Chapter - 1

INTRODUCTION TO THE
PROJECT

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1.1 RESEARCH OBJECTIVES:
1. To understand the concept of venture capital

2. To understand venture capital investment process in India

3. To study the evolution and need of Venture Capital Industry in India

4. To understand the legal framework formulated by SEBI to encourage Venture

Capital activity in Indian economy

5. To find out opportunities & threats those hinder and encourage Venture Capital
Industry in India

1.2 Limitations of the project:

A study of this type cannot be without limitations. It has been observed that venture
capital is very sensitive about their performance as well as about their investment. This
attitude has been a major hurdle in data collection. However, venture capital
funds/companies that are members of Indian Venture Capital association are included in
study. Financial analysis has been restricted by and large to members of IVCA.

1.3 Research & Design Instruments:

In India neither the venture capital theory has been developed nor are there many
comprehensive books on this project. Even the number of research papers available is
limited . The research design used is descriptive in nature. (The attempt has been made to
collect maximum facts & figures available on the availability of venture capital in India,
nature of assistance granted, future projected demand for this financing, analysis of
problem faced by entrepreneurs in getting venture capital, analysis of venture capitalist,
and social and environmental impact on the existing framework.)

The research is based on secondary data collected from published material. The data was
also collected from the publications and press releases of venture capital associations in
India.

Scanning the business papers filled the gap in information. The Economic Times,
Financial Express and Business Standards were scanned for any article of news item
related to venture capital. Sufficient amount of data about the venture capital has been
derived from these reports.
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1.4 Scope:
The scope of the research includes all type of Venture capital firms whether set up as
company or a trust fund. Venture Capital companies & funds irrespective of the fact that
they are registered with SEBI of India or not the part of this study. Angel investors have
been kept out of the study as it was not feasible to collect authenticated information about
them.

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 Chapter – 2

CONCEPTUAL FRAMEWORK

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2.1 Concept of Venture Capital
Venture Capital plays an important role in financing small scale enterprise and high
technology and risky ventures. The Venture Capital activity is quite advanced in
developed countries. It has also taken root in a number of developing countries. Venture
Capital has potential to become an important source of financing small scale enterprises.

The term Venture Capital comprises of two words that is, “Venture” and “Capital”.
Venture is a course of processing, the outcome of which is uncertain but to which is
attended the risk or danger of “loss”. “Capital” means recourses to start an enterprise. To
connote the risk and adventure of such a fund, the generic name Venture Capital was
coined.

Venture capital is considered as financing of high and new technology based enterprises.
It is said that Venture Capital involves investment in new or relatively untried
technology, initiated by relatively new and professionally or technically qualified
entrepreneurs with inadequate funds. The conventional financiers, unlike Venture
capitals, mainly finance proven technologies and established markets. However, high
technology need not be pre-requisite for venture capital.

Venture Capital has also been described as ‘unsecured risk financing’. The relatively high
risk of venture capital is compensated by the possibility of high returns usually through
substantial capital gains in the medium term. Venture capital in broader sense is not
solely an injection of funds into a new firm, it is also an input of skills needed to set up
the firm, design its marketing strategy, organize and manage it. Thus it is a long term
association with successive stages of company’s development under highly risk
investment conditions, with distinctive type of financing appropriate to each stage of
development. Investors join the entrepreneurs as co-partners and support the project with
finance and business skills to exploit the market opportunities.

Venture capital is not a passive finance. It may be at any stage of business/production

cycle, that is, start up, expansion or to improve a product or process, which are associated
with both risk and reward. The Venture capital makes higher capital gains through
appreciation in the value of such investments when the new technology succeeds. Thus
the primary return sought by the investor is essentially capital gain rather than steady
interest income or dividend yield.

The most flexible definition of Venture capital is-

“The support by investors of entrepreneurial talent with finance and business skills to
exploit market opportunities and thus obtain capital gains.”

Venture capital commonly describes not only the provision of start up finance or ‘seed
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corn’ capital but also development capital for later stages of business. A long term
commitment of funds is involved in the form of equity investments, with the aim of
eventual capital gains rather than income and active involvement in the management of
customer’s business.

2.2 Features of Venture Capital:

“Venture capital combines the qualities of a banker, stock market investor and
entrepreneur in one.”

The main features of venture capital can be summarized as follows:

i. High Degrees of Risk: Venture capital represents financial investment in a highly

risky project with the objective of earning a high rate of return. Venture
capital assumes 4 types of risk:

 Management risk: Inability of management teams to work together.

 Market risk: Product may fail in the market.

 Product risk: Product may not be commercially viable.

 Operations risk: Operation may not be cost effective resulting in increased cost
and decreased gross margins.

ii. Equity Participation: Venture capital financing is, invariably, an actual or

potential equity participation wherein the objective of venture capitalist is to
make capital gain by selling the shares once the firm becomes profitable.

iii. Long Term Investment: Venture capital financing is a long term investment. It
generally takes a long period to en-cash the investment in securities made by
the venture capitalists.

iv. Participation in Management: In addition to providing capital, venture capital

funds take an active interest in the management of the assisted firms. Thus,
the approach of venture capital firms is different from that of a traditional
lender or banker. It is also different from that of a ordinary stock market
investor who merely trades in the shares of a company without participating in
their management. It has been rightly said, “venture capital combines the
qualities of banker, stock market investor and entrepreneur in one”.

v. Achieve Social Objectives: It is different from the development capital provided

by several central and state level government bodies in that the profit
objective is the motive behind the financing. But venture capital projects
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generate employment, and balanced regional growth indirectly due to setting

up of successful new business.
 vi. Investment is liquid: A venture capital is not subject to repayment on demand as
with an overdraft or following a loan repayment schedule. The investment is
realized only when the company is sold or achieves a stock market listing. It is
lost when the company goes into liquidation.

2.3 Difference between Venture Capital & Other Funds:

2.3.1. Venture Capital VS Development Funds:

Venture Capital differs from Development Funds as latter means putting up of industries
without much consideration of use of new technology or new entrepreneurial venture but
having a focus on undeveloped areas (locations). In majority of cases it is in the form of
loan capital and proportion of equity is very thin. Development finance is security
oriented and liquidity prone. The criteria for investment are proven track record of
company and its promoters, and sufficient cash generation to provide for returns
(principal & interest). The development bank safeguards its interest through collateral.

They have no say in working of the enterprise except safeguarding their interest by
having a nominee director. They do not play any active role in the enterprise except
ensuring flow of information and proper management information system, regular board
meetings, adherence to statutory requirements for effective management control where as
Venture capitalist remain interested if the overall management of the project o account of
high risk involved I the project till its completion, entering into production and making
available proper exit route for liquidation of the investment. As against this fixed
payments in the form of installment of principal and interest are to be made to
development banks.

2.3.2 Venture Capital Vs Seed Capital & Risk capital

It is difficult to make a distinction between venture capital and seed capital and Risk
capital as the latter two forms part of broader meaning of venture capital. Difference
between them arises on account of application of funds and terms and conditions
applicable. The seed capital and risk funds in India are being provided basically to
arrange promoters contribution to the project. The objective is to provide finance and
encourage professionals to become promoters of industrial projects. The seed capital is
provided to conventional project on the consideration of low risk and security and use
conventional techniques for appraisal. Unlike Venture Capital, Seed capital providers
neither provide any value addition nor participation in the management of the project.
Unlike Venture capital Seed capital provider is satisfied with low risk-normal returns and
lacks any flexibility in its approach.
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Risk capital is also provided to established companies for adapting new technologies.
Herein the approach is not business oriented but developmental. As a result on the one
hand the success rates of units assisted by Seed Capital\Risk
Finance has been lower than those provided with venture capital. On the other hand the
return to the seed\risk capital financier has been very low as compare to venture
capitalist.

Seed capital scheme Venture capital scheme

Basis Income or aid Commercial viability

Beneficiaries Very small entrepreneurs Medium or large

entrepreneurs are also
covered
Size of assistance Upto 15 Lacs (Max) Upto 40% of promoters
equity
Appraisal process Normal Skilled & Specialized
Estimates returns 20% 30% plus
Flexibility Nil Highly Flexible
Value addition NIL Multiple ways
Exit options Sell back to promoters Several, including public
offer
Funding sources Owners fund Outsider contribution
allowed
Syndication Not done Possible
Tax concession Nil Exempted
Success rate Not good Very satisfactory

Difference between Seed Capital Scheme and Venture Capital Scheme

2.3.3 Venture Capital Vs Bought out deals

The important difference between Venture Capital and Bought out deals is that bought
out deals are not based on high risk-high reward principle. Further unlike Venture
Capital, they do not provide equity finance at different stages of the enterprise, However
both have common exception of capital gains yet their objectives and intents are totally
different.

2.4 The Venture Capital Spectrum:

The growth of an enterprise follows a life cycle. The requirement of funds vary with the
life stages of the enterprise. Even before a business plan is prepared the entrepreneur
invests his time and resource in surveying the market, finding and understanding the
target customers and their needs. At the seed stage, the entrepreneur continue to fund the
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venture with his own funds. At this stage, the funds are needed to solicit the consultants’
service in formulation of business plan, meeting potential customers and technology
partners. Next the fund would be required for the development of the product\process,
hiring key people and building up the management team. This is followed by funds for
assembling the manufacturing and marketing facilities in that order. Finally the funds are
needed to expand the business for more profits. Venture Capitalist cater to the need of the
entrepreneurs at the different stages of their enterprise. Depending upon the stage they
finance, venture capitalist are called angel investors, venture capitalist or private equity
supplier/investor.

Venture capital was started as early stage financing of relatively small but growing
companies. However various reasons forced venture capitalist to be more and more
involved in expansion financing to support the development of existing portfolio
companies. With increasing demand of capital for newer business, Venture capitalist
began to operate across a broader spectrum of investment interest. This diversity of
opportunities enabled Venture capitalists to balance their activities in term of time
involvement, risk acceptance and reward potential, while providing on going assistance
to developing business.

Different venture capital firms have different attributes and aptitudes for different types
of Venture capital investments. Hence there are different stages of entry for different
venture capitalist and they can identify and differentiate between types of venture capital
investments, each appropriate for the given stage of the investee company. These are:

1. Early Stage Finance

 Seed capital
 Start up capital
 Early\First stage capital
 Later\Third Stage Capital

2. Later Stage Finance

 Expansion\Development stage capital

 Replacement finance
 Management Buyouts and Buy ins
 Turnarounds
 Mezzanine\Bridge Finance

Not all business firms pass all of these stages in a sequential manner. For instance seed
capital is not required by service based ventures. It implies largely to manufacturing or
research based activities. Similarly second round finance does not always follow early
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stage finance. If the business grows successfully, it is likely to develop sufficient cash to
fund its own growth, so does not require venture capital for growth.
The table below shows risk perception and time orientation for different stages of venture
capital financing.

Financing stage Period (funds Risk perception Activity to be

locked in years) financed
Early stage finance 7 – 10 Extreme For supporting a
seed concept or idea or
R&D for product
development
Start – up 5–9 Very high Initializing
operations or
developing
prototypes
First stage 3-7 High Start commercial
production and
marketing
Second stage 3–5 Sufficiently high Expand market and
growing capital
need
Later stage 1–3 Medium Market expansion,
acquisition &
product
development for
profit making
company
Buy out-in 1- 3 Medium Acquisition
financing
Turnaround 3–5 Medium to high Turning around a
sick company
Mezzanine 1–3 Low Facilitating public
issue

Venture capital financing stages

2.4.1 Seed Capital

It is an idea or concept as opposed to a business. European Venture capital association

defines seed capital as “The financing of the initial product development or capital
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provided to an entrepreneur to prove the feasibility of a project and to qualify for start up
capital”.
The characteristics of the seed capital may be enumerated as follows:

 Absence of ready product market

 Absence of complete management team

 Product/ process still in R & D stage

 Initial period / licensing stage of technology transfer

Broadly speaking seed capital investment may take 7 to 10 years to achieve realization. It
is the earliest and therefore riskiest stage of Venture capital investment. The new
technology and innovations being attempted have equal chance of success and failure.
Such projects, particularly hi-tech, projects sink a lot of cash and need a strong financial
support for their adaptation, commencement and eventual success.

