venture capital
TRANSCRIPT
Chapter – 1
INTRODUCTION TO VENTURE CAPITAL FUNDS
1.1 Introduction
1.2 The Origin
1.3 Background
1.4 Meaning and Definition
1.5 Characteristics
1.6 Types of VCF
INTRODUCTION to Venture Capital
1.1 VENTURE CAPITAL
Small businesses never seem to have enough money. Bankers and Suppliers,
naturally, are important in financing small business growth through loans and credit,
but an equally important source of long term. Growth Capital is the venture capital
firm. Venture Capital financing may have an extra bonus, for if a small firm has an
adequate equity base; banks are more willing to extend credit.
Venture capital is money provided by professionals who invest alongside
management in young, rapidly growing companies that have the potential to develop
into significant economic contributors. Venture capital is an important source of
equity for start-up companies.
Venture capital is capital typically provided by outside investors for financing of new,
growing or struggling businesses. Venture capital investments generally are high risk
investments but offer the potential for above average returns and/or a percentage of
ownership of the company. A venture capitalist (VC) is a person who makes such
investments. A venture capital fund is a pooled investment vehicle (often a
partnership) that primarily invests the financial capital of third-party investors in
enterprises that are too risky for the standard capital markets or bank loans.
The term ‘Venture Capital’ is understood in many ways. In a narrow sense, it refers to, investment in new and tried enterprises that are lacking a stable record of growth. In a broader sense, venture capital refers to the commitment of capital as shareholding, for the formulation and setting up of small firms specializing in new ideas or new technologies. It is not merely an injection of funds into a new firm, it is a simultaneous input of skill needed to set up the firm, design its marketing strategy and organize and manage it. It is an association with successive stages of firm’s development with distinctive types of financing appropriate to each stage of development.
According to International Finance Corporation (IFC), venture capital is equity or
equity featured capital seeking investment in new ideas, new companies, new
production, new process or new services that offer the potential of high returns on
investments.
As defined in Regulation 2(m)of SEBI (Venture Capital Funds) Regulation , 1996
"venture capital fund means a fund established in the form of a company or trust
which raises monies through loans, donations issue of securities or units as the case
may be, and makes or proposes to make investments in accordance with these
regulations.
Thus venture capital is the capital invested in young, rapidly growing or changing
companies that have the potential for high growth. The VC may also invest in a firm
that is unable to raise finance through the conventional means.
Professionally managed venture capital firms generally are private partnerships or
closely-held corporations funded by private and public pension funds, endowment
funds, foundations, corporations, wealthy individuals, foreign investors, and the
venture capitalists themselves.
Venture capitalists generally:
Finance new and rapidly growing companies;
Purchase equity securities;
Assist in the development of new products or services;
Add value to the company through active participation;
Take higher risks with the expectation of higher rewards;
Have a long-term orientation
When considering an investment, venture capitalists carefully screen the technical and
business merits of the proposed company. Venture capitalists only invest in a small
percentage of the businesses they review and have a long-term perspective. Going
forward, they actively work with the company's management by contributing their
experience and business savvy gained from helping other companies with similar
growth challenges.
Venture capitalists mitigate the risk of venture investing by developing a portfolio of
young companies in a single venture fund. Many times they will co-invest with other
professional venture capital firms. In addition, many venture partnership will manage
multiple funds simultaneously. For decades, venture capitalists have nurtured the
growth of America's high technology and entrepreneurial communities resulting in
significant job creation, economic growth and international competitiveness.
Companies such as Digital Equipment Corporation, Apple, Federal Express, Compaq,
Sun Microsystems, Intel, Microsoft, Yahoo, Airtel and Genentech are famous
examples of companies that received venture capital early in their development.
Venture Capital is the business of establishing an investment fund in the form of
equity financing via investments in the common stocks, preferred stocks and
convertible debentures of various companies. These companies are seen to have a
high growth potential and are able to be listed on the stock exchange in order to gain
the highest returns in dividends and capital gain.
1.2 The Origin of Venture Capital
In the 1920's & 30's, the wealthy families of and individuals investors provided the
start up money for companies that would later become famous. Eastern Airlines and
Xerox are the more famous ventures they financed. Among the early VC funds set up
was the one by the Rockfeller Family which started a special fund called VENROCK
in 1950, to finance new technology companies.
USA is the birth place of Venture Capital Industry as we know it today. During most
its historical evolution, the market for arranging such financing was fairly informal,
relying primarily on the resources of wealthy families.
In 1946, American Research and Development Corporation (ARD), a publicly traded,
closed-end investment company was formed. ARD's best known investment was the
start-up financing it provided in 1958 for computer maker Digital Equipment Corp.
ARD was eventually profitable, providing its original investors with a 15.8 percent
annual rate of return over its twenty-five years as an independent firm. General
Doriot, a professor at Harvard Business School, set up the ARD, the first firm, as
opposed to private individuals, at MIT to finance the commercial promotion of
advanced technology developed in the US Universities. ARD's approach was a classic
VC in the sense that it used only equity, invested for long term, and was prepared to
live with losers. ARD's investment in Digital Equipment Corporation (DEC) in 1957
was a watershed in the history of VC financing.
The number of such specialized investment firms, eventually to be called venture
capital firms, began to boom in the late 1950s.The growth was aided in large part by
the creation in 1958 of the federal Small Business Investment Company program.
Hundreds of SBICs were formed in the 1960s, and many remain in operation today.
Slow Growth in 1960s & early 1970s, and the First Boom Year in 1978
During the 1960s and 1970s, venture capital firms focused their investment activity
primarily on starting and expanding companies. More often than not, these companies
were exploiting breakthroughs in electronic, medical or data-processing technology.
As a result, venture capital came to be almost synonymous with technology finance.
Venture capital firms suffered a temporary downturn in 1974, when the stock market
crashed and investors were naturally wary of this new kind of investment fund. 1978
was the first big year for venture capital. The industry raised approximately $750
million in 1978.
Highs & Lows of the 1980s
In 1980, legislation made it possible for pension funds to invest in alternative assets
classes such as venture capital firms. 1983 was the boom year - the stock market went
through the roof and there were over 100 initial public offerings for the first time in
U.S. history. That year was also the year that many of today's largest and most
prominent firms were founded.
Due to the excess of IPOs and the inexperience of many venture capital fund
managers, VC returns were very low through the 1980s. VC firms retrenched,
working hard to make their portfolio companies successful. The work paid off and
returns began climbing back up.
Boom Times in the 1990s
The 1990s have been, by far the best years for the Venture Capital Industry. The
engine for growth has been the favourable economic climate in the US coupled with
the advent of the Internet boom. During this decade, the interest rates were low and
the P/Es were very high compared to historical averages. Finally, the rate of M&A
activity has increased dramatically in the 1990s, creating more opportunities for
small, venture-backed companies to exit (cash out) at high prices.
The advent of the Internet as a new medium for both personal and business
communications and commerce created an avalanche of opportunities for venture
capitalists in the mid and late 1990s. As a result, the industry has experienced
extraordinary growth in the past few years, both in the number of firms, and in the
amount of capital they have raised.
1.3 The Background
In September 1995, Government of India issued guidelines for overseas venture
capital investment in India whereas the Central Board of Direct Taxes (CBDT) issued
guidelines for tax exemption purposes. (The Reserve Bank of India governs the
investment and flow of foreign currency in and out of India.) As a part of its mandate
to regulate and to develop the Indian capital markets, Securities and Exchange Board
of India (SEBI) framed the SEBI (Venture Capital Funds) Regulations, 1996.
Pursuant to the regulatory framework, some domestic VCFs were registered with
SEBI. Some overseas investments also came through the Mauritius route. However,
the venture capital industry, understood globally as 'independently managed,
dedicated pools of capital that focus on equity or equity linked investments in
privately held, high growth companies' (The Venture Capital Cycle, Gompers and
Lerner, 1999) is still relatively in a nascent stage in India. Figures from the Indian
Venture Capital Association (IVCA) reveal that, till 2000, around Rs. 2,200 crore
(US$ 500 million) had been committed by the domestic VCFs and offshore funds
which are members of IVCA. Figures available from private sources indicate that
overall funds committed are around US$ 1.3 billion.
Funds that can be invested were less than 50 percent of the committed funds and
actual investments were lower still. At the same time, due to economic liberalisation
and increasing global outlook in India, an increased awareness and interest of
domestic as well as foreign investors in venture capital was observed. While only 8
domestic VCFs were registered with SEBI during 1996-98, more than 30 additional
funds have already been registered in 2000-01.
Institutional interest is growing and foreign venture investments are also on the
increase. Given the proper environment and policy support, there is a tremendous
potential for venture capital activity in India.
The Finance Minister, in the Budget 2000 speech announced, "For boosting high tech
sectors and supporting first generation entrepreneurs, there is an acute need for higher
investments in venture capital activities." He also said that the guidelines for the
registration of venture capital activity with the Central Board of Direct Taxes would
be harmonized with those for registration with the Securities and Exchange Board of
India.
SEBI decided to set up a committee on venture capital to identify the impediments
and suggest suitable measures to facilitate the growth of venture capital activity in
India. Keeping in view the need for global perspective, it was decided to associate
Indian entrepreneur from Silicon Valley in the committee. The setting up of this
committee was primarily motivated by the need to play a facilitating role in tune with
the mandate of SEBI, to regulate as well as develop the market. The committee
headed by K. B. Chandrasekhar, Chairman, Exodus Communications Inc., submitted
its report on 8 January 2000.
