In small or medium business environment, the decision of capital structure are not matters of theoretically proper calculations, but the question is from where the firm can get financing. Thus, this paper aims to address the challenges of capital venture investment in companies compared to other forms of investing. Venture capital is a category of private equity which funds early-stage, small, and startups firms that are newly started with high potential growth. The firm under consideration in this case is mInfo Inc. which is a young and small business hence high level of uncertainty (Bloomberg, 2018). During its establishment, mInfo Inc. acquired its investment capital through series A and seed funding round, where around 70% of the raised funds came from the venture capitalists from the US and the rest from Chinese financiers (Bloomberg, 2018). Additionally, despite the risks associated with capital venture investment, the company is planning to expand its market reach to Asian market especially China (Bloomberg, 2018). Since mInfo Inc. has gone through series A and seed funding rounds, it implies that the firm has already developed substantial customer bases and this proves to venture capitalists that they are prepared for success on a larger scale (Bloomberg, 2018). Thus, series B funding round in this case is likely to facilitate the growth and expansion of mInfo Company to Chinese market.
Challenges
Venture capital has been a crucial driver in the funding of innovative start-ups in various industries; however, evidence suggests that venture capital investment stands a significantly higher chance of failure than other types of investment (Kaplan & Lerner, 2016). In other words, regardless of the fact that venture capital investing is highly profitable, it is also considered risky. Thus, the need to explore the possible challenges or risks associated with venture capital investing in a company expanding in a Chinese market with fierce competition and low margins
i) The lack of solid information on a company’s situation and prospects
One of the primary challenges that venture capitalists face in any economy is determining the viability of a suggested investment due to lack of solid information on a company’s situations and prospects. In capital venture investing, the value of firms is often based on the future projections, which usually are difficult to communicate to markets (Kaplan & Lerner, 2016). Moreover, there lacks cheap monitoring information in the markets since the success stories of small company such as mInfo Inc. are rarely discussed in media. Additionally, information asymmetry between venture capitalists is likely to occur since the reporting of the unlisted enterprises’ company is less regulated (Harrison & Mason, 2017). This implies that funding mInfo Inc. to expand in Chinese markets that are characterised by enforceable rule of law and lack of property rights reduce the risk of the systematic marker and is likely to contribute to the complexity of the process of venture capital (Kaplan & Lerner, 2016). Thus, the value of entrepreneurial firm is more based on human capital benefits, whereas relevant information is connected more on qualitative data and intuition than on accurate computer modelling.
Moreover, mInfo Inc. being a new technology-based company, managerial and financial needs are likely to be different from the old ones since in such firms it is often difficult to use and raise traditional long-term finance (Harrison & Mason, 2017). New enterprises lack track record for investors to utilize for purposes of evaluation, and the available intangible assets, including research results, ideas, market access or technical skills, are much more challenging to interpret and understand as solid collateral (Kaplan & Lerner, 2016).
ii) Due Diligence
The other challenge associated with the capital venture investment is due diligence, which takes places as the venture capitalist tries to validate the data the company submits. The process will involve efforts at acquiring solid market information; however, the accuracy and availability of such data is challenging (Kaplan & Lerner, 2016). Yet another challenge, in the present scenario, is to secure accurate engineering data of mInfo Inc. for evaluation as it is a high-tech enterprise (Harrison & Mason, 2017). Additionally, in China, venture capitalists must anticipate to make significant efforts than in any other environments to aid aggregate the information typically needed (Harrison & Mason, 2017).
iii) Negotiations
Negotiating is the other part a venture capitalist need to fund and can be extremely challenging. The difficulty in negotiating is due to the fact that business owners in China often do not agree on the valuations of the company (Ewens et al. 2018). Chinese companies usually benchmark high valuations based on similar entrepreneurs in the United States. On other hands, in China, venture capitalist emphasise the differences as well as country-specific risk; however, there is no set standard methodology for valuing a firm (Kaplan & Lerner, 2016). One possible explanation is that since rates of national growth are crucial elements of a company’s overall valuation, highly optimistic growth forecasts might inflate valuations for Chinese companies and difficult to confirm economic figures (Ewens et al. 2018).