However, while the earliest stage of financing is fraught with risk, it also provides greater
potential for realizing significant gains in long term. Typically seed enterprises lack asset
base or track record to obtain finance from conventional sources and are largely
dependent upon entrepreneur’s personal resources. Seed capital is provided after being
satisfied that the entrepreneur has used up his own resources and carried out his idea to a
stage of acceptance and has initiated research. The asset underlying the seed capital is
often technology or an idea as opposed to human assets (a good management team) so
often sought by venture capitalists.

Volume of Investment Activity

It has been observed that Venture capitalist seldom make seed capital investment and
these are relatively small by comparison to other forms of venture finance. The absence
of interest in providing a significant amount of seed capital can be attributed to the
following three factors: -

a) Seed capital projects by their very nature require a relatively small amount of capital.
The success or failure of an individual seed capital investment will have little impact on
the performance of all but the smallest venture capitalist’s portfolio. Larger venture
capitalists avoid seed capital investments. This is because the small investments are seen
to be cost inefficient in terms of time required to analyze, structure and manage them.

b) The time horizon to realization for most seed capital investments is typically 7-10
years which is longer than all but most long-term oriented investors will desire.

c) The risk of product and technology obsolescence increases as the time to realization is
extended. These types of obsolescence are particularly likely to occur with high
technology investments particularly in the fields related to Information Technology.
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2.4.2 Start up Capital

It is stage 2 in the venture capital cycle and is distinguishable from seed capital
investments. An entrepreneur often needs finance when the business is just starting. The
start up stage involves starting a new business. Here in the entrepreneur has moved closer
towards establishment of a going concern. Here in the business concept has been fully
investigated and the business risk now becomes that of turning the concept into product.

Start up capital is defined as: “Capital needed to finance the product development, initial
marketing and establishment of product facility. “

The characteristics of start-up capital are:-

i. Establishment of company or business: The company is either being

organized or is established recently. New business activity could be based on
experts, experience or a spin-off from R & D.

ii. Establishment of most but not all the members of the team: The skills and
fitness to the job and situation of the entrepreneur’s team is an important
factor for start up finance.

iii. Development of business plan or idea: The business plan should be fully
developed yet the acceptability of the product by the market is uncertain. The
company has not yet started trading.

In the start up preposition venture capitalists’ investment criteria shifts from idea to
people involved in the venture and the market opportunity. Before committing any
finance at this stage, Venture capitalist however, assesses the managerial ability and the
capacity of the entrepreneur, besides the skills, suitability and competence of the
managerial team are also evaluated. If required they supply managerial skills and
supervision for implementation. The time horizon for start up capital will be typically 6
or 8 years. Failure rate for start up is 2 out of 3. Start up needs funds by way of both first
round investment and subsequent follow-up investments. The risk tends t be lower
relative to seed capital situation. The risk is controlled by initially investing a smaller
amount of capital in start-ups. The decision on additional financing is based upon the
successful performance of the company. However, the term to realization of a start up
investment remains longer than the term of finance normally provided by the majority of
financial institutions. Longer time scale for using exit route demands continued watch on
start up projects.

Volume of Investment Activity

Despite potential for spectacular returns most venture firms avoid investing in start-ups.
One reason for the paucity of start up financing may be high discount rate that venture
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capitalist applies to venture proposals at this level of risk and maturity. They often prefer
to spread their risk by sharing the financing. Thus syndicates of investor’s often
participate in start up finance.

2.4.3 Early Stage Finance

It is also called first stage capital is provided to entrepreneur who has a proven product,
to start commercial production and marketing, not covering market expansion, de-risking
and acquisition costs.

At this stage the company passed into early success stage of its life cycle. A proven
management team is put into this stage, a product is established and an identifiable
market is being targeted.

British Venture Capital Association has vividly defined early stage finance as: “Finance
provided to companies that have completed the product development stage and require
further funds to initiate commercial manufacturing and sales but may not be generating
profits.”

The characteristics of early stage finance may be: -

 Little or no sales revenue.

 Cash flow and profit still negative.
 A small but enthusiastic management team which consists of people with
technical and specialist background and with little experience in the management
of growing business.
 Short term prospective for dramatic growth in revenue and profits.

The early stage finance usually takes 4 to 6 years time horizon to realization. Early stage
finance is the earliest in which two of the fundamentals of business are in place i.e. fully
assembled management team and a marketable product. A company needs this round of
finance because of any of the following reasons: -

 Project overruns on product development.

 Initial loss after start up phase.

The firm needs additional equity funds, which are not available from other sources thus
prompting venture capitalist that, have financed the start up stage to provide further
financing. The management risk is shifted from factors internal to the firm (lack of
management, lack of product etc.) to factors external to the firm (competitive pressures,
in sufficient will of financial institutions to provide adequate capital, risk of product
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obsolescence etc.)
At this stage, capital needs, both fixed and working capital needs are greatest. Further,
since firms do not have foundation of a trading record, finance will be difficult to obtain
and so Venture capital particularly equity investment without associated debt burden is
key to survival of the business.

The following risks are normally associated to firms at this stage: -

a) The early stage firms may have drawn the attention of and incurred the challenge of a
larger competition.

b) There is a risk of product obsolescence. This is more so when the firm is involved in
high-tech business like computer, information technology etc.

2.4.4 Second Stage Finance

It is the capital provided for marketing and meeting the growing working capital needs of
an enterprise that has commenced the production but does not have positive cash flows
sufficient to take care of its growing needs. Second stage finance, the second trench of
Early State Finance is also referred to as follow on finance and can be defined as the
provision of capital to the firm which has previously been in receipt of external capital
but whose financial needs have subsequently exploded. This may be second or even third
injection of capital.

The characteristics of a second stage finance are:

 A developed product on the market

 A full management team in place
 Sales revenue being generated from one or more products
 There are losses in the firm or at best there may be a break even but the surplus
generated is insufficient to meet the firm’s needs.

Second round financing typically comes in after start up and early stage funding and so
have shorter time to maturity, generally ranging from 3 to 7 years. This stage of financing
has both positive and negative reasons.

Negative reasons include:

I. Cost overruns in market development.
II. Failure of new product to live up to sales forecast.
III. Need to re-position products through a new marketing campaign.
IV. Need to re-define the product in the market place once the product deficiency
is revealed.
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Positive reasons include:

I. Sales appear to be exceeding forecasts and the enterprise needs to acquire assets
to gear up for production volumes greater than forecasts.
 II. High growth enterprises expand faster than their working capital permit, thus
needing additional finance. Aim is to provide working capital for initial expansion
of an enterprise to meet needs of increasing stocks and receivables.

It is additional injection of funds and is an acceptable part of venture capital. Often

provision for such additional finance can be included in the original financing package as
an option, subject to certain management performance targets.

2.4.5 Later Stage Finance:

It is called third stage capital is provided to an enterprise that has established commercial
production and basic marketing set-up, typically for market expansion, acquisition,
product development etc. It is provided for market expansion of the enterprise. The
enterprises eligible for this round of finance have following characteristics:

I. Established business, having already passed the risky early stage.

II. Expanding high yield, capital growth and good profitability.
III. Reputed market position and an established formal organization structure.

“Funds are utilized for further plant expansion, marketing, working capital or
development of improved products.” Third stage financing is a mix of equity with debt or
subordinate debt. As it is half way between equity and debt in US it is called
“mezzanine” finance. It is also called last round of finance in run up to the trade sale or
public offer.

Venture capitalist s prefer later stage investment vis a vis early stage investments, as the
rate of failure in later stage financing is low. It is because firms at this stage have a past
performance data, track record of management, established procedures of financial
control. The time horizon for realization is shorter, ranging from 3 to 5 years. This helps
the venture capitalists to balance their own portfolio of investment as it provides a
running yield to venture capitalists. Further the loan component in third stage finance
provides tax advantage and superior return to the investors.

There are four sub divisions of later stage finance.

 Expansion / Development Finance

 Replacement Finance
 Buyout Financing
 Turnaround Finance

Expansion / Development Finance:

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An enterprise established in a given market increases its profits exponentially by

achieving the economies of scale. This expansion can be achieved either through an
organic growth, that is by expanding production capacity and setting up proper
distribution system or by way of acquisitions. Anyhow, expansion needs finance and
venture capitalists support both organic growth as well as acquisitions for expansion.

At this stage the real market feedback is used to analyze competition. It may be found
that the entrepreneur needs to develop his managerial team for handling growth and
managing a larger business.

Realization horizon for expansion / development investment is one to three years. It is

favored by venture capitalist as it offers higher rewards in shorter period with lower risk.
Funds are needed for new or larger factories and warehouses, production capacities,
developing improved or new products, developing new markets or entering exports by
enterprise with established business that has already achieved break even and has started
making profits.

Replacement Finance:

It means substituting one shareholder for another, rather than raising new capital resulting
in the change of ownership pattern. Venture capitalist purchase shares from the
entrepreneurs and their associates enabling them to reduce their shareholding in unlisted
companies. They also buy ordinary shares from non-promoters and convert them to
preference shares with fixed dividend coupon. Later, on sale of the company or its listing
on stock exchange, these are re-converted to ordinary shares. Thus Venture capitalist
makes a capital gain in a period of 1 to 5 years.

Buy - out / Buy - in Financing :

It is a recent development and a new form of investment by venture capitalist. The funds
provided to the current operating management to acquire or purchase a significant share
holding in the business they manage are called management buyout.

Management Buy-in refers to the funds provided to enable a manager or a group of

managers from outside the company to buy into it.

It is the most popular form of venture capital amongst later stage financing. It is less risky
as venture capitalist in invests in solid, ongoing and more mature business. The funds are
provided for acquiring and revitalizing an existing product line or division of a major
business. MBO (Management buyout) has low risk as enterprise to be bought have
existed for some time besides having positive cash flow to provide regular returns to the
venture capitalist, who structure their investment by judicious combination of debt and
equity. Of late there has been a gradual shift away from start up and early finance to
wards MBO opportunities. This shift is because of lower risk than start up investments.

Turnaround Finance :
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It is rare form later stage finance which most of the venture capitalist avoid because of
higher degree of risk. When an established enterprise becomes sick, it needs finance as
well as management assistance foe a major restructuring to revitalize growth of profits.
Unquoted company at an early stage of development often has higher debt than equity; its
cash flows are slowing down due to lack of managerial skill and inability to exploit the
market potential. The sick companies at the later stages of development do not normally
have high debt burden but lack competent staff at various levels. Such enterprises are
compelled to relinquish control to new management. The venture capitalist has to carry
out the recovery process using hands on management in 2 to 5 years. The risk profile and
anticipated rewards are akin to early stage investment.

Bridge Finance:

It is the pre-public offering or pre-merger/acquisition finance to a company. It is the last

round of financing before the planned exit. Venture capitalist help in building a stable
and experienced management team that will help the company in its initial public offer.
Most of the time bridge finance helps improves the valuation of the company. Bridge
finance often has a realization period of 6 months to one year and hence the risk involved
is low. The bridge finance is paid back from the proceeds of the public issue.

2.5 What does a Venture Capitalist look in a Venture Capital?

Venture Capitalists are high risk investors and, in accepting these risks, they desire a
higher risks, they desire a higher return on their investment. The Venture Capitalist
manages the risk-return ratio by only investing in businesses that fit their investment
criteria and after having completed extensive due diligence.

Venture capitalists have differing operating approaches. These differences may relate to
the location of the business, the size of the investment, the stage of the company, industry
specialization, structure to the investment and involvement of the venture capitalists in
the company’s activities. The entrepreneur should not be discouraged if one venture
capitalist does not wish to proceed with an investment in the company. The rejection may
not be a reflection of the quality of the business, but rather a matter of the business not
fitting with the venture capitalist’s particular investment criteria.