1.4 (a)Meaning of Venture Capital
Venture capital is long-term risk capital to finance high technology projects which
involve risk but at the same time has strong potential for growth. Venture capitalist
pools their resources including managerial abilities to assist new entrepreneur in the
early years of the project. Once the project reaches the stage of profitability, they sell
their equity holdings at high premium.
(b) Definition of the Venture Capital Company
A venture capital company is defined as “a financing institutions which joints an
entrepreneur as a co-promoter in a project and shares the risks and rewards of the
enterprise.”
1.5 Characteristics of Venture Capital
The three primary characteristics of venture capital funds which may them
eminently suitable as a source of risk finance are:
(1) that it is equity or quasi equity investments;
(2) it is long-term investment; and
(3) it is an active from of investment.
First, venture capital is equity or quasi equity because the investor assumes risk.
There is no security for his investment. Venture capital funds by participating in the
equity capital institutionalize the process of risk taking which promotes successful
domestic technology development.
Investors of venture capital have no liquidity for a period of time. Venture capitalist
or funds hope that the company they are backing will thrive and after five to seven
years from making the investment it will be large and profitable enough to sell its
shares in the stock market. But a reward is thee for liquidity and waiting. The venture
capitalists hope to sell their share for many times what they paid for. If the unit fails
the venture capitalists losses everything. The probability distribution of expected
returns for most venture capital investment is highly skewed to the right. The success
rate is 10-20 percent.
Secondly, venture capital is long-term investment involving both money and time.
Finally, venture capital investment involves participation in the management of the
company. Venture capitalist participates in the Board and guides the firm on strategic
and policy matters. The features of venture capital generally are, financing new and
rapidly growing companies; purchase of equity shares; assist in transformation of
innovative technology based ideas into products and services; and value to company
by active participation; assume risks in the expectation of large rewards; and possess a
long-term perspective. These features of venture capital render it eminently suitable
as a source of risk capital for domestically developed technologies.
New venture proposals in high technology area are attractive because of the
perceived possibility of substantial growth and capital gains. Although venture
capital evolved as a method of early sage financing it includes development,
expansion and buyout financing for units which are unable to raise funds through
normal financing channels. Units in developing countries need funds for financing
various stages of development. Such a broad approach would help venture funds to
diversify their investment and spread risks.
1.6 Types of Venture Capital Firms
Venture Capital can be divided into many different types according to the
characteristics of the shareholders and sources of investment -- such as private equity
firms, banks, financial institutions, private corporations, the government or insurance
companies.
Generally there are three types of organized or institutional venture capital funds:
venture capital funds set up by angel investors, that is, high net worth individual
investors; venture capital subsidiaries of corporations and private venture capital
firms/ funds. Venture capital subsidiaries are established by major corporations,
commercial bank holding companies and other financial institutions.
Venture funds in India can be classified on the basis of the type of promoters.
Financial institutions led by ICICI ventures, ILFS, etc. Private venture funds
like Indus, etc.
Regional funds: Warburg Pincus, JF Electra (mostly operating out of Hong
Kong).
Regional funds dedicated to India: Draper, Walden, etc.
Offshore funds: Barings, TCW, HSBC, etc.
Corporate ventures: venture capital subsidiaries of corporations.
Angels: high net worth individual investors.
Merchant bankers and NBFCs who specialize in "bought out" deals also fund
companies.
On the basis of geographical focus
Regional
Global
On the basis of industry specialty
IT and IT-enabled services
Software Products (Mainly Enterprise-focused)
Wireless/Telecom/Semiconductor
Banking
Media/Entertainment
Bio Technology/Bio Informatics
Pharmaceuticals
Contract Manufacturing
Retail
On the basis of funding stage:
Seed/early
Late/mbo
Pipe
The Venture Capital firms in India can be categorized into the following four groups:
1. All-India DFI-sponsored VCFs such as Technology Development and Information
Company of India Ltd. (TDICI) by ICICI, Risk Capital and Technology Finance
Corporation Ltd. (RCTFC) by IFCI and Risk Capital Fund by IDBI
2. SFC-sponsored VCFs such as Gujarat Venture Capital Ltd. (GVCL) by GIIC and
Andhra Pradesh Venture Capital Ltd. (APVCL) by APSFC
3. Bank-sponsored VCFs such as Canfina and SBI Caps
4. Private VCFs supported by private sector companies such as Indus Venture
Capital Fund, Credit Capital Venture Fund.
Chapter – 2
Development of VCF in International Arena and INDIA
2.1 VCF in International Arena
2.2 Venture Capital in India
2.3 Future of Venture Capital in India
Development of Venture Capital
2.1 The International arena
The modern venture capital industry began taking shape in the post – World War II
years. It is often said that people decide to become entrepreneurs because they see
role models in other people who have become successful entrepreneurs. Much the
same thing can be said about venture capitalists.
USA
The history of the venture capital in US traces back to the period after World War II
when a few wealthy family groups like Rockefeller, Andrew Carnegie and others took
the initiative. The venture capital industry was started by George Detroit who
collaborated in establishing Corporation at Boston. From 1965 to 1972 nearly 40
venture capital companies were formed with committed assets of $500 million. It is
noted that in the US, the venture capital industry has been associated with technology
development. In the 1980s, the US venture industry began to establish its business
overseas at large.
UK
In the UK, the development of venture capital owes to the professionally managed
specialist fund – Charter House – set up in 1980 for providing risk equity finance for
young and growing small business. In 1983, British Venture Capital Association was
established with a membership of 33 funds, which rose to 115 in 1992.
JAPAN
In 1963, 3 Government assisted companies were established in Tokyo, Osaka and
Nagoya, to provide venture capital t small and medium industries. Leading financial
institutions in Japan started venture capital companies for financing high technology
industrial units. The rapid growth of industry in Japan is credited to the easy
availability of venture capital.
2.2 VENTURE CAPITAL IN INDIA
This activity in the past was possibly done by the developmental financial institutions
like IDBI, ICICI and State Financial Corporations. These institutions promoted
entities in the private sector with debt as an instrument of funding.
For a long time funds raised from public were used as a source of VC. This source
however depended a lot on the market vagaries. And with the minimum paid up
capital requirements being raised for listing at the stock exchanges, it became difficult
for smaller firms with viable projects to raise funds from public.
In India, the need for VC was recognised in the 7th five year plan and long term fiscal
policy of GOI. In 1973 a committee on Development of small and medium enterprises
highlighted the need to faster VC as a source of funding new entrepreneurs and
technology. VC financing really started in India in 1988 with the formation of
Technology Development and Information Company of India Ltd. (TDICI) -
promoted by ICICI and UTI.
The first private VC fund was sponsored by Credit Capital Finance Corporation (CFC) and promoted by Bank of India, Asian Development Bank and the Commonwealth Development Corporation viz. Credit Capital Venture Fund. At the same time Gujarat Venture Finance Ltd. and APIDC Venture Capital Ltd. were started by state level financial institutions. Sources of these funds were the financial institutions, foreign institutional investors or pension funds and high net-worth individuals. Though an attempt was also made to raise funds from the public and fund new ventures, the venture capitalists had hardly any impact on the economic scenario for the next eight years
GROWTH OF FIRMS IN INDIA
Year No. of Funds Year No. of Funds
1995 4 2001 12
1996 7 2002 6
1997 10 2003 2
1998 6 2004 3
1999 5 2005 1
2000 47 2006 2
Source: AVCJ/IVCA
India is prime target for venture capital and private equity today, owing to various
factors such as fast growing knowledge based industries, favourable investment
opportunities, cost competitive workforce, booming stock markets and supportive
regulatory environment among others. The sectors where the country attracts venture
capital are IT and ITES, software products, banking, PSU disinvestments,
entertainment and media, biotechnology, pharmaceuticals, contract manufacturing and
retail. An offshore venture capital company may contribute upto 100 percent of the
capital of a domestic venture capital fund and may also set up a domestic asset
management company to manage the fund. Venture capital funds (VCFs) and venture
capital companies (VCC) are permitted upto 40 percent of the paid up corpus of the
domestic unlisted companies. This ceiling would be subject to relevant equity
investment limit in force in relation to areas reserved for SSI. Investment in a single
company by a VCF/VCC shall not exceed 5 percent of the paid up corpus of a
domestic VCF/VCC. The automatic route is not available.
2.3Future of Venture Capital in India
Rapidly changing economic environment accelerated by the high technology
explosion, emerging needs of new generation of entrepreneurs in the process and
inadequacy of the existing venture capital funds/schemes are indicative of the
tremendous scope for venture capital in India and pointers to the need for the
creation of a sound and broad-based venture capital movement India.
There are many entrepreneurs in India with a good project idea but no previous
entrepreneurial track record to leverage their firms, handle customers and bankers.
Venture capital can open a new window for such entrepreneurs and help them to
launch their projects successfully.
With rapid international march of technology, demand for newer technology and
products in India has gone up tremendously. the pace of development of new and
indigenous technology in the country has been slack in view of the fact that several
process developed in laboratories are not commercialized because of unwillingness of
people to take entrepreneurial risks, i.e. risk their funds as also undergo the ordeal of
marketing the products and process. In such a situation, venture financing assumes
more significance. It can act not only act as a financial catalyst but also provide strong
impetus for entrepreneurs to develop products involving newer technologies and
commercialize them. This will give a boost to the development of new technology and
would go a long way in broadening the industrial base, creation of jobs, provide a
thrust to exports and help in the overall enrichment of the economy.
