can secure more
financing from venture capital fund:
* The track records of business should be good.
* Yearly balance sheet of the company should be
* Taxation documents should be properly maintained
viz. income tax and sales tax etc.
* Banks relationships should be good.
* There should be good management team in the company
that would further be assisted by the venture capitalists.
* Finally, there should be a growing business and it
has the potentials to absorb venture investment, which has a reasonable
return in near future.
VENTURE CAPITALISTS WILL PREFER THE FOLLOWING
* The SMEs who are in contract with the large and
well established firms and companies as per their specialization. These
large and well established firms and companies already know the
creditworthiness of these SMEs. Therefore, it would be easy to secure
more from venture capital funds.
* These large companies have sufficient information
about the SMEs who are the supplier of goods and services to them. These
companies can share the information with the lending venture
capitalists. In this way the SMEs can secure more from venture capital
* The large firms confer a lot of externalities by
assisting these SMEs in designing, quality control, technical know-how
etc. and helping improve their productivity. Some of the SMEs through
this process will mature and cross the threshold and become the venture
capitalists of the future.
* Intermediation is an integral part of securing
financing from bank. The SMEs may take help from SMEDA in connection
with technical know-how, marketing, managerial skills, accounting and
book keeping, preparation of basic financial statements. The SMEs may
pay for the services, as it will improve the venture capitalist to
consider the proposal and requests for fixed capital as well as working
* In Pakistan there is a gap between small enterprise
which are incapable of presenting the documents required by the banks
and the insistence of the banks that they cannot appraise credit risk
unless the necessary cash flow projections and other information become
available. The same would be in the case of venture capitalists who see
the risk of their investment in the SMEs. Though SMEDA is present to
provide these services. The SMEs may benefit from this body.
In concluding, the venture capital if introduced and
encouraged in Pakistan it will have better impacts on the economy of
Pakistan especially it will create employment and reduce poverty in the
country, as Pakistan has become an emerging paradise for foreign as well
as indigenous investors, the venture capitalists may benefit from the
growing economy of Pakistan.