Venture capital is not suitable for all businesses, as a venture capitalist typically seeks:

Superior businesses: Venture capitalists look for companies with superior products or
services targeted at fast-growing or untapped markets with a defensible strategic position.
Alternatively, for leveraged management buyouts, they are seeking companies with high
borrowing capacity, stability of earnings and an ability to generate surplus cash to quickly
repay debt.
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Quality and depth of management: Venture capitalists must be confident that the firm
has the quality and depth in the management team to achieve its aspirations. Venture
capitalists seldom seek managerial control; rather, they want to add value to the
investment where they have particular skills including fundraising, mergers and
acquisitions, international marketing and networks.

Corporate governance and structure: In many ways the introduction of a venture

capitalist is preparatory to a public listing. The venture capitalist will want to ensure that
the investee company has the willingness to adopt modern corporate governance
standards, such as non-executive directors, including a representative of the venture
capitalist. Venture capitalists are put off by complex corporate structures without a clear
ownership and where personal and business assets are merged.

Appropriate investment structure: As well as the requirement of being an attractive

business opportunity, the venture capitalist will also be seeking to structure a satisfactory
deal to produce the anticipated financial returns to investors.

Exit plan: Lastly, venture capitalists look for clear exit routes for their investments such
as public listing or a third-party acquisition of the investee company.

2.6 The Venture Capital Process

The venture capital investment activity is a sequential process involving five steps:

1. Deal Origination
2. Screening
3. Evaluation or due diligence
4. Deal structuring
5. Post-investment activities and exit

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 The Venture Capital Investment Process

The Venture Capital Investment Process

1. Deal origination: A continuous flow of deals is essential for the venture capital
business. Deals may originate in various ways. Referral system is an important source of
deals. Deals may be referred to the VCs through their parent organizations, trade partners,
industry associations, friends etc. The venture capital industry in India has become quite
proactive in its approach to generating the deal flow by encouraging individuals to come
up with their business plans. Consultancy firms like Mckinsey and Arthur Anderson have
come up with business plan competitions on an all India basis through the popular press
as well as direct interaction with premier educational and research institutions to source
new and innovative ideas. The short listed plans are provided with necessary expertise
through people who have experience in the industry.
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2. Screening: VCFs carry out initial screening of all projects on the basis of some broad
criteria. For example the screening process may limit projects to areas in which the
venture capitalist is familiar in terms of technology, or product, or market scope. The size
of investment, geographical location and stage of financing could also be used as the
broad screening criteria.

3. Evaluation or due diligence: Once a proposal has passed through initial screening, it
is subjected to a detailed evaluation or due diligence process. Most ventures are new and
the entrepreneurs may lack operating experience. Hence a sophisticated, formal
evaluation is neither possible nor desirable. The VCs thus rely on a subjective but
comprehensive, evaluation. VCFs evaluate the quality of the entrepreneur before
appraising the characteristics of the product, market or technology. Most venture
capitalists ask for a business plan to make an assessment of the possible risk and expected
return on the venture.

According to a study conducted by Professor IM Pandey of Indian Institute of

Management, Ahmedabad a venture capital fund places most importance on the
following eleven parameters in the same order of importance while evaluating a venture
for possible funding: Integrity, urge to grow, long-term vision, commercial orientation,
critical competence vis-à-vis venture, ability to evaluate and react to risk, well-thought
out strategy to remain ahead of competition, high market growth rate, expected return
over 25% p.a. in five years, managerial skills, marketing skills.

Investment Valuation The investment valuation process is aimed at ascertaining an

acceptable price for the deal. The valuation process goes through the following steps:

• Projections on future revenue and profitability

• Expected market capitalization
• Deciding on the ownership stake based on the return expected on the proposed
investment

The pricing thus calculated is rationalized after taking in to consideration various

economic scenarios, demand and supply of capital, founder's/management team's track
record, innovation/ unique selling propositions (USPs), the product/service size of the
potential market, etc

4. Deal Structuring: Once the venture has been evaluated as viable, the venture capitalist
and the investment company negotiate the terms of the deal, i.e. the amount, form and
price of the investment. This process is termed as deal structuring. The agreement also
includes the protective covenants and earn-out arrangements. Covenants include the
venture capitalists right to control the investee company and to change its management if
needed, buy back arrangements, acquisition, making initial public offerings (IPOs) etc,
Earn-out arrangements specify the entrepreneur's equity share and the objectives to be
achieved.
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Venture capitalists generally negotiate deals to ensure protection of their interests. They
would like a deal to provide for:

• A return commensurate with the risk

• Influence over the firm through board membership
• Minimizing taxes
• Assuring investment liquidity
• The right to replace management in case of consistent poor managerial
performance.

The investee companies would like the deal to be structured in such a way that their
interests are protected. They would like to earn reasonable return, minimize taxes, have
enough liquidity to operate their business and remain in commanding position of their
business.

There are a number of common concerns shared by both the venture capitalists and the
investee companies. They should be flexible, and have a structure, which protects their
mutual interests and provides enough incentives to both to cooperate with each other.

The instruments to be used in structuring deals are many and varied. The objective in
selecting the instrument would be to maximize (or optimize) venture capital's
returns/protection and yet satisfy the entrepreneur's requirements. The different
instruments through which a Venture Capitalist could invest a company include: Equity
shares, preference shares, loans, warrants and options.

5. Post-investment Activities and Exit: Once the deal has been structured and
agreement finalized, the venture capitalist generally assumes the role of a partner and
collaborator. He also gets involved in shaping of the direction of the venture. This may be
done via a formal representation of the board of directors, or informal influence in
improving the quality of marketing, finance and other managerial functions. The degree
of the venture capitalists involvement depends on his policy. It may not, however, be
desirable for a venture capitalist to get involved in the day-to-day operation of the
venture. If a financial or managerial crisis occurs, the venture capitalist may intervene,
and even install a new management team.

Venture capitalists typically aim at making medium-to long-term capital gains. They
generally want to cash-out their gains in five to ten years after the initial investment.
They play a positive role in directing the company towards particular exit routes. A
venture capitalist can exit in four ways:

• Initial Public Offerings (IPOs)

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• Acquisition by another company

• Repurchase of the venture capitalist’s share by the investee company
• Purchase of the Venture Capitalist's share by a third party.
2.7 Methods of Venture Financing
Venture capital is typically available in three forms in India, they are:

 Equity: All VCFs in India provide equity but generally their contribution does
not exceed 49 percent of the total equity capital. Thus, the effective control and
majority ownership of the firm remains with the entrepreneur. They buy shares of
an enterprise with an intention to ultimately sell them off to make capital gains.

 Conditional Loan: It is repayable in the form of a royalty after the venture is

able to generate sales. No interest is paid on such loans. In India, VCFs charge
royalty ranging between 2 to 15 percent; actual rate depends on other factors of
the venture such as gestation period, cost-flow patterns, riskiness and other factors
of the enterprise.

 Income Note: It is a hybrid security which combines the features of both

conventional loan and conditional loan. The entrepreneur has to pay both interest
and royalty on sales, but at substantially low rates.

 Other Financing Methods: A few venture capitalists, particularly in the private

sector, have started introducing innovative financial securities. The participating
debentures is an example of innovative venture financial. Such security carries in
three phases:

In the start-up phase, before the venture attains operations to a minimum level, no interest
is charged. After this, a low rate of interest is charged up to a particular level of
operation. Once the venture starts operating on full commercial basis, a high rate of
interest is required to be paid. A variation could be in terms of paying a certain share of
the post-tax profits instead of royalty.

VCFs in India provide venture finance through partially of fully convertible debentures
and cumulative convertible preference shares (CPP). CPP could be particularly attractive
in the Indian context since CPP shareholders do not have the right to receive dividend
consecutively for two years

In the developed countries like USA and the UK, the venture capital firms are
accustomed to using a wide range of financial instruments. They include:

1. Deferred Shares: where ordinary share rights are deferred for a certain number
of years
2. Convertible Loan Stock: which is unsecured long term loan convertible into
ordinary shares and subordinated to all creditors
3. Special Ordinary Shares: with voting rights but without a commitment towards
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dividend.
4. Preferred Ordinary Shares: With voting rights and a modest fixed dividend
right and a right to share in profits.
2.8 Disinvestment Mechanism:
The true objective of a true venture capitalist is to sell of his investment at substantial
capital gains. But most venture funds in India aim to operate on commercial lines along
with satisfying their developmental objectives. A venture capitalist is generally not in a
position to realize his investment before five to seven years.

The disinvestment options generally available to venture capitalist are:

1. Promoters Buyback:

The most important disinvestments route in India is the promoter’s buyback. This route is
suited to Indian condition because it keeps the ownership and control of the promoter
intact. The obvious limitation, however, is that in the majority of cases the market value
of the shares of the venture firm would have appreciated so much after some years that
the promoter would not be in a position to buy them back.

In India, promoters are invariably given the option to buyback the equity of their
enterprises. For example, RCTC participates in the assisted firm’s equity with suitable
agreement for the promoter to repurchase it. Similarly, Canfina-VCF offers an
opportunity to promoters to buyback the shares of the assisted firm within an agreed
period at a predetermined price. If the promoter fails to buyback the shares within the
stipulated time, Canfina-VCF would have the discretion to divest them in any manner it
deemed appropriate. SBI capital market ensures through examining the personal assets of
the promoters and their associates, which buyback, would be a feasible option.

2. Initial Public Offerings (IPOs):

The benefits of the disinvestments via the public issue route are improved marketability
and liquidity, better prospects for capital gains and widely known status of the venture as
well as market control through public share participation. The option has certain
limitations in Indian context. The promotion of the public issue would be difficult and
expensive since the first generation entrepreneurs are not known in the capital market.
Further, difficulties will be caused if the entrepreneur’s business is perceived to be an
unattractive investment proposition by investors. Also the emphasis of the Indian
investors on the short term profits and dividends may tend to make the market price
unattractive. Yet another difficulty in India until recently was the Controller of Capital
Issues (CCI) guidelines for determining the premium on shares took into account the
book value and the cumulative average EPS till the date of the new issue. This formula
failed to give due weight age to the expected stream of earning of the venture firm. Thus,
the formula would underestimate the premium. The Government has now abolished the
Capital Issues Control Act, 1947 and consequently, the office of the controller of Capital
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Issues. The existing companies are now free to fix the premium on their shares. The
initial public issue for disinvestments of VCFs’ holding can involve high transaction
costs because of the inefficiency of the secondary market in a country like India. Also,
this option has become far less feasible for small ventures on account of the higher listing
requirement of the stock exchanges. In February 1989, the Government of India raised
the minimum capital for listing on the stock exchanges from Rs 10 million to Rs 30
million and the minimum public offer from Rs 6 million to Rs 18 million.

3. Sale on the OTC Market

An active secondary capital market provides the necessary impetus to the success of the
venture capital. VCFs should be able to sell their holdings, and investors should be able
to trade shares conveniently and freely. In the USA, there exist well-developed OTC
markets where dealers trade in shares on telephone/terminal and not on an exchange
floor. This mechanism enables new, small companies which are not otherwise eligible to
be listed on the stock exchange, to enlist on the OTC markets and provides liquidity to
investors. The National Association of Securities Dealers Automated Quotation System
(NASDAQ) in the USA daily quotes over 8000 stock prices of companies backed by
venture capital.

The OTC Exchange in India was established in June 1992. The Government of India had
approved the creation for the Exchange under the Securities Contracts (Regulations) Act
in 1989. It has been promoted jointly by UTI, ICICI, SBI Capital Markets, Can bank
Financial Services, GIC, LIC and IDBI. Since this list of market-makers (who will decide
daily prices and appoint dealers for trading) includes most of the public sector venture
financiers, it should pick up fast, and it should be possible for investors to trade in the
securities of new small and medium size enterprises.

The other disinvestments mechanisms such as the management buyouts or sale to other
venture funds are not considered to be appropriate by VCFs in India.