Another type of situation commonly found in our country is where the local group and
a multi-national company may be ready to enter into a joint venture but the former
does not have sufficient funds to put up its share of the equity and the latter is
restricted to a certain percentage. For the personal reasons or because of competition,
the local group may not be keen to invite any one in its industry or any major private
investor to contribute equity and may prefer a venture capital company, as a less
intimately involved and temporary shareholder. Venture capitalists can also lend their
expertise and standing to the entrepreneurs.
In service sector, which has immense growth prospects in India, venture capitalists
can play significant role in tapping its potentiality to the full. For instance, venture
capitalists can provide capital and expertise to organizations selling antique,
remodeled jewellery, builders of resort hotels, baby and health care market, retirement
homes and small houses.
In view of the above, it will be desirable to establish a separate national venture
capital fund tow which the financial institutions and banks can contribute. In scope
and content such a national venture capital fund should cover:
(i) all the aspects of venture capital financing in all the three stages of conceptual,
developmental an exploitation phases in the process of commercialization of the
technological innovation and
(ii) as may of the risk stages-development, manufacturing, marketing, management
and growth as possible under Indian Conditions. The fund should offer a
comprehensive package of technical, commercial, managerial and financial assistance
and services to building entrepreneurs and be a position to offer innovative solutions
to the varied problems faced by them in business promotion, transfer and innovation.
To this end, the proposed national venture capital fund should have at its command
multi-disciplinary technical expertise. The major thrust of this fund should be on the
promotion of viable new business in India to take advantage of the on coming high
technology revolution and setting up of high growth industries so as to take the Indian
economy to commanding heights.
Chapter – 3
Venture Capital Investment Process
3.1 Investment Procedure
3.2 Investment in VC by Banks
3.3 Angle
3.4 Corporate Venturing
3.5 Consortium Financing
3.6 Favourites of the Investors
3.7 Promotion Strategies
3.8 Incentives
3.9 Initiatives
3.10 Special Purpose Vehicle
Venture Capital Investment Process
3.1 Investment Procedure
In generating a deal flow, the venture capital investor creates a pipeline of ‘deals’ or
investment opportunities that he would consider investing in. This is achieved
primarily through plugging into an appropriate network. The most popular network
obviously is the network of venture capital funds/investors. It is also common for
venture capitals to develop working relationships with R&D institutions, academia,
etc, which could potentially lead to business opportunities. Understandably the
composition of the network would depend on the investment focus of the venture
capital funds/company. Thus venture capital funds focusing on early stage technology
based deals would develop a network of R&D centers working in those areas. The
network is crucial to the success of the venture capital investor. It is almost imperative
for the venture capital investor to receive a large number of investment proposals
from which he can select a few good investment candidates finally.
Before making any investment, the goal as venture capitalists is to understand
virtually every aspect of the target company: the experience and capabilities of the
management team, the business plan, the nature of its operations, its products and/or
services, the methods by which sales are made, the market for the products and/or
services, the competitive landscape, and other factors that may affect the outcome of
the investment. While due diligence investigations are viewed by many as mundane
and irritating tasks, the process enables venture capitalists to address areas of concern,
is an important tool in determining a fair pre-investment valuation, and may help to
avoid significant and otherwise unexpected liability following the investment.
The venture capitalists view the due diligence process as a means of identifying and
becoming comfortable with the risks to which their capital will be exposed. The due
diligence process involves an assessment of both the microeconomic and
macroeconomic factors that can affect the earnings growth of the target company. The
due diligence process also includes a review of the corporate and legal records,
including the documentation supporting any previous issuances of the company's
securities.
Only one or two business plans in 100 result in successful financing. And of every
10 investments made, only one or two are successful. But this is enough to recover
investments made by the venture capital (VC) in all 10 start-ups in addition to an
average 40-50% return! Securing an investment from an institutional venture capital
fund is extremely difficult. It is estimated that only five business plans in 100 are
viable investment opportunities and only three in 100 results in successful financing.
In fact, the odds could be as low as one in 100. More than half of the proposals to
venture capitalists are usually rejected after a 20-30 minute scanning, and 25 per cent
are discarded after a lengthier review. The remaining 15 per cent are looked at in
more detail, but at least 10 per cent of these are dismissed due to irreconcilable flaws
in the management team or the business plan.
A Venture Capitalist looks at various aspects before investing in any venture. First,
you need to work out a business plan. The business plan is a document that outlines
the management team, product, marketing plan, capital costs and means of financing
and profitability statements.
1. Initial Evaluation: This involves the initial process of assessing the feasibility of
the project.
2. Due diligence: In this stage an in-depth study is conducted to analyse the
feasibility of the project.
3. Deal structuring and negotiation: Having established the feasibility, the
instruments that give the required return are structured.
4. Investment valuation: In this stage, final amount for deal is decided.
5. Documentation: This is the process of creating and executing legal documents to
protect the interest of the venture.
6. Monitoring and Value addition: In this stage, the project is monitored by
executives from the venture fund and undesirable variations from the business plan
are dealt with.
7. Exit Policies: There are mainly 3 exit policies followed by VCF’s in general.
1. Initial Evaluation:
Before any in depth analysis is done on a project, an initial screening is carried out to
satisfy the venture capitalist of certain aspects of the project. These include
Competitive aspects of the product or service
Outlook of the target market and their perception of the new product
Abilities of the management team
Availability of other sources of funding
Expected returns
Time and resources required from the venture capital firm
Through this screening the venture firm builds an initial overview about the
Technical skills, experience, business sense, temperament and ethics of the
promoters
The stage of the technology being used, the drivers of the technology and the
direction in which it is moving
Location and size of market and market development costs, driving forces of
the market, competitors and share, distribution channels and other market
related issues
Financial facts of the deal
Competitive edge available to the the company and factors affecting it
significantly
Advantages from the deal for the venture capitalist
Exit options available
2. Due diligence
Due diligence is term used that includes all the activities that are associated with
investigating an investment proposal to assess feasibility. It includes carrying out in-
depth reference checks on the proposal related aspects such as management team,
products, technology and market. Additional studies and collection of project-based
data are done during this stage. The important feature to note is that venture capital
due diligence focuses on the qualitative aspects of an investment opportunity.
Areas of due diligence would include
General assessment
business plan analysis
contract details
collaborators
corporate objectives
SWOT analysis
Time scale of implementation
People
Managerial abilities, past performance and credibility of promoters
Financial background and feedback about promoters from bankers and previous
lenders
Details of Board of Directors and their role in the activities
Availability of skilled labour
Recruitment process
Products/services, technology and process
In this category the type of questions asked will depend on the nature of the industry
into which the company is planning to enter. Some of the areas generally considered
are
Technical details, manufacturing process and patent rights
Competing technologies and comparisons
Raw materials to be used, their availability and major suppliers, reliability of
these suppliers
Machinery to be used and its availability
Details of various tests conducted regarding the new product
Product life-cycle
Environment and pollution related issues
Secondary data collection on the product and technology, if so available
Market
The questions asked under this head also vary depending on the type of product.
Some of the main questions asked are
main customers
future demand for the product
competitors in the market for the same product category and their strategy
pricing strategy
supplier and buyer bargaining power
channels of distribution
marketing plan to be followed
future sales forecast.
Market survey could be conducted to gather further more accurate and relevant data.
Finance
Financial forecasts for the next 3-5 years
Analysis of financial reports and balance sheets of firms already promoted or run
by the promoters of the new venture
Cost of production
Wage structure details
Accounting process to be used
Financial report of critical suppliers
Returns for the next 3-5 years and thereby the returns to the venture fund
Budgeting methods to be adopted and budgetary control systems
External financial audit if required
Sometimes, companies may have experienced operational problems during their early
stages of growth or due to bad management. These could result in losses or cash flow
drains on the company. Sometimes financing from venture capital may end up being
used to finance these losses. They avoid this through due diligence and scrutiny of the
business plan.
3. Structuring a deal
Structuring refers to putting together the financial aspects of the deal and negotiating
with the entrepreneurs to accept a venture capital’s proposal and finally closing the
deal. Also the structure should take into consideration the various commercial issues
(ie what the entrepreneur wants and what the venture capital would require to protect
the investment).
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 instruments
could be as follows:
Instrument Issues
Equity sharesnew or vendor shares
par value
partially-paid shares
Preference sharesredeemable (conditions under Company Act)
participating
par value
nominal shares
Loanclean vs secured
Interest bearing vs non interest bearing
convertible vs one with features (warrants)
1st Charge, 2nd Charge,
loan vs loan stock
maturity
Warrants exercise price, expiry period
Options exercise price, expiry period, call, put
In India, straight equity and convertibles are popular and commonly used. Nowadays,
warrants are issued as a tool to bring down pricing.
A variation that was first used by PACT and TDICI was "royalty on sales". Under
this, the company was given a conditional loan. If the project was successful, the
company had to pay a percentage of sales as royalty and if it failed then the amount
was written off.
In structuring a deal, it is important to listen to what the entrepreneur wants, but the
venture capital comes up with his own solution. Even for the proposed investment
amount, the venture capital decides whether or not the amount requested, is
appropriate and consistent with the risk level of the investment. The risks should be
analyzed, taking into consideration the stage at which the company is in and other
factors relating to the project. (eg exit problems, etc).
