How to choose the right target for venture capital

DEG has been in China's venture capital market for 22 years and has invested in a total of 85 projects, only one small project with a small loss. It breaks a common law in the venture capital industry: 50% of venture capital projects fail completely, 40% just tie, and only 10% are profitable.

DEG, a wholly-owned subsidiary of KfW, specializes in investing in high-potential businesses. The research and utilization of the financial report of the investment object is the key to its successful investment.

In fact, in addition to financial reports, the investment object's product structure, development stage, market prospects, business model, and social reputation are all factors that must be considered when choosing an investment object. Only in this way can the risk of venture capital be reduced.

Financial report

In a certain sense, financial report is a "barometer" of a company's operating conditions. Relying on the information in the financial report, investors can roughly judge whether the company is "bright and sunny" or "stormy".

The implementation of the new accounting standards, especially the introduction of the fair value model, makes the financial statements better reflect the real situation of the enterprise. The fair value model refers to the amount at which two parties familiar with the situation voluntarily exchange assets and pay off debts in an arm's length transaction. It is valued at the current market value and reflects the situation at the balance sheet date and does not require depreciation or amortization. The fair value model makes up for the defects of the old accounting standards to a certain extent, making the financial statements more scientific and conducive to investors' correct judgment.

DEG requires the selection of investment objects, and requires the other party to provide audited financial reports for the past 3 years, including balance sheets, profit and loss statements, cash flow statements and their descriptions. After getting the report, DEG will carefully study the data, not letting go of every small change, and then conduct scientific analysis according to the actual situation of the market and the enterprise.

Of course, you can't be superstitious about companies with good financial performance. Winfried Polte, chairman of DEG's board of directors, said that only 20% of the financial report was enough. He believes that if you want to invest successfully, you must practice and observe in person. "Go and see if the invested company's bathroom is clean, whether the employees' working attitude is correct, whether the management's evaluation is positive, and whether the company pays workers overtime pay on time." These specific details may better reflect the development potential of the company.

Product Structure

It is not enough to just have a financial report. It is also critical to go deep into the enterprise and understand the product structure.

Although a survey report released by Ventureone, an authoritative venture capital research institution under Dow Jones, shows that IT is the focus of venture capital in China, not all IT companies have high returns. How to identify their investment value?

Start with the structure of the product. For example, those video game companies, network equipment and online advertising companies in the IT industry have greater room for appreciation. This is the forecast result of Sanford C. Beurnstein, a venture capital institution with a history of more than 40 years. A survey conducted by China Youth Daily and Sina.com also supports this judgment. The survey shows that young people have used the Internet as their main means of entertainment. Among the nearly 3,000 respondents, 81.4% preferred the Internet as an entertainment method, and online video and game companies would benefit from it. At the same time, the application of the Internet has further expanded the market of network equipment. On the other hand, online advertising companies have huge user support, and they are showing an upward trend.

Enterprise development stage

The product structure only allows investors to judge its value at the "point", while the development stage of the enterprise gives investors a "face" understanding.

Enterprises have to go through a life cycle from infancy to decline. Different development stages of enterprises have different investment risk factors. If you invest in the rising period of the enterprise, you will be more profitable; if you invest in the stable period of the enterprise, the investment risk coefficient will be relatively small.

DEG companies tend to invest in companies with a longer history. Winfried Polte emphasized that the total assets or sales of an enterprise greater than RMB 50 million is the primary condition for DEG investment. Judging from DEG's 22 years of investment experience in China, 70% of the companies are concentrated in the traditional manufacturing field. In their opinion, this is more secure.

Market Prospect

The stage of enterprise development can provide investors with a microscopic understanding, and the market prospect can help make macroscopic judgments.

Generally speaking, the rising stage of industry development has better market prospects. This is because, in the early stage of product development, the market prospect is not clear enough; in the later stage, with the intensification of competition, the elimination of enterprises or mergers and acquisitions will gradually increase.

Three international investment institutions including Morgan Stanley in the United States, CDH in Hong Kong and Actis in the United Kingdom have achieved high returns on their investments in Mengniu because they correctly judged the market prospects of Mengniu.

In 2002, China's dairy market has just opened up, and the real competition pattern has not yet been formed, and there are great market opportunities. In December of that year, the three companies invested more than US$26 million in Mengniu, equivalent to about 216 million yuan. In the fourth quarter of 2003, they added another US$35 million to Mengniu. In June 2005, they sold most of their equity. In just 3 years, they invested a total of US$60 million and realized a return of more than HK$2 billion.

Rui Meng, an associate professor of accounting at the Chinese University of Hong Kong and a consultant to Ericsson, suggested hiring some professional institutions to investigate the market prospects of products, which will help make investment judgments scientifically.

Business Model

The market prospect only represents the development potential of the product. In order to realize the successful operation of the enterprise, it also depends on an excellent business model.

Management guru Peter Dulac said: "The competition between enterprises today is not the competition between products, but the competition between business models."

What is a business model? Robertson Steven, a well-known American investor, made a pictorial description: a dollar turns around in the company, and finally becomes a dollar, and the added cent is the value brought by the business model.

Meng Rui, an associate professor of accounting at the Chinese University of Hong Kong, explained that the business model depends on which route the company takes. When making venture capital, it depends on whether the product has a competitive advantage in this positioning. For example, if it is a high-end product, quality should be the main factor to consider; if it is a low-end product, price competitiveness becomes the key.

IDG, a well-known venture capital institution, has obtained a relatively high return on its venture capital investment in Kingdee, which is closely related to Kingdee's business model. In 1993, Kingdee launched V2.0 and V3.0 DOS financial software; in 1995, Kingdee developed a brand-new WINDOWS product, which caused a great sensation in the industry. Since then, Kingdee has focused on product innovation, shortened product update cycles, and led other financial software in product technology.

The chairman of IDG believes that Kingdee has advanced technology in products and services, and the market response speed is also in a leading position in the industry. These two points are very critical for software companies.

So, in April 1998, IDG invested 10 million yuan through its subsidiary "Guangdong Pacific". A year later, IDG made an additional 10 million venture capital investment through its venture capital firm IDGVC. In 2003, IDG recovered HKD 120 million from Kingdee, which is 6 times higher than the 20 million it invested in that year.

Social Reputation

If the above five conditions are met, can the investment target be determined?

The answer is no. A company with a good corporate reputation is the guarantee of successful investment.

Good credit is an endless check. Liu Chuanzhi, founder of Lenovo Group, said that choosing a reputable company to invest in will increase the safety factor of your investment. You Denghong, a well-known financial management expert and the chief consultant of Huishang Sway, also pointed out that venture capitalists attach great importance to the credibility of enterprises, and the credibility of enterprises plays a key role in the confidence of investors.

SHARON WANG is Associate Editor of the CEConlines website.