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2.9 The Players

The players:

There are following group of players:

• Angels and angel clubs

• Venture Capital funds
 Small
 Medium
 Large
• Corporate Venture Funds
• Financial service venture groups
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Angels and angel clubs:

Angels are wealthy individuals who invest directly into companies. They can form angel
clubs to coordinate and bundle their activities. Besides the money, angels often provide
their personal knowledge, experience and contacts to support their investees. With
average deals sizes from USD 100,000 to USD 500,000 they finance companies in their
early stages. Examples for angel clubs are Media Club, Dinner Club, Angel's Forum

Small and Upstart Venture Capital Funds:

These are smaller Venture Capital Companies that mostly provide seed and start-up
capital. The so called "Boutique firms" are often specialised in certain industries or
market segments. Their capitalisation is about USD 20 to USD 50 million (is this deals
size or total money under management or money under management per fund?).
Examples are:

 Artemis Comaford
 Abbell Venture Fund
 Acacia Venture Partners

Medium Venture Funds:

The medium venture funds finance all stages after seed stage and operate in all business
segments. They provide money for deals up to USD 250 million. Single funds have up to
USD 5 billion under management. An example is Accel Partners

Large Venture Funds:

As the medium funds, large funds operate in all business sectors and provide all types of
capital for companies after seed stage. They often operate internationally and finance
deals up to USD 500 mio. Examples are:
 AIG American International Group
 Cap Vest Man
 3i

Corporate Venture Funds:

These Venture Capital funds are set up and owned by technology companies. Their aim is
to widen the parent company's technology base in an win-win-situation for both, the
investor and the investee. In general, corporate funds invest in growing or maturing
companies, often when the investee wishes to make additional investments in technology
or product development. The average deals size is between USD 2 million and USD 5
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million. Examples are:

 Oracle
  Adobe
 Dell
 Kyocera

As an example, Adobe systems launched a $40m venture fund in 1994 to invest in

companies strategic to its core business, such as Cascade Systems Inc and Lantana
Research Corporation- has been successfully boosting demand for its core products, so
that Adobe recently launched a second $40m fund.

Financial funds:

A solution for financial funds could be a shift to a higher security of Venture Capital
activities. That means that the parent companies shift the risk to their customers by
creating new products such as stakes in an Venture Capital fund. However, the success of
such products will depend on the overall climate and expectations in the economy. As
long as the sownturn continues without any sign of recovery customers might prefer less
risky alternatives.

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 CHAPTER – 3

VENTURE CAPITAL
IN INDIA

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3.1 Evolution of VC Industry in India
The major analysis on risk capital on India was reported in 1983. It indicated that new
companies often confront serious barriers to entry into capital markets for raising equity
finance which undermines their future prospects of expansion & diversification. It also
indicated that on the whole there is the need to revive the equity cult among the masses
by ensuring competitive return on equity investment. This brought out the institutional
inadequacies with respect to evolution of the Venture Capital.

In India, Industrial Finance Corporation of India (IFCI) initiated the idea of VC when it
established the Risk Capital Foundation in 1975 to provide seed capital to small and risky
projects. However the concept of VC financing got statutory recognition for the first time
in the Fiscal Budget for the year 1986 – 87.

The Venture Capital companies operating at present can be divided into 4 groups:
 Promoted by All India Development Financial Institutions
 Promoted by State Level Financial Institutions
 Promoted by Commercial Banks
 Private Venture Capitalists

 Promoted by All India Development Financial Institutions

The IDBI started a VC fund in 1987 as per the long term fiscal policy of government of
India, with an initial capital of 10 crores which raised by imposing a cess of 5% on all
payment made for the import of Technology know-how projects requiring funds from Rs
5 Lacs to Rs 2.5 Crores were considered for financing. Promoters contribution ranged
from this fund was available at a concessional interest rate of 9% (during gestation
period) which could be increased at later stages.

The ICICI provides the required impetus to VC activities in India, 1986, it started
providing VC finance on 1998 it promoted, along with the Unit Trust of India (UTI)
Technology Development & Information Company of India (TDICI) as the first VC
company registered under companies act, 1956. The TDICI may provide financial
assistance to Venture Capital undertakings which are set up by technocrat entrepreneurs
or technology information & guidance services.

The Risk Capital Foundation established by the Industrial Finance Corporation of India
(IFCI) in 1975, was converted in 1988 into the Risk Capital & Technology Finance
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Company (RCTC) as a subsidiary company of IFCI. The RCTC provides assistance in

the form of conventional loans, interest free conditional loans on profit and risk sharing
basis or equity participation in extends financial support to high technology projects for
technological up-gradation. The RCTC has been renamed as IFCI Venture Capital Funds
Ltd (IVCF).

 Promoted by State Level Financial Institutions

In India, the State Level Financial Institutions in some states such as Madhya Pradesh,
Gujarat, Uttar Pradesh etc have done an excellent job and have provided VC to a small
scale enterprises. Several successful entrepreneurs have been the beneficiaries of the
liberal funding environment. In 1990, the Gujarat Industrial Investment Corporation,
promoted the Gujarat Venture Financial Ltd (GVFL) along with other promoters such as
IDBI, the World Bank etc. The GVFL provides assistance to businesses in the form of
equity , conditional loans or income notes for technological development and product
innovation. It also provides financial assistance to entrepreneurs.

The Government of Andhra Pradesh has also promoted the Andhra Pradesh Industrial
Development Corporation (APIDC) Venture Capital Ltd to provide VC financing in
Andhra Pradesh.

 Promoted by Commercial Banks

Canbank Venture Capital Fund, State bank Venture Capital Fund and Grindlays Bank
Venture Capital Funds have been set up by respective commercial banks to undertake VC
activities.

The State bank Venture Capital Fund provides financial assistance for bought-out deal as
well as new companies in the form of equity which it disinvests after the
commercialization of the project.

Canbank Venture Capital Fund provides financial assistance for proven but yet to be
commercially exploited technologies. It provides assistance both in the form of equity
and conditional loans.

 Private Venture Capitalists

Several private sector Venture Capital Funds have been established in India such as the
20th Centure Venture Capital Company, Indus venture Capital Fund, Infrastructure
Leasing and Financial services Ltd.

Some of the companies that have received funding through this route includes:
• Mastek, one of the oldest software house in India
• Ruskan Software, Pune based software consultancy
• SQL Star, Hyderabad based training and software development consultancy
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• Satyam Infoway, the first private ISP in India

• Hinditron, makers of embedded software
• Selectia, provider of interactive software selectior
 • Yantra, ITLinfosy’s US subsidiary, solution for supply chain management
• Rediff on the net, Indian website featuring electronic shopping, news, chat etc.

3.2 Industry Life Cycle:

From the industry life cycle we can know in which stage we are standing. On the basis of
this management can make future strategies of their business.

The growth of VC in India has four separate phases:

3.2.1 Phase I - Formation of TDICI in the 80’s and regional funds as GVFL & APIDC in
the early 90s.

The first origins of modern venture capital in India can be traced to the setting up of a
Technology Development Fund in the year 1987-88, through the levy of access on all
technology import payments. Technology Development Fund was started to provide
financial support to innovative and high risk technological programs through the
Industrial Development Bank of India.

The first phase was the initial phase in which the concept of VC got wider acceptance.
The first period did not really experience any substantial growth of VCs’. The 1980’s
were marked by an increasing disillusionment with the trajectory of the economic system
and a belief that liberalization was needed. The liberalization process started in 1985 in a
limited way. The concept of venture capital received official recognition in 1988 with the
announcement of the venture capital guidelines.

During 1988 to 1992 about 9 venture capital institutions came up in India. Though the
venture capital funds should operate as open entities, Government of India controlled
them rigidly. One of the major forces that induced Government of India to start venture
funding was the World Bank. The initial funding has been provided by World Bank. The
most important feature of the 1988 rules was that venture capital funds received the
benefit of a relatively low capital gains tax rate which was lower than the corporate rate.
The 1988 guidelines stipulated that VC funding firms should meet the following criteria:

• Technology involved should be new, relatively untried, very closely held, in the
process of being taken from pilot to commercial stage or incorporate some
significant improvement over the existing ones in India

• Promoters / entrepreneurs using the technology should be relatively new,

professionally or technically qualified, with inadequate resources to finance the
project.
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Between 1988 and 1994 about 11 VC funds became operational either through
reorganizing the businesses or through new entities.
All these followed the Government of India guidelines for venture capital activities and
have primarily supported technology oriented innovative businesses started by first
generation entrepreneurs. Most of these were operated more like a financing operation.
The main feature of this phase was that the concept got accepted. VCs became
operational in India before the liberalization process started. The context was not fully
ripe for the growth of VCs. Till 1995; the VCs operated like any bank but provided funds
without collateral. The first stage of the venture capital industry in India was plagued by
in experienced management, mandates to invest in certain states and sectors and general
regulatory problems. Many public issues by small and medium companies have shown
that the Indian investor is becoming increasingly wary of investing in the projects of new
and unknown promoters.

The liberation of the economy and toning up of the capital market changed the economic
landscape. The decisions relating to issue of stocks and shares was handled by an office
namely: Controller of Capital Issues (CCI). According to 1988 VC guideline, any
organization requiring to start venture funds have to forward an application to CCI.
Subsequent to the liberalization of the economy in 1991, the office of CCI was abolished
in May 1992 and the powers were vested in Securities and Exchange Board of India. The
Securities and Exchange Board of India Act, 1992 empowers SEBI under section 11(2)
thereof to register and regulate the working of venture capital funds. This was done in
1996, through a government notification. The power to control venture funds has been
given to SEBI only in 1995 and the notification came out in 1996. Till this time, venture
funds were dominated by Indian firms. The new regulations became the harbinger of the
second phase of the VC growth.

3.2.2Phase II - Entry of Foreign Venture Capital funds (VCF) between 1995 -1999

The second phase of VC growth attracted many foreign institutional investors. During
this period overseas and private domestic venture capitalists began investing in VCF. The
new regulations in 1996 helped in this. Though the changes proposed in 1996 had a
salutary effect, the development of venture capital continued to be inhibited because of
the regulatory regime and restricted the FDI environment. To facilitate the growth of
venture funds, SEBI appointed a committee to recommend the changes needed in the VC
funding context. This coincided with the IT boom as well as the success of Silicon Valley
start-ups. In other words, VC growth and IT growth co-evolved in India

3.2.3 Phase III - (2000 onwards) - VC becomes risk averse and activity declines:

Not surprisingly, the investing in India came “crashing down” when NASDAQ lost 60%
of its value during the second quarter of 2000 and other public markets (including those
in India) also declined substantially. Consequently, during 2001-2003, the VCs started
investing less money and in more mature companies in an effort to minimize the risks.
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This decline broadly continued until 2003.

3.2.4 Phase IV – 2004 onwards - Global VCs firms actively investing in India

Since India’s economy has been growing at 7%-8% a year, and since some sectors,
including the services sector and the high-end manufacturing sector, have been growing
at 12%-14% a year, investors renewed their interest and started investing again in 2004.
The number of deals and the total dollars invested in India has been increasing
substantially.

3.3 Growth of venture capital in India:

The venture capital is growing 43% CAGR. However, in spite of the venture capital
scenario improving, several specific VC funds are setting up shop in India, with the year
2006 having been a landmark year for VC funding in India. The total deal value in 2007
is 14234 USD Million. The No. of deals are increasing year by year. The no. of deals in
2006 only 56 and now in 2007 it touch the 387 deals. The introduction stage of venture
capital industry in India is completed in 2003 after that growing stage of Indian venture
capital industry is started.

There are 160 venture capital firms/funds in India. In 2006 it is only but in 2007 the
number of venture capital firms are 146. The reason is good position of capital market.
But in 2008 no. of venture capital firms increase by only 14. the reason is crash down of
capital market by 51% from January to November 2008. The No. of venture capital funds
are increasing year by year.

2000 2001 2002 2003 2004 2005 2006 2007 2008

841 77 78 81 86 89 105 146 160

www.nasscom.org, strategic review 2008 published by (National Association of Software

and Service Companies)

Venture capital growth and industrial clustering have a strong positive correlation.
Foreign direct investment, starting of R&D centers, availability of venture capital and
growth of entrepreneurial firms are getting concentrated into five clusters. The cost of
monitoring and the cost of skill acquisition are lower in clusters, especially for
innovation. Entry costs are also lower in clusters. Creating entrepreneurship and
stimulating innovation in clusters have to become a major concern of public policy
makers. This is essential because only when the cultural context is conducive for risk
management venture capital will take-of clusters support innovation and facilitates risk
bearing. VCs prefer clusters because the information costs are lower. Policies for
promoting dispersion of industries are becoming redundant after the economic
liberalization.