The process of negotiation is further challenging by the fact that perception of contracts in Chinese markets are not in the same absolute terms as in other environments. In Chinese markets, a signed contract can be subjected to more negotiations when it is convenient (Ewens et al. 2018). As a result, negotiations are considered as ongoing process in funding a company in which there will be significant changes in the contract that would be projected in the US (Ewens et al. 2018). Therefore, venture capitalist can forecast that companies in Chinese markets may continue revising the signed contract as their relationship with the investors from other environments develop.
iv) Substantial dependency on the skills of the entrepreneurial team
Most of the capital-funded firm’s failure or success depends on the entrepreneurial or management team. Ideally, venture capitalist search for a company which is run by managers with track history of success, either in past position or in the firm they are giving the money (Freeman & Siegfried Jr, 2015). Venture capitalists take a substantial risk in the human side of the equation as they cannot often project the way human beings will act or behave (Kaplan & Lerner, 2016). Therefore, it is difficult to guarantee the talented entrepreneurial team will continue staying on the board or they will meet the set objectives.
v) Alignment of the incentives of the entrepreneurial team with those of investors
One of the key challenges or risks associated with venture capital investment is the alignment of the investor’s interests with those of the entrepreneurial team of a corporation. More specifically, in companies’ funded using venture capital, shareowners or shareholders are the eventual decision makers, however, it is not practical for venture capitalists to make every decision in the corporation (Del Guercio et al. 2018). Therefore, venture capitalists give the authority of decision making to the executives and directors. However, the entrepreneurial team may pursue its economic self-interests ahead of venture capitalists hence resulting in conflict of interests in the corporation (Kaplan & Lerner, 2016). For instance, this conflict of interest may be observed in the form of long-term employment contracts (Del Guercio et al. 2018). In other words, the entrepreneurial team are vulnerable to human nature and might decide to work towards meeting their economic agendas while disregarding wealth maximization of the venture capitalists.
vi) Market Trends
Venture capitalists search for firms associated with high growth potential, whereas the risk factor is based on the term “potential” (Drover et al. 2018). The trends of the market can affect company’s growth once poised for success (Kaplan & Lerner, 2016). Venture capitalists funds companies that depict a competitive advantage; however, it is based on assumptions and projection about the future of a service or product, the competition movement, and the market’s acceptance of the new entry (Kaplan & Lerner, 2016). Although the venture capitalists may conduct an in-depth due diligence before financing the proposed company, external market factors can eventually determine the success or failure of a new company (Drover et al. 2018).
How to structure the deal to give venture capitalists some safeguards against the aforementioned risks or challenges.
To safeguard against the aforementioned challenges, venture capitalists should not only offer financial capital, but also need to play a significant role in firm decision making, typically by having a board seat. Although, there is no guarantee for a seat on the board, venture capitalists need to put an extra effort and ensure he or she has secured that seat (Ewens et al. 2018). This is due to the specific condition of new enterprises, which are associated with high uncertainty levels and asymmetry of information between outsiders and insiders (Bottazzi et al. 2016). In other words, once the venture capitalist funds the company, he or she should monitor its business operations carefully. Venture capitalists need to maintain adequate and appropriate vigilance to make sure that the company is meeting the desired goals (Ewens et al. 2018). It is important for venture capitalist to send people into the company to double check and count things that are functioning smoothly (Bottazzi et al. 2016). Furthermore, the venture capitalist need to try and place middle managers with the ones they are familiar and he or she trusts to act as his or her information conduit into the business function of the financed company (Bottazzi et al. 2016). Moreover, the venture capitalist need to build trust with top management and relationships with the individuals in the lower level in the company.
The other tactic of safeguarding from the challenges discussed above, the venture capitalist need try to reconcile conflicting incentives. In the process of monitoring the funded firm, venture capitalist should recognize that his or her incentives or goals for the company may be differ from those of the entrepreneurs (Del Guercio et al. 2018). For instance, in China, the state encourages both public and private companies to maximize production and employment (Del Guercio et al. 2018). Therefore, if the venture capitalist lacks careful oversight, companies can end up unsaleable inventory in the warehouses or extra employees on the payroll.