A typical proposal may include a combination of several different instruments listed
above. Under normal circumstances, entrepreneurs would prefer venture capitals to
invest in equity as this would be the lowest risk option for the company. However
from the venture capitals point of view, the safest instrument, but with the least return,
would be a secured loan. Hence, ultimately, what you end up with would be some
instruments in between which are sold to the entrepreneur. A number of factors affect
the choice of instruments, such as -
Categories Factors influencing the choice of Instrument
Company specific Risk, current stage of operation, , expected profitability, future cash
flows, investment liquidity options
Promoter specific Current financial position of promoters, performance track-record,
willingness of promoters to dilute stake
Product/Project specific Future market potential, product life-cycle, gestation period
Macro environment Tax options on different instruments, legal framework, policies
adopted by competition
4. Investment valuation
The investment valuation process is an exercise aimed at arriving at ‘an acceptable
price’ for the deal. Typically in countries where free pricing regimes exist, the
valuation process goes through the following steps:
1. Evaluate future revenue and profitability
2. Forecast likely future value of the firm based on experienced market capitalization
or expected acquisition proceeds depending upon the anticipated exit from the
investment.
3. Target ownership positions in the investee firm so as to achieve desired
appreciation on the proposed investment. The appreciation desired should yield a
hurdle rate of return on a Discounted Cash Flow basis.
In certainty the valuation of the firm is driven by a number of factors. The more
significant among these are:
• Overall economic conditions: A buoyant economy produces an optimistic long- term
outlook for new products/services and therefore results in more liberal pre-money
valuations.
• Demand and supply of capital: when there is a surplus of venture capital of venture
capital chasing a relatively limited number of venture capital deals, valuations go up.
This can result in unhealthy levels of low returns for venture capital investors.
• Specific rates of deals: such as the founder’s/management team’s track record,
innovation/ unique selling propositions (USPs), the product/service size of the
potential market, etc affects valuations in an obvious manner.
• The degree of popularity of the industry/technology in question also influences the
pre-money. Computer Aided Skills Software Engineering (CASE) tools and Artificial
Intelligence were one time darlings of the venture capital community that have now
given place to biotech and retailing.
• The standing of the individual venture capital Well established venture capitals who
are sought after by entrepreneurs for a number of reasons could get away with tighter
valuations than their less known counterparts.
• Investor’s considerations could vary significantly. A study by an American venture
capital, Venture One, revealed the following trend. Large corporations who invest for
strategic advantages such as access to technologies, products or markets pay twice as
much as a professional venture capital investor, for a given ownership position in a
company but only half as much as investors in a public offering.
• Valuation offered on comparable deals around the time of investing in the deal.
5. Documentation
It is the process of creating and executing legal agreements that are needed by the
venture fund for guarding of investment.
Based on the type of instrument used the different types of agreements are
Equity Agreement
Income Note Agreement
Conditional Loan Agreement
Optionally Convertible Debenture Agreement etc.
There are also different agreements based on whether the agreement is with the
promoters or the company. The different legal documents that are to be created and
executed by the venture firm are
Shareholders agreement - This agreement is made between the venture
capitalist, the company and the promoters. The agreement takes into account
Capital structure.
Transfer of shares: This lays the condition for transfer of equity between the
equity holders. The promoters cannot sell their shares without the prior permission of
the venture capitalist.
Appointment of Board of Directors
Provisions regarding suspension/cancellation of the investment. The issues under
which such cancellation or suspension takes place are default of covenants and
conditions, supply of misleading information, inability to pay debts, disposal and
removal of assets, refusal of disbursal by other financial institutions, proceedings
against the company, and liquidation or dissolution of the company.
Equity subscription agreement - This is the agreement between the venture
capitalist and the company on
Number of shares to be subscribed by the venture capitalist
Purpose of the subscription
Pre-disbursement conditions that need to be met
Submission of reports to the venture capitalist
Currency of the agreement
Deed of Undertaking - The agreement is signed between the promoters and the
venture capitalist wherein the promoter agrees not to withdraw, transfer, assign,
pledge, hypothecate etc their investment without prior permission of the venture
capitalist. The promoters shall not diversify, expand or change product mix without
permission.
Income Note Agreement - It contains details of repayment, interest, royalty,
conversion, dividend etc.
Conditional Loan Agreement - It contains details on the terms and conditions
of the loan, security of loan, appointment of nominee directors etc.
Deed of Hypothecation, Shortfall Undertaking, Joint and Several Personal
Guarantee Power of Attorney etc.
Whenever there is a modification in any of the agreements, then a Supplementary
Agreement is created for the same.
6. Monitoring and follow up
The role of the venture capitalist does not stop after the investment is made in the
project. The skills of the venture capitalist are most required once the investment is
made. The venture capitalist gives ongoing advice to the promoters and monitors the
project continuously.
It is to be understood that the providers of venture capital are not just financiers or
subscribers to the equity of the project they fund. They function as a dual capacity, as
a financial partner and strategic advisor.
Venture capitalists monitor and evaluate projects regularly. They are actively
involved in the management of the of the investor unit and provide expert business
counsel, to ensure its survival and growth. Deviations or causes of worry may alert
them to potential problems and they can suggest remedial actions or measures to
avoid these problems. As professional in this unique method of financing, they may
have innovative solutions to maximize the chances of success of the project. After all,
the ultimate aim of the venture capitalist is the same as that of the promoters – the
long term profitability and viability of the investor company.
The various styles are:
Hands-on Style suggests supportive and direct involvement of the venture capitalist in
the assisted firm through Board representation and regularly advising the entrepreneur
on matters of technology, marketing and general management. Indian venture
capitalists do not generally involve themselves on a hands-on basis bit they do have
board representations.
Hands-off Style involves occasional assessment of the assisted firms management and
its performance with no direct management assistance being provided. Indian venture
funds generally follow this approach.
Intermediate Style venture capital funds awe entitled to obtain on a regular basis
information about the assisted projects.
Venture capital target companies with superior products or services focussed at
fast-growing or untapped markets. Venture capitalists must be confident that
the firm has the quality and depth in the management team to achieve its
aspirations. They will want to ensure that the investee company has the
willingness to adopt modern corporate governance standards.
Firms strong in factors relating to patents, management, idea, and potential are more
likely to obtain VC financing and willing partners to support commercialisation
activities.
7. EXIT strategies adopted by VCF’s:
A venture capital firm enters a relationship with a company with the expectation that a
significant return of investment will result when the firm exits the investment. The
firm plans for that exit to take place within a certain amount of time, usually from
three to six years, depending on the development stage of the company in which it is
investing.
Depending on the investment focus and strategy of the venture firm, it will seek to
exit the investment in the portfolio company. While the initial public offering may be
the most glamorous and heralded type of exit for the venture capitalist and owners of
the company, most successful exits of venture investments occur through a merger or
acquisition of the company by either the original founders or another company.
Again, the expertise of the venture firm in successfully exiting its investment will
dictate the success of the exit for themselves and the owner of the company.
There are several common exit strategies:
IPO
Mergers and Acquisitions
Redemption
IPO
The initial public offering is the most glamorous and visible type of exit for a venture
investment. In recent years technology IPOs have been in the limelight during the IPO
boom of the last six years.
At public offering, the venture firm is considered an insider and will receive stock in
the company, but the firm is regulated and restricted in how that stock can be sold or
liquidated for several years. Once this stock is freely tradable, usually after about two
years, the venture fund will distribute this stock or cash to its limited partner investor
who may then manage the public stock as a regular stock holding or may liquidate it
upon receipt. Over the last twenty-five years, almost 3000 companies financed by
venture funds have gone public.
Mergers and Acquisitions
Mergers and acquisitions represent the most common type of successful exit for
venture investments. In an era of large companies dominating industry landscapes,
acquisition is often the targeted and most common exit strategy. Smaller companies
have, in essence, become the research and development arm of larger companies who
often look to buy them once their innovations can contribute to their own profitability.
In the case of a merger or acquisition, the venture firm will receive stock or cash
from the acquiring company and the venture investor will distribute the proceeds from
the sale to its limited partners.
Redemption
Another alternative is that the company may be required to buy back a venture capital
firm's stock at cost plus a certain premium. Often a venture capital firm will put a
redemption clause (sometimes referred to as a "buy-back clause") in the investment
terms which allows them to exit their investment in your company in the event that an
IPO or acquisition does not happen within a designated time period.
2.2 Investment in Venture Capital by Banks
To encourage the flow of finance for venture capital commercial banks are allowed
to invest in venture capital without any limit since April 1999. The monetary and
credit policy for the year 1999-2000 provides that the overall ceiling of investment by
banks in ordinary shares, convertible debentures of corporate and units of mutual
funds which is currently at 5 per cent of their incremental deposits will stand
automatically enhanced to the extent of banks’ investments in venture capital.
Further, the Monetary and Credit Policy (1999-2000) provides for the inclusion of
investment in venture capital under priority sector lending.
2.3 Angels
Angels are people with less money orientation, but who play an active role in making
an early-stage company work. They are people with enough hands-on experience and
are experts in their fields. They understand the field from an operational perspective.
An entrepreneur needs this kind of expertise. He also needs money to make things
happen. Angels bring both to the table of an entrepreneur.
Angels are important links in the entire process of venture capital funding. This is
because they support a fledging enterprise at a very early stage – sometime even
before commercialization of the product or service offering. Typically, an angel is an
experienced industry-bred individual with high net worth.
Angels provide funding by "first round" financing for risky investments – risky
because they are a young /start-up company or because their financial track record is
unstable.
This venture capital financing is typically used to prepare the company for "second
round" financing in the form of an initial public offering (IPO). Example – A
company may need "first round" financing to develop a new product line, (viz a new
drug which would require significant research & development funding) or make a
strategic acquisition to achieve certain levels of growth & stability.