The venture capital firm invest their money in most developing sectors like health care,
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IT-ITES, telecom, Bio-technology, Media& Entertainment, shipping & logistics etc.

Venture capital is nascent stage in India. Now due to growth of this sector, the venture
capital industry is also grow. The top most player in the industries are ICICI venture
capital fund, Avishhkar venture capital fund, IL&FS venture capital fund, Canbank.

3.4 Venture Capital investment Q3, 2008:

Venture Capital firms invested $274 million over 49 deals in India during the three
months ending September 2008. The VC investment activity during the period was
significantly higher compared to the same quarter last year (which had witnessed 36
investments worth $252 million) as well as the immediate previous quarter ($165 million
invested across 28 deals).

The latest numbers take the total VC investments in the first nine months of 2008 to $661
million (across 108 deals) as against the $648 million (across 97 deals) during the
corresponding period in 2007.

3.4.1 Top Investments :

The largest investment reported during Q3 2008 was the $18 million raised by online
tutoring services provider TutorVista from existing investors Sequoia Capital India and
LightSpeed Ventures.

Company Sector Amount Investors

(US$ M)
Tutor Vista Online servicing 18.0 Sequoia Capital
(Remote Tutoring) India,
Lightspeed Ventures
Connectiva Systems Communications 17.0 IFC, NEA-IUV,
Tech SAP
(Revenue Assurance Ventures, Others
Seventymm Online Services 12.0 NEA-IUV, ePlanet
(Video Rental) Ventures, Matrix
Partners
India,DFJ

Equitas Micro Microfinance 12.0 Bellwether, Others

Finance

HaloSource Water Purifiers 11.5 Origo Sino-India,

Unilever
Tech Ventures

Top venture capital investments

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3.4.2 Investments by Industry:
Information Technology and IT-Enabled Services (IT & ITES) industry retained its
status as the favorite among VC investors during Q3 ’08.

Industry Volume No of Deals Value US$ M

Q3’ 08 YTD Q3’ 08 YTD
IT & ITES 25 58 147 361
BFSI 5 8 34 54
Engineering & 3 4 23 33
Construction
Healthcare & 6 12 4 52
Life Sciences
Education 2 3 17 23
Other Services 1 6 15 29
Manufacturing 2 2 13 13
Media 2 5 11 19
Energy 2 6 6 48
Travel & 1 2 4 14
Transport
Retail - 1 - 10
Telecom - 1 - 5

Venture capital investment by industry

Led by the $12 million investment by Bellwether and others into Chennai-based
microfinance firm Equitas, BFSI emerged as the second largest (in value terms) for VC
investments during the period. Other microfinance firms that attracted investments during
Q3 ’08 included Kolkata-based Arohan Financial Services (which raised funding from
Lok Capital and others) and Guwahati-based Asomi Finance (IFC and Aavishkaar
Goodwell).

3.4.3 Investment By Stage:

About 67% of VC investments during Q3 ‘08 were in the early stage segment.

Stage of Company Volume Value

Development Q3’ 08 YTD Q3’ 08 YTD
Early 33 67 172 339
Growth 16 41 102 322

Investment by Stage
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3.5 Need for growth of venture capital in India

In India, a revolution is ushering in a new economy, wherein entrepreneurs mind set is

taking a shift from risk averse business to investment in new ideas which involve high
risk. The conventional industrial finance in India is not of much help to these new
emerging enterprises. Therefore there is a need of financing mechanism that will fit with
the requirement of entrepreneurs and thus it needs venture capital industry to grow in
India.

Few reasons for which active Venture Capital Industry is important for India include:

 Innovation : needs risk capital in a largely regulated, conservative, legacy

financial system

 Job creation: large pool of skilled graduates in the first and second tier cities

 Patient capital : Not flighty, unlike FIIs

 Creating new industry clusters: Media, Retail, Call Centers and back office
processing, trickling down to organized effort of support services like office
services, catering, transportation

3.6 Regulatory and legal framework

Definition of Venture Capital Fund : The Venture Capital Fund is defined as a

fund established in the form of a Trust, a company including a body corporate and
registered with SEBI which:

A. Has a dedicated pool of capital;

B. Raised in the manner specified under the regulations; and
C. To invest in venture capital undertakings in accordance with the regulations."

Definition of Venture Capital Undertaking: Venture Capital Undertaking

means a domestic company:-

a. Whose shares are not listed on a recognized stock exchange in India

b. Which is engaged in business including providing services, production or manufacture
of articles or things, or does not include such activities or sectors which are specified in
the negative list by the Board with the approval of the Central Government by
notification in the Official Gazette in this behalf? The negative list includes real estate,
non-banking financial services, gold financing, activities not permitted under the
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Industrial Policy of the Government of India.

Minimum contribution and fund size: The minimum investment in a Venture Capital
Fund from any investor will not be less than Rs. 5 lacs and the minimum corpus of the
fund before the fund can start activities shall be at least Rs. 5 crores.

Investment Criteria: The earlier investment criteria has been substituted by a new
investment criteria which has the following requirements :

 Disclosure of investment strategy;

 maximum investment in single venture capital undertaking not to exceed 25% of

the corpus of the fund;

 Investment in the associated companies not permitted;

 At least 75% of the investible funds to be invested in unlisted equity shares or

equity linked instruments.

 Not more than 25% of the investible funds may be invested by way of:

a) Subscription to initial public offer of a venture capital undertaking whose shares

are proposed to be listed subject to lock-in period of one year;
b) Debt or debt instrument of a venture capital undertaking in which the venture
capital fund has already made an investment by way of equity

It has also been provided that Venture Capital Fund seeking to avail benefit under the
relevant provisions of the Income Tax Act will be required to divest from the investment
within a period of one year from the listing of the Venture Capital Undertaking.

Disclosure and Information to Investors: In order to simplify and expedite the process
of fund raising, the requirement of filing the Placement memorandum with SEBI is
dispensed with and instead the fund will be required to submit a copy of Placement
Memorandum/ copy of contribution agreement entered with the investors along with the
details of the fund raised for information to SEBI. Further, the contents of the Placement
Memorandum are strengthened to provide adequate disclosure and information to
investors. SEBI will also prescribe suitable reporting requirement from the fund on their
investment activity.

QIB status for Venture Capital Funds: The venture capital funds will be eligible to
participate in the IPO through book building route as Qualified Institutional Buyer
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subject to compliance with the SEBI (Venture Capital Fund) Regulations.

Relaxation in Takeover Code: The acquisition of shares by the company or any of the
promoters from the Venture Capital Fund under the terms of agreement shall be treated
on the same footing as that of acquisition of shares by promoters/companies from the
state level financial institutions and shall be exempt from making an open offer to other
shareholders.

Investments by Mutual Funds in Venture Capital Funds: In order to increase the

resources for domestic venture capital funds, mutual funds are permitted to invest upto
5% of its corpus in the case of open ended schemes and upto 10% of its corpus in the
case of close ended schemes. Apart from raising the resources for Venture Capital Funds
this would provide an opportunity to small investors to participate in Venture Capital
activities through mutual funds.

Government of India Guidelines: The Government of India (MOF) Guidelines for

Overseas Venture Capital Investment in India dated September 20, 1995 will be repealed
by the MOF on notification of SEBI Venture Capital Fund Regulations.

The following will be the salient features of SEBI (Foreign Venture Capital
Investors) Regulations, 2000 :

Definition of Foreign Venture Capital Investor : Any entity incorporated and

established outside India and proposes to make investment in Venture Capital Fund or
Venture Capital Undertaking and registered with SEBI.

Eligibility Criteria : Entity incorporated and established outside India in the form of
investment company, trust, partnership, pension fund, mutual fund, university fund,
endowment fund, asset management company, investment manager, investment
management company or other investment vehicle incorporated outside India would be
eligible for seeking registration from SEBI. SEBI for the purpose of registration shall
consider whether the applicant is regulated by an appropriate foreign regulatory
authority; or is an income tax payer; or submits a certificate from its banker of its or its
promoters’ track record where the applicant is neither a regulated entity nor an income
tax payer.

Investment Criteria:
 Disclosure of investment strategy;
 Maximum investment in single venture capital undertaking not to exceed 25% of the
funds committed for investment to India however it can invest its total fund committed in
one venture capital fund;
 Atleast 75% of the investible funds to be invested in unlisted equity shares or equity
linked instruments.
 Not more than 25% of the investible funds may be invested by way of:

a. Subscription to initial public offer of a venture capital undertaking whose shares

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are proposed to be listed subject to lock-in period of one year;

 b. Debt or debt instrument of a venture capital undertaking in which the venture
capital fund has already made an investment by way of equity.
Hassle Free Entry and Exit: The Foreign Venture Capital Investors proposing to make
venture capital investment under the Regulations would be granted registration by SEBI.
SEBI registered Foreign Venture Capital Investors shall be permitted to make investment
on an automatic route within the overall sectoral ceiling of foreign investment under
Annexure III of Statement of Industrial Policy without any approval from FIPB. Further,
SEBI registered FVCIs shall be granted a general permission from the exchange control
angle for inflow and outflow of funds and no prior approval of RBI would be required for
pricing, however, there would be ex-post reporting requirement for the amount
transacted.

Trading in unlisted equity : The Board also approved the proposal to permit OTCEI to
develop a trading window for unlisted securities where Qualified Institutional Buyers
(QIB) would be permitted to participate.

Over the last few years Indian venture capital has evolved its own set of procedures and
practices. The foremost of these practices is the manner in which Indian venture firms
choose their investments. Like their counterparts in US and Europe venture capitalists
here look for investments with a characteristic of high risk and high return. The choice of
investment is the function of the venture capitalists policy with regards to the preferred
industries and the stage of the investee company, yet the exact choice of investment vary
from one venture capital fund to another.

3.7 Key considerations

For investor/venture capitalist Ideal entrepreneur

A venture capital (VC) who is financing the firm would as the first necessity assess and
gauge the promoters. Because in the case of start-up where the product or the technology
is yet to be tested, the only thing they can trust and their investment on the people behind
it. While investing in a company what a VC is essentially looking for is a partnership and
therefore the first decision making criterion is the character and personality of the
promoters. However from a venture capitalist’s perspective, the ideal entrepreneur,

 Is qualified in a ‘hot’ area of interest

 Delivers sales or technical advances such as FDA approval with reasonable
probability
 Tells a compelling story and is presentable to outside investors,
 Recognizes the need for speed to an Initial Public Offering (IPO) for liquidity,
 Has a good reputation and can provide references that show competences and
skill,
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 Understand the need for a team with a variety of skill and therefore sees why
equity has to be allocated to other people
 Works diligently toward a goal but maintains flexibility
  Get along with the investor group
 Understands the cost of capital and typical deal structures and is not offended by
them
 Is sought after by many VCs
 Has a realistic expectation about process and outcome.

Besides the ideal entrepreneur, the investor tries to ensure the following for himself.

 Reasonable reward given in the level of risk.

 Sufficient influence on the management of the company through board
representation.
 Minimization of taxes.
 Ease in achieving future liquidity on the investment.
 Flexibility of structure that will allow room to enable additional investment later,
incentives for future management and retention of stocks if management leaves
 Balance-sheet attractiveness to suppliers and debt financier
 Retention of key employees through adequate equity participation

3.8 Venture financing practices and procedures:

Factors Influencing Venture Capitalists Choice of Investment

The venture capitalists usually take into account the following factors while deciding on
the investment.

1. Track record of the promoters and the management team is the single most important
factor. It is often said that three most important considerations in selecting the venture
capital investment are “Management”, “Management” and “Management”. Venture
capitalists look for a track record in terms of the successes of the promoters in their
previous vocations, whatever these might have been. They put their bets on successful
people and avoid those who have tasted failures earlier.

A venture capital fund manager does not take more than ten minutes to decide if the
management quality is not okay. The two key points a venture capital manager sees are
weather the entrepreneur has a vision and whether the management team is cohesive.
Here he looks for various questions like:

 How do entrepreneurs work together?