Venture capitalists also need to participate in the process of searching and recruiting professional managers with right connections and skills to deter the risk of unexperienced management or entrepreneurial team (Freeman & Siegfried Jr, 2015). The outside connections and advice that venture capitalists add to their financed companies can be valuable in the department of human resources and success of the funded company (Freeman & Siegfried Jr, 2015).
Due to fierce competition and low margins which might cause losses in mInfo Inc. the venture capitalist needs to develop well-planned strategies of exit once he or she decided to fund the company. The venture capitalist need to invest with a plan to exit after some years. In this case the investor might decide to search for strategic buyers as an exit or a liquidity source; however, in Asian markets, strategic buyers are larger companies that need to acquire new institutional positions or capabilities in China (Mason & Botelho, 2016).
What would you describe as ‘different’ from the US or other non-Chinese environment?
A key difference and challenge of making capital venture investment in Chinese market is that accounting standards in China vary greatly from those in the developed nations such as the Britain or US. Consequently, assets such as inventory and assets may not be as completely valued as in the US or any non-Chinese environment, and receivable accounts may not be realistic (Cheng & Schwienbacher, 2016). In other words, the accounting standards in China as practiced today differ substantially from global accounting standards. The accounting conventions and rules in Chinese market vary from global standards of accounting in three major areas (Zheng et al. 2014). First is the policy foundation of the company’s goals. Most of the accounting mechanisms employed by enterprise in Chinese market are aimed at production management rather that valuation of an asset (Zheng et al. 2014). Therefore, for some well-established companies, as well as entrepreneurs trained in such a system, this bent is challenging to unlearn, regardless of the adjustments in regulations. Second, the substantially varying intended audiences for the financial reports can prove to be a challenge for venture capitalist to manage (Zheng et al. 2014). International practice defines creditors and investors as the primary audiences of accounting information, whereas Chinese markets deems the internal customers such as the production and sales managers as the primary users (Cheng & Schwienbacher, 2016). Furthermore, despite of the current changes in the accounting regulations in Chinese markets, owing to weak enforcement, the operating statements in China seem to be subjugated by operational information and lack of accurate summarized financial data (Zheng et al. 2014). Subsequently, there is a gap between Chinese and US earning results of accounting standards regardless of much harmonization of accounting rules in China and those of more advanced countries. Third, sometimes terms may be explained or understood much differently in Chinese markets that other environment, and accounting terminology can take of different implications in various regions or industries of China, together with varying formats (Gu & Lu, 2014).
Thus, the aforementioned challenges result in financial reports that are likely to be of limited help to venture capitalist as they try to examine which companies to fund. Current attempts to match accounting standards in China with other markets across the globe will eventually make financial reports easier for venture capitalist to understand and interpret in a meaningful way (Cheng & Schwienbacher, 2016). However, still today such accounting data on company searching for funding is of limited value to the venture capitalist (Zheng et al. 2014). Thus, to solve this challenge, venture capitalist need to hire auditors from Hong Kong to aid in confirming the reported statements of accounting.
How I should advise Graylin and Derrick to grow the company
Although China is perceived as a “target-rich environment,” it is also a nation with several different regional and provincial markets (Gu & Lu, 2014). Each industry, city, province, or region may need somewhat different resources hence depicting presence of decentralised decision making in China (Gu & Lu, 2014). This implies that competition and laws can vary from one region to the other as well as their implementation. Thus, for the growth of the company in Asian market, Graylin and Derrick need to consider provinces or regions that have lighter laws, low competition, and high customer base. However, to be profitable, mInfo Company needs a national markets instead of relying on single province or city of China for product sales. To achieve national market in China the partners of mInfo Inc. should open local offices throughout the country to seek new investments and offer support to the current one trying to expand across the Asian market (Gu & Lu, 2014). In other words, need to research and understand the local China situation since it is important to success of mInfo Inc. in the market.
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