It is important to choose the right Angel because they will sit on your Board of
Directors, often for the duration of their investment and will assist in getting "second
round" financing. When choosing an 'Angel', it is imperative to consider their
experience in a relevant industry, reputation, qualifications and track record.
2.4 Corporate Venturing
Even though corporate venturing is an attractive alternative, most companies find it
difficult to establish systems, capabilities and cultures that make good venture capital
firms. Corporate managers seldom have the same freedom to fund innovative projects
or to cancel them midstream. Their skills are honed for managing mature businesses
and not nurturing start up companies. If a firm is to apply the venture capital model, it
must understand the characteristics of the model and tailor its venture capital program
to its own circumstances without losing sight of these essentials.
Success of venture capital firms rest on the following characteristics:
Focus on specific industry niches
• Although corporate managers have a clear focus in their business, they run into
ambiguity with venture programs. Their biggest challenge is to establish clear,
prioritized objectives. Simply making a good financial return is not sufficient.
• Manage portfolios ruthlessly; abandon losers, whereas abandoning ventures has
never been easy for large corporations, whose projects are underpinned by personal
relationships, political concerns.
• Venture capital firms share several attributes with start up they fund. They tend to be
small, flexible and quick to make decisions. They have flat hierarchies and rely
heavily on equity and incentive pay.
Apple Computers established a venture fund in 1986 with the dual objectives of
earning high financial return and supporting development of Macintosh software.
They structured compensation mechanisms, decision criteria and operating procedures
on those of top venture capital firms. While they considered Macintosh as an initial
screening factor, its funding decisions were aimed at optimizing financial returns. The
result was an IRR of 90 per cent but little success in improving the position of
Macintosh.
New ventures can be powerful source of revenues, diversification and flexibility in
rapidly changing environments. The company should create an environment that
encourages venturing. An innovative culture cannot be transplanted but must evolve
within the company. Venture investing requires different mindset from typical
corporate investors.
How relevant is corporate venturing in the Indian scenario?
The firms, which launched the successful corporate ventures had created new
products in the market operating at the higher end of the value chain and had attained
a certain size in the market. Most Indian companies are yet to move up the value
chain and consolidate their position as players in the global market. Corporate
venturing models would probably benefit Indian companies who are large players in
the Indian market in another five to 10 years by enabling them to diversify and at the
same time help start up companies. Multinationals led by Intel are the best examples
of corporate venturing in an Indian context.
2.5 Consortium Financing
Where the project cost is high (Rs 100 million or more) and a single fund is not in a
position to provide the entire venture capital required then venture funds may act in
consortium with other funds and take a lead in making investment decisions. This
helps in diversifying risk but however it has not been very successful in the India
case.
In the organized sector, there are a number of players operating in India whose
activity is not monitored by the association. Add together the infusion of funds by
overseas funds, private individuals, ‘angel’ investors and a host of financial
intermediaries and the total pool of Indian Venture Capital today, stands at Rs50bn,
according to industry estimates!
The primary markets in the country have remained depressed for quite some time
now. In the last two years, there have been just 74 initial public offerings (IPOs) at the
stock exchanges, leading to an investment of just Rs14.24bn. That’s less than 12% of
the money raised in the previous two years. That makes the conservative estimate of
Rs36bn invested in companies through the Venture Capital/Private Equity route all
the more significant.
Some of the companies that have received funding through this route include:
• Mastek, one of the oldest software houses in India
• Geometric Software, a producer of software solutions for the CAD/CAM market
• Ruksun Software, Pune-based software consultancy
• Hinditron, makers of embedded software
• PowerTel Boca, distributor of telecomputing products for the Indian market
• Rediff on the Net, Indian website featuring electronic shopping, news, chat, etc
2.6 Favourites of the Investors
Though the InfoTech companies are among the most favored by venture capitalists,
companies from other sectors also feature equally in their portfolios. The healthcare
sector with pharmaceutical, medical appliances and biotechnology industries also get
much attention in India. With the deregulation of the telecom sector,
telecommunications industries like Zip Telecom and media companies like UTV and
Television Eighteen have joined the list of favorites. So far, these trends have been in
keeping with the global course.
However, recent developments have shown that India is maturing into a more
developed marketplace; unconventional investments in a gamut of industries have
sprung up all over the country.
This includes:
Indus League Clothing, a company set up by eight former employees of readymade
garments giant Madura, who set up shop on their own to develop a unique virtual
organization that will license global apparel brands and sell them, without owning any
manufacturing units. They dream to build a network of 2,500 outlets in three years
and to be among the top three readymade brands.
Shoppers Stop, Mumbai’s premier departmental store innovates with retailing and
decides to go global. This deal is facing some problems in getting regulatory
approvals.
Airfreight, the courier-company which has been growing at a rapid pace and needed
funds for heavy investments in technology, networking and aircrafts.
Pizza Corner, a Chennai based pizza delivery company that is set to take on global
giants like Pizza Hut and Dominos Pizza with its innovative servicing strategy.
Car designer Dilip Chhabria, who plans to turn his studio, where he remodels and
overhauls cars into fancy designer pieces of automation, into a company with a
turnover of Rs1.5bn (up from Rs40mn today).
2.7 Promotion Strategies
There is inadequate flow of applications for venture financing in India. The need
is promotional efforts not only to increase the flow of applications but also to
popularize the generic idea of venture financing. The promotion efforts of venture
capital funds in India could be classified as Contacting R&D organisations
Conducting seminars and industrial meets where the salient features of venture
capital schemes can be presented to prospective entrepreneurs
Creation of information services
Promotion of entrepreneurial activities
Venture Fairs in which the members of the VC industry listen to entrepreneurs
about their new ideas and business propositions
Venture Capital Networks and Associations
2.8 Incentives
Recognizing the importance of venture capital, the government introduced major
liberalisation of tax treatment for venture capital funds and simplification of
procedures. These included the following:
SEBI was recognized as the single nodal agency.
A new clause (23FB) in Section 10 of Income Tax Act was introduced with
effect from 1st March 2000. This clause stated that any income, of a venture
capital company or a venture capital fund, from any investments made in
venture capital undertaking, would not be included in computing the total
income.
Section 115U was also introduced in the Income Tax Act with effect from the
assessment year 2001-02 to establish a VC pass through. This means that the
VC profits will not be taxed twice. The regulated VC Fund (with SEBI) would
be exempted from tax (subject to certain conditions) but the VC investor will
have to pay tax.
Earlier on, if a VCF wished to avail certain tax benefits, the VCF had to exit
from investments made in a venture capital undertaking (VCU) within twelve
months of the VCU obtaining a listing. However, this requirement was done
away around November 2000. The Finance Bill 2001, proposes to amend
section 10 (23 FB) so as to provide that a VCC / VCF will continue to be
eligible for exemption under section 10 (23 FB), even if the shares of the
VCU, in which the VCC / VCF has made the initial investment, are
subsequently listed in a recognized stock exchange in India.
2.9 Initiatives
There have been a number of initiatives by the Government as well as the industry to
pave way for a business and regulatory environment that is conducive to new venture
development and to innovation at the user end. Some of the initiatives in the past have
included those by the Ministry of Finance, the Securities, Exchange Board of India
(SEBI), Ministry of Information Technology (formerly Department of Electronics),
State Governments, Financial Institutions, the Indian Venture Capital Association.
These initiatives resulted in the availability of more than US$ 500 million of venture
funds for Indian ventures during 1999-2000. With the growing realisation of the
immense potential offered by Indian technology companies, funding opportunities are
rapidly increasing.
The Government of India has already taken laudable steps to facilitate the creation of
an environment that is conducive for venture capital funds and start-ups in India.
These include:
introduction of sweat equity,
allowing venture capital funds to offset losses incurred in one company
against profits from another and establishment of government facilitated
venture capital funds.
However, the present regulatory framework is still not enough to provide for an
environment that lays stress on
encouraging the flow of venture funds,
easy exit options (for either party),
mentoring,
non-qualified availability of funds,
and flow of public funds for enterprise building in India.
India needs to encourage the growth of risk capital by acting on three fronts:
1. The Government of India and Indian financial institutions should catalyse the
process by creating Israel's Yozma-like funds. This will stimulate competition
but also protect entrepreneurs from inevitable risks.
2. India should amend its regulatory framework so that the VC funds can earn a
reasonable return on their risk capital.
3. India should actively promote the infusion of VC skills and capabilities, either
by attracting global VC funds or attracting managers from these funds.
However, the above moves need to be substantiated with the earliest implementation
of the recommendations of the SEBI Committee on Venture Capital.
2.10 SPECIAL PURPOSE VEHICLE
The DefinitionAn account, administered by a third party that holds shares bought back by
themanagement in trust.
THE ADVANTAGES THE DISADVANTAGES
Greater security for lenders
improves credit ratingLess control over cash flows generated by project
Lowers the cost of capital Tax treatment of SPV still unclear
Better management of debt repayment
Administration fees can be high
Enables new ventures to raise funds. Requires intensive monitoring by trustee
2.11 SPECIAL PURPOSE VEHICLE
The DefinitionAn account, administered by a third party that holds shares bought back by the
management in trust.