 How compatible is the venture capital fund with the team?
 How complete is the management expertise in the area of business? This means,
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do the team have members with expertise in various aspects of business.

 How is the chemistry between various members of the team?
They also check on the softer issues like temperament of team members, past record and
overall management competence.

2. The nature of the business and the promoters experience in the proposed or related
business is an important consideration. Venture capitalists are the firm believer of the
Corridor Principal1 that states that the probability of the venture‘s success is high when
the business falls in the corridor of the entrepreneur‘s previous vocation or education.

3. The business should meet the investment objectives of the venture capitalist in terms of
risk profile, the return and the time horizon of the fund. In case of closed ended funds, if
the venture capital has earned a substantial return in the first round of investments, it is
more open to investments with comparatively higher risk. In the initial investment rounds
of a fund the venture capitalist is normally willing to take a longer term exposure as
compared the later rounds when the fund is nearing maturity. In the later rounds the
venture capitalist goes in for balancing investments.

4. The funds normally invest in select industries where they have the knowledge and
expertise. This helps then in providing value added services to the investee companies.

5. Project cost, scheme for financing and financial projections over next few years,
including details of underlying assumptions are closely studied, The resultant Internal
rate of return (IRR) must meet the minimum fixed by the venture capitalist as the hurdle
rate. The IRR is adjusted for any protection, the venture might be enjoying in the form of
subsidy or any other concession from any government or statutory body. This is to ensure
the inherent earning potential of the investment in spite of policy changes by the
government.

6. Marketing strategy, including target market, market survey, marketing effort, market
size and growth potential also effect the decision.

7. Technology and technology collaboration if any are looked at carefully.

8. Miscellaneous factors looked at include raw material availability, pollution clearances,

government policy, rules and regulations — controlling the industry, location, water and
electricity needs etc..

Most of the venture capital firms do not want an introduction from any one. A business
proposal that is well prepared is the best introduction that one can ha‘ye. Most venture
capital firms are interested in good investments and not in social contacts and
introductions.

A detailed and well-organized business plan is the only way to gain a venture capitalist
attention and obtain funding. VCs do not invest in a two page summery. The summary is
needed as a start but not as a substitute for a sound plan. A well prepared business plan
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serves two functions. Firstly it informs the venture capitalists about the entrepreneur‘s
ideas, secondly it shows that the entrepreneur has seriously thought about the intended
business, knows the industry and has thought through all the potential problems.

The summary should contain the name, address and telephone number of the contact
persons in a conspicuous location. Briefly the type of business or nature of industry
should be discussed. This should be followed by a thumb nail sketch of the company‘s up
to date history. The experience of the entrepreneurs and the top management personal
should be mentioned. A short description of product or service is required. The amount of
funds and the form in which required should also be given. Summary of five years
financial projections and five years history of existing group companies should be
appended. Besides the exit plan should also be mentioned.

The detailed proposal must cover the following issues:

I. Business and its Future

1. Nature of Business
2. Business History
3. Future Projections
4. Uniqueness
5. Target Customers
6. Competition
7. Production Process
8. Market
9. Labor and Employees
10. Suppliers
11. Sub-contractors
12. Plant and Equipment
13. Property and Facilities
14. Patents and Trademark
15. Research & Development
16. Litigations
17. Government Regulations
18. Conflict of Interest
19. Orders outstanding
20. Insurance
21. Taxes
22. Corporate Structure

II. Management
1. Directors and Officers
2. Key Employees
3. Remunerations
4. Conflict of Interest
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5. Principal Share Holders

6. Consultants, Lawyers Accountants, & Bankers
III. Financing
1. Proposed Financing
2. Collaterals
3. Condition of Financing
4. Proposed Reporting and MIS
5. Investor Involvement
6. Capital Structure
7. Guarantees
8. Use of Proceeds
9. Fees Paid

IV. Risk Factors

1. Limited Operating History
2. Limited Resources
3. Limited Management Experience
4. Market Uncertainties
5. Production Uncertainties
6. Liquidation
7. Dependence on Key Management Personal
8. What Could Go Wrong?

V. Analysis of Operations and Projections

1. Financial Projections
2. Ratio Analysis
3. Contingent Liability

VI. Product Literature, Procedure and Articles

Venture capital firms in India usually have either a fixed format or guidelines on how to
present a proposal and the information they are looking for.

IDBI has prescribed a preliminary application format, to include, brief details of

performance of industrial concerns if existing, nature and advantages of the proposed
process / product, development content in the process, proposal for scheme including
nature of up-scaling and appropriate cost of venture. After examining the prima facie
eligibility of the proposal a detailed application form is send by IDBI.

In case of IDBI the factors taken into account while appraising the project include the
technology development content. The commercial aspects such as cost advantage of the
proposed technology, market potential, demand supply gap, and the availability of
management team well versed in various disciplines.
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Indus venture capital fund usually accepts the project report prepared as per the format
prescribed by the financial institutions as in most cases the project will have been
received and appraised by the institution before it comes to Indus Investment Fund.
Customer is asked to bear the transaction cost relating to investment by Fund including
any professional fee of accountants, solicitors etc. In the - proposal or project report, they
look for the background and performance record of promoters, nature of promoters
business, summary of the project cost and the amount of money sought, information on
loan and bank facilities, other equity participants, details of government approvals
required for the project and their current status, details of management team and its
experience, outline of product, market size, strategy and marketing plan, summary of
premises, production and general operations, financial projections covering five years
period, cash flow forecasts. Details of financial operations of the existing group
companies for last five years particularly audited figures and forecast for the current year
are also sought.

IFCI Venture also has a detailed Techno Economic evaluation and takes help of outside
experts whenever required. The format prescribed by them includes name and address of
the organization, write up on promoters and their background, particulars of the company
structure, R & D set up, project / feasibility report, market survey report, production
process / technology, status / stage of development of technology, advantages of the
proposed project over existing products, scope of commercial exploitation, proposed
strategy for achieving the objective including specific approach for such tasks, as
technology inputs, design, development, prototype development and production, large
scale production, testing, evaluation, manufacturing arrangement for up gradation to
commercial scald economic scale of production, manpower development, market
penetration and also likely constraints and how these are proposed to be overcome;
details of government‘s consents, cost of project and proposed means of financing,
organization chart for the company and the project, responsibility centers, bio-data of key
personals, sales forecasts, profitability projections, cash flow statements and amount and
type of assistance required from IFCI Ventures.

ICICI venture considers investment on the basis of four important aspects. First is the
sound management team whose members have established track records with displayed
ability, dedication and integrity. Second is the large and rapidly growing market
opportunity. Scope for international marketing of the product or service is considered an
added advantage. Third is the long term competitive advantage that would pose entry
barriers to competition. This could be in terms of quality, performance or cost over
substitute and competitive products. Finally it is the potential for above average
profitability leading to attractive return over a longer period.

The criterions used by APIDC Venture Capital Fund in selecting the investee company
include several factors. The quality, depth, maturity and experience of management or
exposure in the industry in which the assisted concern proposes to implement the project
are factored in. In case of project by first generation entrepreneur, the experience,
qualification and depth of knowledge of the relevant lines and the efforts put in by the
entrepreneur are considered. The other factors are innovativeness of the technology /
process, its advantage over the existing technology / process, the resultant benefits that
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may accrue on account of the new technology and process; in case of existing products,
the potential size of the market with long term growth prospects, existence of clear
demand supply gap over the period of investment or advantage available to the assisted
concern for marketing its product over its competitors; in case of innovative product the
competitive advantage of such product over existing products, the potential for
replacement and estimate of such replacement demand; in case of new products its
uniqueness and innovation to give competitive edge over the existing products.

IL&FS Venture Corporation considers market growth potential, management skills,

technology, quality consciousness, experience in the related field, commitment to the
business and business ethics in the order of priority. Their investment in a particular
industry is based upon its growth potential, technical innovation and rate of obsolescence.

With the maturity of venture capital industry the decision to invest now hinges on four
criteria, each of which must be satisfied before the venture capitalist commits his funds.

A host of new breed private sector and offshore funds during due diligence follow a four
point criteria as under:

1. Fundamental analysis as to the soundness of the business.

2. Financial analysis of the prospect for the value of the business to grow.
3. Portfolio analysis is to determine whether the investment will fit into the venture
capitalists “basket” of investments.
4. Disinvestment analysis to determine the mean time and a probable value of the
investment upon exit.

1. Fundamental Analysis

A detailed fundamental analysis of the enterprise and the industry is considered essential.
The fundamental analysis at the minimum should consider the following:

 A brief history of the company including date of incorporation and summery of

progress to date.
 The quality, experience, strategy and motivation of the management, directors and
existing shareholders.
 A complete description of company‘s products or services. This considers the
distinctive advantage or unique selling points which is likely to lead to the
company‘s success.
 The market which the company services, including size and nature of the industry,
the size, location and characteristics of customer base, potential competition and
distinctive or any unique selling point.
 Manufacturing and operational aspects of business, including a description of
technology employed, access to sources of supply, manufacturing capacity and
the premises owned or occupied.
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 An objective analysis of the fundamental risk and the management‘s plan to cope
with these.
 2. Financial Analysis

Indian venture capital firms use financial analysis to look at the financial implications of
the company‘s strategy and to measure its performance. Venture capitalists use this to
determine:

 The earning growth potential of the company.

 The sensitivity of these earnings to fluctuations in sales & margins and thus the
risk associated with the returns.
 The likely time lag between investments (e.g. Capital equipments, marketing etc,)
and returns.
 The likely impact on cash flows, and possibility of having to make second or third
round financing into the Investee Company, which do not live up to their
projections.
 The expected value of the company at the time of disinvestment.
 An objective analysis of the financial risk and management‘s plans to cope with
them.

3. Portfolio Analysis

The initial investment decision also depends upon the venture capitalist‘s portfolio
balance at the time the investment proposal is being considered. That is the proposed
investment must be an acceptable addition to venture capitalist‘s portfolio in terms of its
size, its stage of development, its geographic location and its industry sector. Many
venture capital firms avoid seed startup or early stage propositions for fundamental
reasons, while a growing number of venture capitalists are wary of irrational and
depressed IPO markets in India and hence avoid Buyout / Buying.

4. Disinvestment Analysis

It is vital that the venture capitalist keeps his mind on exit at all times; clear idea as to the
method, the timing and the valuation of the company upon disinvestment. Indian venture
capital funds have faced maximum problem in this respect. Presently the exit plan is
finalized and agreed upon before the venture capital fund commits investment.

Till 1998 foreign venture capital funds were not convinced that money could be made in
India and concerns existed on the exit options, The successful exit of ICICI ventures and
some other domestic funds have acted as a trigger in attracting a number of foreign
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venture capital funds to India.

The other important practices relate to use of financing instrument and the process of
monitoring and value addition.

Structuring A Deal
During structuring a deal venture capital in India has faced two specific problems,
namely:

Promoter share: As venture capital is to finance growth, venture capital investment

should ideally be used for financing expansion of the ventures (eg. New plant, capital
equipment, additional working capital etc.). On the other hand, entrepreneurs may want
to sell away a part of their own interests in order to book-in a profit for their work in
building up the company. In such case, the structuring often includes some vendor shares,
with the bulk of financing going to buying new shares to finance growth.

Handling director’s and shareholder’s loans:

In India a company often has an existing director‘s and shareholder‘s loans prior to
inviting a venture capitalist to invest. As the money from venture capital is put into the
company to finance growth, it is preferable to secure the deal to require these loans to be
repaid back to the shareholders / directors only upon IPOs / exits or at some mutually
agreed period (say 1 Or 2 years after investment) This increases the financial
commitment of the entrepreneurs and the shareholders of the enterprise.

