Equity Investment: Decision Making – Business Valuation

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Table of Contents

Introduction
Literature Review
Conclusion
List of References

Introduction

The acquisition of capital is a challenge faced by businesses. However, business enterprises can obtain startup funds from venture capital firms. Venture capital focuses mainly on high-risk startup businesses. Often, entrepreneurs seek venture capital once their businesses are operational and need expansion.

Venture capitalists, however, prefer to finance high-risk businesses that promise high financial returns (Bart & Mlambo 2008, pp. 33). Nevertheless, venture capital firms usually perform evaluation of new investment opportunities before they decide to invest in a new venture. They use both qualitative and quantitative data in evaluation processes. Nonetheless, their evaluation processes do not yield dependable results.

Notably, new ventures do not have relevant revenue and financial performance information that can be used in evaluation processes. Moreover, venture capital firms usually have lean staff. However, they have to evaluate numerous proposals to determine appropriate ones.

This affects the productivity of venture capitalists’ staff. This paper presents literature on decision assembly and business evaluation considerations that venture capital firms consider before they finance a project.

Literature Review

Venture Capital

Many entrepreneurs have business ideas but lack the required funds to start business operations. Banks and other debt finance providers can fund business projects that entrepreneurs have. However, these organizations do not fund high-risk businesses.

Moreover, they require much information that startup businesses do not have. Hence, entrepreneurs turn to venture capitalists since they focus on high-risk businesses that have high financial rewards.

However, the problem that venture capital firms and entrepreneurs face is the determination of the financial viability of an enterprise to be financed. Additionally, there is little academic guidance on the determination of financial viability of an enterprise (Wong 2009, pp. 62).

The inadequacy of information on new ventures and the ineffectiveness of venture capital market creates theoretical and economic challenges in valuation of new businesses. Valuation approaches of businesses rely on accounting information. However, new ventures do not have such information. Hence, venture capitalists can use nonfinancial methods to determine whether to invest in a new venture or not.

The arrangement of investment markets facilitates the existence of venture capital. Venture capital assists entrepreneurs who do not have adequate capital. The return on capital that they use to finance entrepreneurs is high. The high returns sustain venture capital firms. Additionally, venture capital exists since it attracts entrepreneurs who have business ideas that can be transformed into profitable ventures.

Venture capital industry has four main participants. These include entrepreneurs, investors, investment bankers and venture capitalists (Bishop & Nixon 2006, pp. 23). Additionally, investment activities of venture capitalists go through different stages. These stages include deal origination, screening process, evaluation process and finally, negotiation process in which a deal is structured.

Moreover, management and control of a financed venture is normally redesigned to protect the investment made by venture capitalists (Wong 2009, pp. 63). An initial stage, where viability of a venture is assessed, can also be included.

Venture Capital Decision Assembly

Several studies have examined the stages and criteria used in decision assembly by venture capitalists (Bart & Mlambo 2008, pp. 34). The processes used in decision assembly require that new businesses undergo screening.

This involves review of the business preparation of a venture. After screening of a venture, the second phase is the due diligence stage. This involves documentation, negotiations and thorough examination of investment details.

Venture capitalists use decision assembly processes to collect vital information needed in the determination of whether to accept or reject a proposal. However, risk is high due to limited financial information.

Investment decision assembly processes used by venture capital firms seek to limit the risk of undesirable choice. The decision processes examine the potential for positive achievement or collapse of a venture based on accessible information.

However, the decision assembly processes of venture capital firms face challenges. This is mainly due to informational asymmetry (Bishop & Nixon 2006, pp. 23). Two kinds of informational asymmetry exist. These are hidden action and hidden information. Hidden action informational asymmetry occurs when a party does not have knowledge of relevant activities done by the other party of a transaction.

On the other hand, hidden information unevenness occurs when one party of a contract knows some germane information while the other party does not (Wong 2009, pp. 63). Often, entrepreneurs have information that financiers cannot access.

Hence, it is possible for entrepreneurs to employ exploitative behaviours after finalization of an investment deal (Bart & Mlambo 2008, pp. 35). The possible exploitative or opportunistic behaviors of entrepreneurs necessitate the need for financiers to make accurate decisions in the selection of projects to finance.

Entrepreneurs should understand the character and procedure of decision assembly used by venture capitalists in evaluation of businesses. In this way, entrepreneurs increase the possibility of their venture being financed. Moreover, knowledge of the decision-making procedures improves their negotiations abilities.

Choice Criteria

The techniques that venture capitalists use in information compilation include interrogation, experiments and surveys. Venture capitalists use in-use and espoused criteria in their evaluations. They use in-use criteria in actual decision assembly.

On the other hand, they use espoused criteria in evaluation processes (Bishop & Nixon 2006, pp. 24). They consider market conditions, competition and management capabilities as they make investment decisions.

The personality and experience of entrepreneurs plays a pivotal role in investment decisions made by venture capitalists. Previous studies used various categories in examination of the factors that distinguish successful and unsuccessful ventures in screening processes (Bishop & Nixon 2006, pp. 21). These categories include product, market, industrialist and monetary characteristics.

Some studies found that competitiveness of a product and market acceptance play critical roles (Bart & Mlambo 2008, pp. 34). Other studies included competitive strategies and resource-based capabilities as additional categories for analysis (Bart & Mlambo 2008, pp. 34). Notably, financial considerations do not influence the success of a venture in the evaluation processes.

However, the generic criteria that all venture capitalists use comprise potential rewards of a venture, proven abilities of a concept or product, competitive advantages and realistic capital requirement. In management construct, venture capitalists rate entrepreneurs through various criteria.

Financiers consider the integrity, experience and records of accomplishment of entrepreneurs. They check leadership, managerial and technical skills (Bishop & Nixon 2006, pp. 21).

It is vital that venture capitalists determine the most appropriate methods to evaluate ventures to minimize risks. At the same time, it is vital that entrepreneurs know the decision factors that affect the financial proposals and negotiations that they make.

Conclusion

New enterprises face numerous financial challenges. However, they can obtain start-up capital from venture capital firms. Venture capital firms fund new businesses that are high-risk but promise high financial rewards. However, evaluation of new businesses is complicated due to the inadequacy of financial information. This complicates investment decision-assembly processes that venture capitalists do.

The lack of academic literature guidance also complicates the situation. This paper explored some of the concerns that venture capitalists should consider in decision assembly. These include market, product, entrepreneur and competitive characteristics. It also discussed features of venture capital and the complications that arise due to information asymmetry.

List of References

Bart, V & Mlambo, C 2008, “Factors influencing venture capitalists’ project financing decisions in South Africa”, South African Journal of Business Management, vol. 40, no. 1, pp. 33-41. Web.

Bishop, K & Nixon, R 2006, “Venture opportunity evaluations: Comparisons between venture capitalists and inexperienced pre-nascent entrepreneurs”, Journal of Developmental Entrepreneurship, vol. 11, no. 1, pp. 19-33. Web.

Wong, L 2009, “Effective evaluation criteria for successful ventures: A study of venture capital in Hong Kong”, The Journal of Private Equity, vol. 13, no. 1, pp. 62-73. Web.

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