THE ADVANTAGES THE DISADVANTAGES
Greater security for lenders
improves credit ratingLess control over cash flows generated by project
Lowers the cost of capital Tax treatment of SPV still unclear
Better management of debt repayment
Administration fees can be high
Enables new ventures to raise funds. Requires intensive monitoring by trustee
Chapter – 4
Venture Capitalist – A key player
4.1 Role of Venture Capitalist
4.2 Difference between VC and money managers/banker
VENTURE CAPITALISTS – A key player
4.1 Role of venture Capitalists
Conventional financing generally extends loans to companies, while VC financing
invests in equity of the company. Conventional financing looks to current income i.e.
dividend and interest, while in VC financing returns are by way of capital
appreciation. Assessment in conventional financing is conservative i.e. lower the risk,
higher the chances of getting loan. On the other hand VC financing is a risk taking
finance where potential returns outweigh risk factors.
Venture Capitalists also lend management support and provide entrepreneurs with
many other facilities. They even participate in the management process. VCs
generally invest in unlisted companies and make profit only after the company obtains
listing. VCs extend need based support in a number of stages of investments unlike
single round financing by conventional financiers. VC’s are in for long run and rarely
exit before 3 years. To sustain such commitment VC and private equity groups seek
extremely high returns… a return of 30% in rupee terms. A bank or an FI will fund a
project as long as it is sure that enough cash flow will be generated to repay the loans.
VC is not a lender but an equity partner.
Venture capitalists take higher risks by investing in an early-stage company with little
or no history, and they expect a higher return for their high-risk equity investment.
Internationally, VCs look at an internal rate of return (IRR) north of 40% plus. In
India, the ideal benchmark is in the region of an IRR of 25% for general funds and
more than 30% for IT-specific funds. With respect to investing in a business,
institutional venture capitalists look for average returns of at least 40 per cent to 50
per cent for start-up funding. Second and later stage funding usually requires at least a
20 per cent to 40 per cent return compounded per annum. Most firms require large
portions of equity in exchange for start-up financing.
The VC Philosophy
As against Bought out deals (BODs), VCs carry out very detailed due diligence and
make 2-7 year investments. The VCs also hand-hold and nurture the companies they
invest in besides helping them reach IPO stage when valuations are favourable. VCFs
help entrepreneurs at four stages: idea generation, start-up, ramp-up and finally in the
exit.
According to Indian Venture Capital Association, almost 41% (Rs 5146.40 m) of the
total venture capital investment is in start-up projects followed by Rs 4478.60 m in
later stage projects and only Rs 82.95 in turnaround projects . Majority have invested
in only three stages of investment, indicating that most VCs in India have not started
developing niches for investing with regard to the stages of projects.
The main difficulty in early stage funding are related to lack of exit opportunities as
probability of an IPO or buy out by of VC stake is less due to lack of understanding
for evaluation of the knowledge based companies compared to the companies in the
traditional sectors. Some such VCs are: ICICI ventures, Draper, SIDBI and Angels.
Apart from finance, venture capitalists provide networking, management and
marketing support as well. The venture capitalist is a business partner, sharing the
risks and rewards and provides strategic, operational and financial advice to the
company based on experience with other companies in similar situations.
Management of investee firms
The venture funds add value to the company by active involvement in running of
enterprises in which they invest. This is called "hands on" or "pro-active" approach.
Draper falls in this category. Incubator funds like e-ventures also have a similar
approach towards their investment. However there can be "hands off" approach like
that of Chase. ICICI Ventures falls in the limited exposure category.
In general, venture funds who fund seed or start ups have a closer interaction with the
companies and advice on strategy, etc while the private equity funds treat their
exposure like any other listed investment. This is partially justified, as they tend to
invest in more mature stories.
4.2 Difference between a venture capitalist and bankers/money managers
Banker is a manager of other people's money while the venture capitalist is basically
an investor.
Venture capitalist generally invests in new ventures started by technocrats who
generally are in need of entrepreneurial aid and funds.
Venture capitalists generally invest in companies that are not listed on any stock
exchanges. They make profits only after the company obtains listing.
The most important difference between a venture capitalist and conventional
investors and mutual funds is that he is a specialist and lends management support and
also
• Financial and strategic planning
• Obtain bank and other debt financing
• Access to international markets and technology
• Introduction to strategic partners and acquisition targets in the region
• Regional expansion of manufacturing and marketing operations
• Obtain a public listing
Differences
PointsVenture Finance Debt Finance
Objective Maximize return Interest payment
Holding period 2-5 years Short/long term
Instruments Common shares, convertible bonds, options, warrants
Loan, factoring, leasing
Pricing Price earnings ratio, net tangible assets Interest spread
Collateral Very rare Yes
Ownership Yes No
Control Minority shareholders, rights protection, board members
Covenants
Impact on Balance sheet of financed
Reduced leverage Increased leverage
Exit Mechanism Public offering, sale to third party, sale to entrepreneur
Loan repayment
Chapter – 5
Pro’s and Quo’s of VCF
5.1 Success factors
5.2 Critical factor
5.3 Problems faces by VCF
5.1 Success factors of VCFs
1. Industry-specific concentration of investments yields better returns than
geographically concentrated investments.
2. Networking with industrial partners is important since these target companies are
potential clients and exit partners.
3. Networking with universities and research institutes helps identify new
technologies and investment targets.
4. Concentrating investments in carefully selected companies showing international
promise will yield better returns than distributing the capital across several smaller
investments. It is crucial that venture capitalists actively support the growth and
internationalisation of the companies through their industry-specific know-how and
international contacts.
5. With respect to the returns from the fund, it is vital that adequate capital is reserved
for further investment in the best investment targets and for maintaining the
holdings until the exit.
6. Joint investments with partners providing added value contribute to the success of
the target companies and improve the returns from the fund.
5.2 Critical Factors
In 1999, SEBI (Securities and Exchange Board of India) had set up a committee under
the Chairmanship of Mr. K. B. Chandrasekhar to look into the issues of venture
capital in India. The Report of the K. B. Chandrasekhar Committee on venture capital
identified the following as critical factors for the success of VC industry in India:
The regulatory, tax and legal environment should play an enabling role. This
emphasizes the facilitating and promotional role of regulation. Internationally,
venture funds have evolved in an atmosphere of structural flexibility, fiscal
neutrality and operational adaptability. And we need to provide regulatory
simplicity and structural flexibility on the same lines. There is also the need
for a level playing field between domestic and offshore venture capital
investors. This has already been done for the mutual fund industry in India.
Investment, management and an exit option 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.
There is also the need for identifying and increasing the domestic pool of
funds for venture capital investment. In US, apart from high net worth
individuals and angel investors, pension funds, insurance funds, mutual funds
etc. provide a very big source of money. The share of corporate funding is also
increasing and it was as high as 25.9 percent in the year 1998 as compared to 2
percent in 1995. Corporations are also setting up their own venture capital
funds. Similar avenues need to be identified in India also.
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 but also add to their experience and expertise to function
successfully in a global environment. We need our enterprises to become global and
create their own success stories. Therefore, automatic, transparent and flexible norms
need to be created for such investments by domestic firms and enterprises.
Venture capital should become an institutionalised industry financed and
managed by successful entrepreneurs, professional and sophisticated investors.
Globally, venture capitalists 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
Infrastructure development also needs to be prioritised using government
support and private management. This involves creation of technology as well
as knowledge incubators for supporting innovation and ideas. R&D also needs
to be promoted by government as well as other organisations.
The above report was well received by the Government and few issues have already
been resolved.
5.3 Problems generally associated with Venture Capital
1. The risk associated with true venture capital is greater than when providing capital
to an established business. Despite the best efforts and intentions, some start-ups will
not succeed. That is simply part of the game. In today's market, though, especially if
dealing with highly leveraged corporations, we have seen there is substantial risk
associated with well established businesses as well as with start-ups. The risk is
different, though, and people providing true venture capital recognizes this risk-
reward trade-off.
2. Most investors have an unrealistic view of venture capital. They expect the high
returns publicized with respect to successful new ventures but do not want to take the
attendant risk. Consequently, such investors go into the marketplace looking for
opportunities, claiming to offer venture capital, but never finding an investment that
meets their requirements.
3. Most venture fund managers come from banking, professional money management
or corporate management; while some come directly from business school and have
been employees of venture capital firms for their entire career. Consequently, the vast
majority of venture capital company employees - at any level - have no actual
"venture" or entrepreneurial experience, particularly with start-ups. A lack of
experience and understanding translates into a lack of comfort with the creation phase
of a business and a reluctance to invest in such deals.
4. Entrepreneurs, in general, have different goals, motivations and personalities than
bankers or corporate executives, who may expect to see people like themselves as
clients. These differences can often create a gap between the venture capitalist and the
entrepreneur sufficient to result in a rejection of the business proposal irrespective of
the merits of the business.
5. The principal source of capital for most entrepreneurs is friends and family. Once
that source runs out (if it exists at all), venture capital companies may be the only
alternative to obtain funding which, most likely, are small or insufficient in
comparison to the cost of, for instance, building a factory or buying a profitable going
concern. Few venture capital companies want to spend the time evaluating small deals
when, within the constraints of their investing limits and in the same amount of time,
they could participate in fewer but larger deals.
6. Three key elements to a successful new venture are (not in order of priority): a
good idea, adequate capital and good management. A failure of any one of these
elements can doom the enterprise. Due primarily to a lack of experience in the
creation or start-up phase, venture capital companies are often lacking in their ability
to evaluate and recognize:
(a) a "good idea" because ideas and the projections associated with them are so
intangible, unlike - so they think - the projections of an established company;
(b) "adequate capital" for a start-up because traditional venture capital companies may
not have the experience to understand whether the entrepreneur's goals can be
achieved with the capital requested or to help the entrepreneur determine the
appropriate capital requirements for a start-up;
(c) the presence or absence of adequate entrepreneurial management, which can be
different than that of a large established corporation; a good example of which was
the changing need of Apple Computers when it replaced Steven Jobs with John
Sculley.
