Jan 10 - 16, 2005



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 sharing.

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.


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 businesses.

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.


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 capital portfolio.

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.


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
* Flotation

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 equity investment.


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 investment performance.

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 (mezzanine).

* 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 stage

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 developed idea;
* the absence of a trading record.

The time horizon for a start-up capital investment will typically be some 6 to 8 years.


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 business.

* Short term prospects for dramatic revenue and profit growth.

Early stage investment might typically have a four to six year time horizon to realization.




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 expanded.

Following are the characteristics of the second round finance:

* 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 other sources.

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.


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 his gains.

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 flotation.

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 debt.

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.


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.


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 Venture Investment)

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.



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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 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



Foreign Institutions



UK Banks



Fund Management Groups



Sub-Total: Financial Sector



Private Individuals



Industrial Corporations






Sub-Total: Non Financial Sector



Sources of publicly raised venture capital in the UK 1982 and 1986 (Figure from Venture Economics)


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.


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.


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 maintained systematically

* 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.


* 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 fund.

* 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 capital.

* 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.