Financing Instruments

The type of financing available from the Indian venture capitalists was mainly equity or
debt or a combination of both. Due to the rigid rules in India, the Indian venture capital
firms do not have the flexibility that UK or US venture capitalists have in innovating new
investment instruments. PACT and TDICI (earlier versions of ICICI Ventures) were first
to use “royalty on sales” in Indian venture capital. Herein the investee company is
provided conditional loan that is serviced through a percentage of sales as royalty if the
venture succeeds and the amount is written off if it fails. Of late with the relaxation of the
regulation and the maturity of the venture capital industry innovative financing
instruments are now available. ICICI venture has introduced optionally and partially
convertible debentures. Share warrants have been used to bring down prices. ICICI and
some other funds have provided bridge finance to the assisted companies. Over the last
five years Indian venture capitalists have become more flexible.

In the five year period 1993-98 venture capital investment in the form of non convertible
debt has reduced from 36 percent to 7 percent. Some funds invest using only one or two
instruments; others use a variety of instruments In India only 20 percent venture capital
firms use just one type of instrument, while 30 percent use two types of instruments. A
few funds use even five types of investment instruments.
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Monitoring
All venture capitalists in India practice hands on active monitoring. 17 venture capital
firms provided information about their monitoring practice. 15 respondents claimed
active monitoring while one called its monitoring approach as proactive. Only one fund is
believed to be following a passive / hands off approach. ICICI Ventures follows a mid
way approach. Almost all the domestic funds nominate their representatives on the Board
of Directors of the investee companies. Offshore funds are not that particular about their
nominee on the Board of the investee company, however they are very particular on
regular monitoring. In terms of value added services most of the Indian venture capital
funds provide only financial advice and a few of them provide management inputs.
According to the views of the assisted entrepreneurs the contribution of the nominee
directors particularly from the public sector funds is lacklustre except in the area of
financial management. Very few funds are able to provide a real value addition through
networking. However some of the state sector venture funds do provide good support in
interfacing with state agencies and are helpful in arranging additional funds from state
industrial development and financial institutions.

Gujarat Venture Finance Ltd. supported Saraf Foods, an investee company in many ways
— by arranging for finance when the company was in need of it, getting technical
problems sorted out when the pilot project had teething problems. It stood behind Suresh
Saraf, the promoter of Saraf Foods even while the company was not making profits in the
first couple of years. It also encouraged the company to expand.3 DHL decided to go in
for venture capital funding, its aim was not only to correct the debt equity structure of the
company but also find a partner who could help them introduce the best practices in
financial management. It wanted to hive off its international travel business and wanted
to choose a partner to do due diligence for it. It chose Bankers Trust as its venture
capitalist which also helped DHL, in Y2K compliance and in its financial management.

3.9 Where are VC’s Investing In India?

• IT and IT enabled services

• Software Products (Mainly Enterprise-focused)
• Wireless/Telecom/Semiconductor
• Banking
• PSU Disinvestments
• Media/Entertainment
• Bio Technology/Bio Informatics
• Pharmaceuticals
• Electronic Manufacturing
• Retail
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 Chapter – 4

Comprehensive Study

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4.1 Alternatives to VC Funding

VENTURE CAPITAL & ALTERNATIVE FINANCING COMPARISON

Private Placement, IPO,

vendor financing, state funding, Venture Capital

strategic alliance, parent company

finance

Angel investment, licensing self Bootstrapping(factoring, trade credit,

funding, friends, family, leasing ), micro loans, financing
Community bank debt, sell some assets, business credit
card

Low High

LEVEL OF RISK

Venture Capital & Alternative Financing comparison

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If we’ are struggling to find success in our quest for venture capital, may be we are
looking in the wrong place. Venture capital is not for everybody. For starters, venture
capitalists tend to be very picky about where they invest. They are looking for something
to dump a lot of money into (usually no less than $1 million) that will pour even more
money right back at them in a short amount of time (typically 3-7 years). We may be
planning for a steady growth rate as opposed to the booming, overnight success that
venture capitalists tend to gravitate toward. We may not be able to turn around as large of
a profit as they are looking for in quick enough time. We may not need the amount of
money that they offer or our business may simply not be big enough.

Simply put, venture capital is not the right fit for our business and there are plenty of
other options available when it comes to finding capital.

4.1.1 Substitute in Early stage

1. Angels

Most venture capital funds will not consider investing in anything under $1 million to $2
million. Angels, however, are wealthy individuals who will provide capital for a startup
business. These investors have usually earned their money as entrepreneurs and business
managers and can serve as a prime resource for advice on top of capital. On the other
hand, due to typically limited resources, angels usually have a shorter investment horizon
than venture capitalists and tend to have less tolerance for losses.

2. Private Placement

An investment bank or agent may be able to raise equity for our company by placing our
unregistered securities with accredited investors. However, you should be aware that the
fees and expenses associated with this practice are generally higher than those that come
with venture and angel investors. We will likely receive little or no business counsel from
private investors who also tend to have little tolerance for losses and under-performance.

3. Initial Public Offering

If we are somehow able to gain access to public equity markets than an initial public
offering (IPO) can be an effective way to raise capital. Keep in mind that, while the
public market’s high valuations, abundant capital and liquidity characteristics make it
attractive, the transaction costs are high and there are ongoing legal expenses associated
with public disclosure requirements.

4.1.2 Later Stage Financing

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1. Bootstrap Financing
 This method is intended to develop a foundation for your business from scratch.
Financial management is essential to make this work. With bootstrap financing you’re
building a business from nothing, which means there is little to no margin for error in the
finance department. Keep a rigid account of all transactions and don’t stray from your
budget.

A few different methods of bootstrapping include :

Factoring, which generates cash flow through the sale of your accounts receivable to a
“factor” at a discounted price for cash.

Trade Credit is an option if you are able to find a vendor or supplier that will allow you
to order goods on net 30, 60 or 90 day terms. If you can sell the goods before the bill
comes due then you have generated cash flow without spending any money. Customers
can pay you up front our services.

Leasing your equipment instead of purchasing it outright.

2. Fund From Operations

Look for ways to tweak your business in order to reduce the cash flowing out and
increase the cash flowing in. Funding found in business operations come free of finance
charges, can reduce future financing charges and can increase the value of your business.
Month-by-month operating and cash projections will show how well we have planned,
how you can optimize the elements of your business that generate cash and allow you to
plan for new investments and contingencies.

3. Licensing

Sell licenses to technology that is non-essential to our company or grant limited licensing
to essential technology that can be shared. Through out licensing we can generate
revenue from up-front fees, access fees, royalties or milestone payments.

4. Vendor Financing

Similar to the trade credit related to bootstrap financing, vendors can play a big role in
financing your new business. Establish vendor relationships through our trade association
and strike deals to offer their product and pay for it at a date in the near future. Selling the
product in time is up to us. In hopes of keeping you as a customer, vendors may also be
willing to work out an arrangement if we need to finance equipment or supplies. Just
make sure to look for stability when you research a vendor’s credentials and reputation
before you sign any kind of agreement. And keep in mind that many major suppliers (GE
Small Business Solutions, IBM Global Financing) own financial companies that can help
you.
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5. Self Funding
 Search between the couch cushions and in old jacket pockets for whatever extra money
you might have lying around and invest it into your business. Obviously loose change
will not be enough for extra business funding, but take a look at your savings, investment
portfolio, retirement funds and employee buyout options from your previous employer.
You won’t have to deal with any creditors or interest and the return on your investment
could be much higher.

However, make sure that you consider the risks involved with using your own resources.
How competitive is the market that you are about to enter into? How long will it take to
pay yourself back? Will you be able to pay yourself back? Can you afford to lose
everything that you are investing if your business were to fail?

It’s important that your projected returns are more than enough to cover the risk that you
will be taking.

6. SBIR and STTR Programs

Coordinated by the SBA, SBIR (Small Business Innovation Research) and STTR
(Small business Technology Transfer) programs offer competitive federal funding
awards to stimulate technological innovation and provide opportunities for small
businesses. You can learn more about these programs at SBIRworld.com.

7. State Funding

If you’re not having any luck finding funding from the federal government take a
look at what your state has to offer. There is a list of links to state development
agencies that offer an array of grants and financial assistance for small businesses
on About.com.

8. Community Banks

These smaller banks may have fewer products than their financial institution
counterparts but they offer a great opportunity to build banking relationships and
are generally more flexible with payment plans and interest rates.

9. Microloans

These types of loans can range from hundreds of dollars to low six-figure
amounts. Although some lenders regard microloans to be a waste of time because
the amount is so low, these can be a real boon for a startup business or one that
just needs to add some extra cash flow.
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10. Finance Debt

 It may be more expensive in the long run than purchasing, but financing your
equipment, facilities and receivables can free up cash in the short term or reduce
the amount of money that you need to raise.

11. Friends

Ask your friends if they have any extra money that they would like to invest.
Assure them that you will pay them back with interest or offer them stock options
or a share of the profits in return.

12. Family

Maybe you have a rich uncle or a wealthy cousin that would be willing to lend
you some money get your business running or send it to the next level. Again,
make it worth their while by offering interest, stocks or a share of the profits.

13. Form a Strategic Alliance

Aligning your business with a corporation can produce funding from upfront or
access fees to your service, milestone payments and royalties. In addition,
corporate partners may be able to provide research funding, loans and equity
investments.

14. Sell Some Assets

Find an interested party to buy some of your assets (computers, equipment, real
estate, etc…) and then lease them back to you. This provides an instant source of
cash and you will still be able to use whatever assets you need.

15. Business Lines Of Credit

If your business has positive cash flow and has proven that it will cover its debts
then you may be eligible for a business line of credit. This type of financing is a
common service offered by most business banks and serves as business capital, up
to an agreed upon amount, that you can access at any time.

16. Personal Credit Cards

Using personal credit cards to finance a business can be risky but, if you take the
right approach, they can also give your business a lift. You should only consider
using this type of financing for acquiring assets and working capital. Never
consider this to be a long-term option. Once your company breaks even or moves
into the black, ditch the credit cards and move toward traditional bank financing
or lease agreements.
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 17. Business Credit Cards

Business credit cards carry similar risks as personal credit cards but tend to be a
safer alternative. While the activity on this card goes toward your credit report, a
business credit card can help you to build business credit, keep your business
expenses separate from your personal expenses and can make tax season easier to
manage.

4.2 Key success factor for venture capital industry in India

Knowledge become the key factor for a competitive advantage for company. Venture
Capital firms need more expert knowledge in various fields. The various key success
factor for venture capital industry are as follow:

 Knowledge about Govt. changing policies:

Investment, management and exit should provide flexibility to suit the business
requirements and should also be driven by global trends. Venture capital investments
have typically come from high net worth individuals who have risk taking capacity. Since
high risk is involved in venture financing, venture investors globally seek investment and
exit on very flexible terms which provides them with certain levels of protection. Such
exit should be possible through IPOs and mergers/acquisitions on a global basis and not
just within India. In this context the judgement of the judiciary raising doubts on
treatment of tax on capital gains made by firms registered in Mauritius gains significance
- changing policies with a retrospective effect is undoubtedly acting as a dampener to
fresh fund raising by Venture capital firms.

 Quick Response time :

The company have flat organization structure results in quicker decision making. The
entrepreneur is relieved of the trauma that one normally goes through in an interface with
a funding institution or a development agency. They follow a clearly defined decision
making process that works with clock like precision, which means that if they agree on a
funding schedule entrepreneur can count on them to stick it.

 Knowledge about Global Environment

With increasing global integration and mobility of capital it is important that Indian
venture capital firms as well as venture financed enterprises be able to have opportunities
for investment abroad. This would not only enhance their ability to generate better returns
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but also add to their experience and expertise to function successfully in a global
environment.
  Good Human Resource :

Venture capital should become an institutionalized industry financed and managed by

successful entrepreneurs, professional and sophisticated investors. Globally, venture
capitalist are not merely finance providers but are also closely involved with the investee
enterprises and provide expertise by way of management and marketing support. This
industry has developed its own ethos and culture. Venture capital has only one common
aspect that cuts across geography i.e. it is risk capital invested by experts in the field. It is
important that venture capital in India be allowed to develop via professional and
institutional management.

 Balance between three factors

Venture Capital backed companies can provide high returns. However, despite of success
stories like Apple, FedEx of Microsoft, a lot of these deals fail. It is said that only one out
of ten companies succeed. That's why every deal has an element of potential profit and an
element of risk, depending on the deals size. To be successful, a Venture Capital
Company must manage the balance between these three factors.