7. Despite the fact that many fund managers will say that inadequate management is
the primary reason for business failure, they will rarely devote time to assist
management to help achieve a greater likelihood of success. Consequently, some
investments are destined to fail from the start; and many firms use everyone else's
failures as a reason for them to avoid start-ups.
8. Many companies and individuals complain that they have money to invest in
"good" projects, but none can be found. First, what is "good" for one person or firm
may not be "good" for another. That definition is guided by goals and requirements of
the individual investor. An older investor may be looking for income while a younger
investor may be looking for appreciation. Often, those goals are unrealistic as applied
to venture capital.
Chapter-6
Case Studies
6.1 Case study-1
6.2 Case study-2
6.3 Case study-3
Case Studies
6.1 Case Study-1: Rise of UK economy
The economic impact of private equity and venture capital on the UK: Keeping
London and the UK the centre of the European industry
Private Equity and venture capital makes a valuable contribution to the economy
generally by having a positive effect on the companies in which private equity is
invested. In addition, the industry makes a very significant contribution to the
financial services industry and in particular plays an important role in maintaining the
City of London as Europe's premier financial centre and helping to build it as the
world's premier financial centre.
The industry has shown incredible growth over the last few years, both in terms of the
funds it has raised and the capital it manages and in the level of investment that is
made, with growth comes responsibility as well as opportunity. The growth of the
industry has increased its profile and with that profile comes a legitimate interest in
what the industry is doing from the public, the press and of course the regulatory
authorities.
The industry is currently facing two major reviews - by the FSA in the Discussion
paper they recently published and by the Treasury focusing on the taxation, not just of
capital gains made by the industry, but also the capital gains made by the risk-taking
entrepreneurs and management team that as an industry VCF back.
Achieving the right outcome for the industry from the tax review and continuing to
ensure regulation is appropriate and not burdensome are two vital tasks the British
Venture Capital Association (BVCA) and the industry faces.
The BVCA and its work
The BVCA is the industry body that represents the UK private equity and venture
capital industry.
Private equity means the equity financing of companies at many stages in the life of a
company from start-up through expansion all the way through to buy-outs of
established companies that in today's world can be very significant and large
transactions.
Venture capital as a term typically covers early stages of start-up or growth funding or
expansion capital. The term buy-outs (MBO, MBI, etc) refers to using - private equity
to finance the change in ownership of a company.
The common threads - and hence the term private equity - is that the investments
made in unquoted equity (i.e. not publicly quoted equity) and into companies that
have real growth potential which can be turned around or transformed under private
equity ownership as opposed to being constantly in the spotlight that having a quoted
share price means for a public company.
The BVCA represents the whole cross section of the private equity industry in the UK
- from small seed stage venture funds all the way through to the large private equity
firms who focus almost exclusively on buy-outs and who are almost becoming
household names today.
BVCA membership comprises well over 90% of all UK-based private equity and
venture capital funds and their advisors.
The role of the BVCA is to ensure that the UK industry is properly represented to
politicians and policy makers here at Westminster, across the UK and in Brussels.
The industry's economic impact
The survey shows once again that private equity-backed companies are a significant
driver in the UK economy and its global competitiveness.
Key findings of this report show once again that in the five years to 2005/2006:
• The growth of employment in private equity-backed companies was faster than both
FTSE 100 and FTSE 250 companies (9% pa vs 1% and 2% respectively)
• Sales grew faster in private equity-backed companies compared with FTSE 100 and
250 companies (9% vs. 7% and 5%)
• Exports from private equity-backed companies grew at a faster rate than the national
growth rate (6% vs. 2%)
• Investment grew faster than the national average (18% vs 1%)
It is now well established that the performance of private equity-backed companies
significantly strengthens the UK economy and improves international competitiveness
and creates jobs at a considerably faster rate than other private sector companies. It is
now estimated that companies that have received private equity funding account for
the employment of around 2.8 million people in the UK, equivalent to 19% of UK
private sector employees.
It is also significant to note that 92% of companies that responded to the survey said
that without private equity the business would not have existed at all or would have
developed less rapidly.
The reason for this is that private equity investment is more than just the provision of
capital. Respondents to the survey noted that strategic direction, financial advice and
help with contacts were key ways in which private equity firms had helped with the
development of their businesses.
It is estimated that companies which have been private equity-backed generated total
sales of £424 billion, exports of £48 billion and contributed over £26 billion in taxes.
The figures in the Economic Impact Survey demonstrate clearly that private equity-
backed businesses are active across all regions of the UK and are valuable
contributors to the wealth of these regions.
The impact of the private equity industry as a UK financial service
The UK private equity industry is playing an increasingly significant role as a source
of revenue for firms operating within the broader financial and professional services
industry, contributing to the overall impetus that these industries provide to the UK
economy.
2005 data shows that:
• Private equity-related activities generated estimated fee revenue for financial and
professional services firms of over £3.3 billion, representing around 7% of the total
annual turnover of the UK financial services industry.
• There are more than 5,500 individuals (3,500 of which are investment professionals)
employed in some 260 private equity, venture capital, funds-of-funds and
secondaries investment firms in the UK.
• The UK has a network of around 750 financial, professional and business services
firms providing advisory and financial support to private equity and venture capital
firms. They employ a full time equivalent pool of close to 6,700 executives
engaged in private equity-related activities.
• Taken together, there are over 10,000 highly skilled professionals employed across
over 1,000 firms engaged either directly or indirectly in private equity-related
activities.
• For every private equity executive investing directly in UK companies, there are 2.3
full time equivalent advisors or finance executives providing specialist advice and
services.
• Financial, professional and other business services executives working on private
equity-related mandates in 2005 generated an average of £500,000 per head in fees.
• Private equity-backed transactions account for a significant proportion of total M&A
activity in the UK with almost 30% of all UK investment banking fees from M&A
and loan financing being derived from private equity backed transactions in 2005.
• The UK private equity industry has long attracted capital investment from outside its
own shores, with almost £50 billion of foreign investment into UK private equity
funds over the past six years.
• Furthermore, two-thirds of the total capital invested by UK firms over the same
period was committed to companies within the UK, demonstrating a positive net
inflow of capital into the UK economy.
Investment activity
BVCA are an industry that invests across all sectors, from start-ups to buy-outs, all
around the UK, across continental Europe and around the world.
In 2005, UK private equity activity increased to its highest ever levels, in terms of
funds raised, private equity investments made and also divestments.
Here are a few key figures that illustrate the scale of what we do:
• Funds raised from investors reached £27.3 billion.
• 1,535 companies were financed.
• Worldwide investment by UK private equity firms increased by 21% in 2005 to
£11.7 billion from £9.7 billion in 2004.
• Companies financed at start-up stage increased by 9% to 208.
By any measure, the UK private equity and venture capital industry is a UK success
story. And yet it is disappointing that despite the fact that the benefits of private
equity as an asset class are so clear that last year 80% of BVCA investors came from
overseas, with 45% coming from the US.
The primary objective of the private equity industry is to drive returns to its investors
and while it is a good thing that we can attract inward investment, it is a pity that the
beneficiaries of the capital gains created by this industry predominantly accrue to
overseas investors.
UK private equity and venture capital industry is a good strong British success
story.
Major investment attract into the UK from overseas, BVCA make major investment
around the UK investing in companies, creating jobs and building businesses, and
they invest across continental Europe and around the world bringing returns home for
the benefit of their investors. This industry has benefited from a strong cross Party
consensus that understands the important role BVCA play in keeping the UK
economy competitive and dynamic. This support is much appreciated.
Private equity investment should not be regarded as an end in itself, but rather as part
of a life cycle of a business. The private equity model brings together absolute
alignment of interest between investor and management.
This enables absolute focus on agreed purpose, the ability to achieve change swiftly
and efficiently and a complete concentration on the direction of the business.
6.2 Case Study- 2: Silicon Valley's success.
Venture capitalists supply the funds to budding entrepreneurs who want to start their
own companies - and 40% of such deals in the US take place in Silicon Valley.
Venture capitalists also help nurture those companies to success, supplying
introductions to potential customers or partners, assistance with raising more funds,
and even management support.
And venture capital has been one of the extraordinary growth industries in the Valley,
with the amount of money invested in venture capital funds rising in the decade from
$1bn in 1990 to $20bn in 1999 - and nearly doubling again to $35bn in 2000.
Dot.com fall-out
Ann Winblad, founder of venture capital firm Hummer Winblad, with $1bn in funds
under management, was one of the victims of the dot.com fall-out.
Her company had backed one of the biggest and most well-known internet companies
selling to consumers, Pets.com, which stopped trading despite millions of dollars in
private investment and an enthusiastic stock market flotation.
In her sleek, wooden-beamed offices in San Francisco's newly fashionable SoMo
district, which has become a beacon for dot.com companies, she explained what went
wrong.
In her view, the increasing frenzy in the stock market for internet companies -
whatever their business plan or chances of profitability - had meant that too many
companies had been funded and brought to the stock market too quickly.
Too many inexperienced people came into the venture capital marketplace, with
financiers, bankers, and big companies all prepared - even desperate - to back internet
ventures.
Fund raising difficulties At one point, she says, $1bn a week was being offered to
entrepreneurs - attracting too many people who were "mercenaries not missionaries"
to the world of enterprise.