Frame work for key success factor

Knowledge is key, to get the balance in this "Magic Triangle". With knowledge we mean
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knowledge about the financial markets and the industries to invest in, risk management
skills and contacts to investors, possible investees and external expertise. High profits,
achievable by larger deals, are not only important for the financial performance of the
Venture Capital company. As a good track record they are also a vital argument to attract
funds which are the basis for larger deals. However, larger deals imply higher risks of
losses. Many Venture Capital companies try to share and limit their risks. Solutions could
be alliances and careful portfolio management. There are Venture Capital firms that
refuse to invest in e-start-up's because they perceive it as too risky to follow today's type.

4.3 Advantages of Venture Capital:

1. It injects long term equity finance which provides a solid capital base for future
growth.
2. The venture capitalist is a business partner, sharing both the risks and rewards.
Venture capitalists are rewarded by business success and the capital gain.
3. The venture capitalist is able to provide practical advice and assistance to the
company based on past experience with other companies which were in similar
situations.
4. The venture capitalist also has a network of contacts in many areas that can add
value to the company, such as in recruiting key personnel, providing contacts in
international markets, introductions to strategic partners, and if needed co-
investments with other venture capital firms when additional rounds of financing
are required.
5. The venture capitalist may be capable of providing additional rounds of funding
should it be required to finance growth.

4.4 Disadvantages of Venture Capital:

Most venture capitalists seek to realize their investment in a company in three to five
years. If an entrepreneur‘s business plan contemplates a longer timetable before
providing liquidity, venture capital may not be appropriate. Entrepreneurs should also
consider this.

4.5 Opportunities and Threats:

4.5.1 Opportunities:

 Initiatives taken by the Government in formulating policies to encourage

investors and entrepreneurs

The emerging scenario of global competitiveness has put an immense pressure on the
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industrial sector to improve the quality level with minimization of cost of products by
making use of latest technological skills. The implication is to obtain adequate financing
along with the necessary hi-tech equipments to produce an innovative product which can
succeed and grow in the present market condition. Unfortunately, our country lacks on
both fronts. The necessary capital can be obtained from the venture capital firms who
expect an above average rate of return on the investment. Government of India
understands this.

Also, The Government of India in an attempt to bring the nation at par and above the
developed nations has been promoting venture capital financing to new, innovative
concepts & ideas, liberalizing taxation norms providing tax incentives to venture firms,
giving an opportunity for the creation of local pools of capital and holding training
sessions for the emerging VC investors.

In the year 2000, the finance ministry announced the liberalization of tax treatment for
venture capital funds to promote them & to increase job creation. This is expected to give
a strong boost to the non resident Indians located in the Silicon Valley and elsewhere to
invest some of their capital, knowledge and enterprise in these ventures.

VC, to be able to contribute to developing entrepreneurship in India, needs to concentrate

its investment in small and medium enterprises. A “Package for Promotion of Micro and
Small Enterprises” was announced in February 2007. This includes measures addressing
concerns of credit, fiscal support, cluster-based development, infrastructure, technology,
and marketing. Capacity building of MSME Associations and support to women
entrepreneurs are the other important features of this package. SMEs have been allowed
to manage their direct/indirect exposure to foreign exchange risk by
looking/canceling/roll over of forward contracts without prior permission of RBI.

To boost the micro and small enterprise sector, the bank has decided to refinance
an amount of 7000 crore to the Small Industries Development Bank of India,
which will be available up to March 31, 2010. The Central Bank said that it is also
working on a similar refinance facility for the National Housing Bank (NHB) of an
amount of Rs 4, 000 crore.

 The Indian economy is growing at 8-9% so the there is a development of all

sector like manufacturing, services sector. So there is a great opportunities for
Venture Capital firms. Because mostly invest their money in this sectors.

 India amongst leading entrepreneurial Hotbeds globally

 City competencies emerging

Bangalore
• All IP-led companies; IT and IT-enabled services
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Delhi (NCR)
• Software services, IT enabled services, Telecom
 Mumbai
• Software services, IT enabled services, Media, Computer
Graphics, Animation, Banking

Other emerging Centers

• Chennai, Hyderabad, and Pune

 Emerging sectors for investments

As the venture industry continues to accelerate, a number of trends that cross

geographies can be seen. The industry is becoming even more globalized .As a result,
innovation in clean tech, IT, and healthcare, pharmaceutical are having a global impact.
This changing landscape is driving new approaches in how large corporations are
interacting with the venture community.

4.5.2 Threats:

 Venture Capital Market in India Getting Overheated

The Venture Capital market in India seems to be getting as hot as the country’s famous
summers. However, this potential over-exuberance may lead to some stormy days ahead,
based on sobering research compiled by global research and analytics services firm,
Evalueserve. Evalueserve research shows an interesting phenomenon is beginning to
emerge:

Over 44 US-based Venture capital firms are now seeking to invest heavily in start-ups
and early-stage companies in India. These firms have raised, or are in the process of
raising, an average of US $100 million each. Indeed, if these 40-plus firms are successful
in raising money, they would garner approximately $4.4 billion to be invested during the
next 4 to 5 years. Taking Indian Purchasing Power Parity (PPP) into consideration, this
would be equivalent to $22 billion worth of investment in the US. Since about $1.75
billion (or approximately 40% of $4.4 billion) has been already raised, even if only $2.2
billion is raised by December 2006, Evalueserve cautions that there will be a glut of
Venture Capital money for early stage investments in India. This will be especially true if
the VCs continue to invest only in currently favorite sectors such as IT, BPO, software
and hardware products, telecom, and consumer Internet. Given that a typical start-up in
India would require $9 million during the first three years (i.e., $3 million per year) and
even assuming that the start-up survives for three years, investing $2.2 billion during
2007-2010 would imply investing in 150 to 180 start-ups every year during this period,
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which simply does not seem practical if the VCs continue to focus only on their current
favorite sectors.
  Unproductive workforce:

A global survey by McKinsey & Company revealed that Indian business leaders are
much more optimistic about the future than their international peers. So Indian employees
are tardy in their job so it will effect reversely on the economic condition of the country.
Because they are unproductive to the economy of the country.

 Exit route barriers :

Due to crash down of market by 51% from January to November 2008. It create a
problem for venture capital firms. Because Nobody is trying to come up with IPO and
IPO is the exit route for Venture Capital.

 Taxes on emerging sector :

As per Union Budget 2007 and its broad guidelines, Government proposed to limit pass-
through status to venture capital funds (VCFs) making investment in nine areas. These
nine areas are biotechnology, information technology, nanotechnology, seed research and
development, R&D for pharmaceuticals sectors, dairy industry, poultry industry and
production of bio-fuels. Pass-through status means that the incomes earned by funds are
taxable now.

4.6 Contemporary Issue in Venture Capital Industry

 IIM-A Eyes venture capital to fund its incubators

 Buoyed by the growing tribe of students wanting to go solo with their own
entrepreneurial venture, the Indian Institute of Management, Ahmedabad
(IIM-A) is looking to attract venture capital funds to the campus. The
premier management institute is also in talks with several corporates to
provide seed capital to budding entrepreneurs from its incubation lab.

 “The number of students starting up their own venture is increasing in

every batch. In a batch of 250 students, at least 10-15 are starting their
own ventures.
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Source: Business Daily from THE HINDU group of publications Sunday, Jan 27, 2008
  Angel investors betting big on Indian start

 Amid a slowdown in global venture capital investments,

Indian start-up firms are emerging as clear favorites for
seed capital among global angel investors.

 During the first quarter of 2008, US-based venture

capitalists invested $350 million in 38 deals in India, a 42
per cent jump from the previous quarter, when $246
million was invested in 33 companies. In the case of
China, the funding by US-based Venture Capital firms
dipped 24 per cent to $250 million invested in 32 firms
during the first quarter of 2008, down from the $331
million invested in 39 deals in the previous quarter,
according to data from the Money Tree report from
PricewaterhouseCoopers and the US-based National
Venture Capital Association

Source: Business Daily from THE HINDU group of publications

Saturday, Apr 26, 2008

4.7 Future prospects of Venture Capital

Venture Capital can play a more innovative and development role in developing country
like India. It could help the rehabilitation of sick units through people with ideas an
turnaround management skills. A large number of enterprises in India become sick even
before the commencement of Production.

Venture Capitalists could also assists small ancillary units to upgrade their technologies
so that they could be in line with the development taking place in their parent companies.
Yet another area where VCFs can play a significant role in developing countries is the
service sector including tourism, publishing, healthcare etc.

They could also provide assistance to people coming out of the universities, technical
institutes etc. who wish to start their own venture with or without high-tech content, but
involving high risk. This would encourage entrepreneurial spirit.

It is not the initial funding which is needed from venture capitalist, but they should also
simultaneously provide management and marketing expertise- a real critical aspect of
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venture capital in developing countries. VCFs can improve their effectiveness by setting
up venture capital cells in R&D and other scientific organizations, providing syndicated
or consortium financing and acting as business incubators.

In sum, venture capital, by combining risk financing with management and marketing
assistance, could become an effective instrument in fostering development of
entrepreneurship and transfer of technology in developing countries.

The experiences of developed countries and the detailed case study of venture capital in
India, however indicate that that the following elements are needed for the success of
venture capital in any country.

 Entrepreneurial tradition: A broad-based (and less family based) entrepreneurial

tradition and societal and government for innovations, creativity and enterprise.

 Unregulated economic environment: A less regulated and controlled business and

economic environment where attractive customer opportunities exist and could be
created for high-tech and quality products.

 Disinvestments avenues: Existence of disinvestments mechanism, particularly,

over the counter stock exchange catering to the needs of SMEs

 Fiscal incentives: Fiscal incentives which render the equity investment more and
develop equity cult in investors.

 Broad-based education: A more general, business and entrepreneurship oriented

education system where scientists and engineers have knowledge of accounting,
finance and economics and accountants understand engineering or physical
sciences.

 Venture Capital managers: An effective management education and training

program for developing professionally competent and committed venture capital
mangers ; they should be trained to evaluate and manage high-tech, high risk
ventures.

 Promotion efforts: A vigorous marketing thrust, promotional efforts and

development strategy, employing new concepts such as venture fairs, venture
clubs, venture networks, business incubators etc. for the growth of venture capital.

 Institute-industry linkage: Linkage between universities/technology institutions,

R&D organizations, industry and financial institutions including venture capital
firms.

 R&D activities: Encouragement and funding of R&D by private and public sector
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companies and the government for ensuring technological competitiveness.

 IV.8 CONCLUSION

The study provides that the maturity if the still nascent Indian Venture Capital market is
imminent.

Venture Capitalists in Indian have notice of newer avenues and regions to expand. VCs
have moved beyond IT service but are cautious in exploring the right business model, for
finding opportunities that generate better returns for their investors.

In terms of impediments to expansion, few concerning factors to VCs include;

unfavorable political and regulatory environment compared to other countries, difficulty
in achieving successful exists and administrative delays in documentation and approval.
In spite of few non attracting factors, Indian opportunities are no doubt promising which
is evident by the large number of new entrants in past years as well in coming days.
Nonetheless the market is challenging for successful investment.

Therefore Venture capitalists responses are upbeat about the attractiveness of the India as
a place to do the business.

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Bibliography

Books

1.Taneja Satish, “ Venture Capital In India”, Galgotia Publishing Company, 2002

2.Pandey I M, “Venture Capital –The Indian Experience”, Prentice Hall of India
pvt. Ltd,1999.

Reports

1.Trends of Venture Capital in India, survey report by Delloitte,2007.

2.Global Trends of Venture Capital, Survey report by Deloitte,2007.
3.Economic survey 2007-08, Chapter-8

Website:

www.sebi.gov.in
www.ivca.org
www.nenonline.org
www.indiavca.org
www.vcindia.com
www.ventureintelligence.in
www.vccircle.com
www.indiape.com
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www.nvca.org
www.nasscom.org
www.Economictimes.indiatimes.com
www.100ventures.com
www.msme.com
www.planningcommission.nic.in

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