But when the market woke up, and dot.com and tech stocks crashed in April, it
became impossible for even well-managed internet companies to raise additional
money. Pets.com and other e-tailers needed more capital to grow - and that was no
longer available at any price.
Now, she says, it is unlikely that anyone would fund any internet company for at least
the next two years, and e-tailers, or dot.com companies selling to consumers, are the
"mad cow disease" of the venture capital world - no one will touch them at all.
And in future, the pace of investment will be slower and more measured, taking 3-5
years to bring companies to the stage at which they can be floated on the stock market
- and that venture capitalists will resume their role of "company coach" rather than
pure deal-makers.
Profit hopes dimmed
And now, one of the factors limiting the further expansion of venture capital firms is
their need to spend more time managing their existing portfolio - "tending to the sick
and needy" in the words of the chief of one dot.com that has survived, Obongo's John
Hunt.
Mr Knoblauch says that in the height of the euphoria one year ago, venture capitalists
began to believe that they could make a profit on nearly any company they backed.
But now, they expect only about one in five of the companies they back to become a
major success - but those successes, with returns of 10-20 times investment, will still
make the whole fund profitable.
Vital role
Venture capitalists will still play a vital role as catalysts for Silicon Valley's future.
It was the presence of the world's most sophisticated venture capital industry that
attracted John Hunt of Obongo from the UK to San Francisco. Venture capitalists
have played a crucial part in launching his company, which provides the software for
electronic wallets used for shopping on the internet.
Obongo was created in the offices of venture capital firm Sequoia, who introduced the
UK based company, then called Smartport, to its Silicon Valley rival, Chabi - and
they agreed to merge with each other 30 minutes into the meeting.
Sunny outlook
And Obongo's other venture capital partner, Atlas, played a central role in helping
them secure their first customer, the large US bank Citibank. It is networks like these
which will secure the future of the Valley, according to historian and city planner
Anna Lee Saxenian. Nowhere else have venture capitalists such a close connection
with their industry, she argues, with most moving from being entrepreneurs
themselves. Their understanding of the technology, the markets, and the competition
means that entrepreneurial knowledge is shared and is transferred more quickly here
than anywhere else.
It is that culture that will ensure that, despite the sharp change in market sentiment,
Silicon Valley will remain the world's high-tech incubator.
6.3Case Study-3: Failure of Analog Devices Enterprises
In 1980, Analog Devices established a corporate venture program, Analog Devices
Enterprises (ADE), to generate both attractive financial returns and strategic benefits
in the form of licensing agreements and acquisitions. Funding was provided by
Amoco, and ADE had invested $26 million in 11 firms by 1985.
That very year Amoco ceased contributing capital, and the ADE program was
suspended. Around this time, Analog Devices took a $7 million charge against
earnings; in 1990, with most of the portfolio liquidated, it took another $12 million
charge. Of the 11 firms in ADE’s portfolio, 10 were terminated, acquired by other
companies at unattractive valuations, or relegated to the "living dead." Only one firm
ultimately went public. In this case, ADE’s stake was so diluted by a merger that it
was worth only about $2 million at the time of the offering.
What went wrong? Clearly, the ADE program exhibits all three of the classic
structural failings:
1. Program managers were hampered by the lack of a clear objective. Instead, they
had a threefold mission: to invest in firms pursuing technologies relevant to the
ongoing business of Analog Devices and Amoco, to obtain options to acquire firms of
interest to Analog’s management, and to generate high financial returns.
2. Analog Devices’ researchers, seeing scarce resources being devoted to ADE,
resented the program. Also, Amoco only committed to fund the program for five
years, considerably less time than was needed to grow the early-stage companies.
3. Incentives of the various parties appear to have been improperly aligned. The
management of Analog Ventures believed that they were insufficiently rewarded, and
Amoco did not share in the profits generated.
Chapter - 7
SURVEY AND CONCLUSION
Survey:
For getting about practical knowledge of working of VCFs, survey was conducted in
3 firms namely SIDBI (Small Industrial Development Bank of India), JM Equity
Fund, IDFC Equity Fund. Following questions were asked and some of the answers
given were:
1) What do VCF looks for in evaluating a new company? Most critical element
VCF looks for.
A- Business potential, Company background, core plan, Promoter details.
B- Growth, management, value, Business model, valuation expectation, return
expected.
C- Promoter – very careful, understanding, profile and background.
Interpretation- VCF looks for good profile and background of promoter, business
potential and management for evaluating in a new company.
2) How is business plan presented?
A - Presentation, calling, executive, e-mail, advisors.
B – Presentation, Financial model, mgmt meeting, matter of convenience to both
Promoter and VCF.
C – Based on business plan and industry in relation to its growth, potential,
growth, returns. Presentation is done in front of Investment banker (middleman
between VCF and Promoter).
Interpretation- Business plan is presented through various ways like presentation,
financial model, etc. whichever is more convenient for both parties.
3) How do VCFs define their contribution?
A- By providing facilities through schemes like Started Investment and Smart
Money.
B- Best practices, Advice for approaching to financial market, etc.
C- Appointment, issues, tie ups with government, tie up with portfolio company,
equipments, training, venturing in new areas, broader view and thinking.
Interpretation- VCFs defines their contributions by showing the Promoters correct
way for taking appropriate steps.
4) What are the milestones in achieving whether the company will achieve their
goal?
A – Milestones are laid down during agreement in top line and bottom line
revenue. Term sheet documentation is signed by promoter.
B – Through companies profit numbers and total sales.
C – All the milestones are noted down in shareholder’s agreement.
Interpretation- The landmarks are decided by the VCFs and Promoter during
signing of agreement between them.
5) What are the major trends in VCF industry?
A – Latest trend is interest in Bio-tech sector.
B – Upcoming sectors like Logistics, BPO, Financial Services, Real Estate.
C – All upcoming sectors especially Transport and Logistics.
Interpretation- The trends in VCFs industry depends upon type of firms, as all of
them have interests in different sectors for financing.
6) What companies in VCF might make interesting investments.
A - Depends upon the sector which is booming at that time.
B – Same as above said sectors.
C – The best sector in today’s scenario is IT sector which will be backbone for
economy.
Interpretation- The companies themselves shows as interested investing sectors to
VCFs by their performance.
7) How long does it take to make investment or participation decision?
A – Taken after a long procedure of investigation gets over from 6-8 weeks.
B – It takes 10 days sometimes and also get extent up to 3-4 months.
C – Lengthy process as investigation about promoter is done. Then too it takes 3-5
months.
Interpretation- Time taken by VCFs for investment decision is from 10 days till 3-
4 months. It also sometime extents till 6 months.
8) Critical features of an agreement between VCF and Promoter.
A – Exit options, Right to appoint a BOD, Internal Auditor, Projects. Even main
steps taken by promoter should be consulted by VCF.
B – Liquidity event, seat in BOD, Minority protection rights, big decisions to be
consulted.
C – Rights and Obligations of Promoter, Board seat, Rights to see committee,
Veto Right.
Interpretation- The most critical features are selecting exit options, rights and
obligations of venture capitalists, and major decisions should be consulted with
VCF.
9) Exit policies followed by VCFs.
A- IPO, Selling stake to 3rd party, Promoter’s buyback from VCF, Drag-along &
Tag-along.
B- Selling to strategic, Block deal, IPO.
C- IPO, Promoter’s buyback, Selling stake, Combination of promoter’s buyback
and selling stake.
Interpretation- There are 3 basic exit options been followed by VCFs all over the
world.
10) Risk analysis.
A – Risk depends upon type of company, market, exit risk, proper investment
done or not, cultural risk, competition.
B – If valuation does not grow as per expectation then business plan fails.
C – Scenario building. Risk in terms of promoter, revenue, cost (as operating
expenses).
Even on potential of promoter.
Interpretation- The risk analysis varies as per depending on the situation.
Note: As per the answers given for the following questions, A presents SIDBI, B
presents JM Equity Fund and C – IDFC Equity Funds. Interpretation is short
conclusion of all answers.
Conclusion:
Earlier patterns of growth or failure in venture capital industries in other countries and
regions indicate that the evolution of venture capital seems to be either entry into a
self reinforcing spiral, such as occurred in Silicon Valley and Israel, or growth and
stagnation, as occurred in Minnesota in the 1980s or the United Kingdom until
recently. Given India’s wish to develop a high-technology industry funded by venture
capital, it is necessary to keep improving the environment by simplifying the policy
and regulatory structure (including eliminating regulations that do not perform
necessary functions such as consumer protection).
The World Bank, with its agenda of decreasing government regulation, funded the
creation of the first venture capital funds. Though these funds experienced little
success, they were the beginnings of a process of legitimitizing venture investing and
they were a training ground for venture capitalists who later established private
venture capital funds. It is unlikely that the venture capital industry could have been
successful without the development of the software industry and a general
liberalization of the economy. Of course, this is not entirely surprising, because an
institution as complicated as venture capital could not emerge without a minimally
supportive environment. This environment both permitted the evolution of the venture
capital industry and simultaneously allowed it to begin changing that environment and
initiating a co-evolutionary dynamic with other institutions.
India still remains a difficult environment for venture capital. Even in 2006 the Indian
government remains bureaucratic and highly regulated. To encourage the growth of
venture capital will require further action, and it is likely that the government will
continue and even accelerate its efforts to encourage venture capital investing. The
role of the government cannot be avoided: it must address tax, regulatory, legal, and
currency exchange policies, since many of these affect both venture capital firms and
the companies that they finance. More mechanisms need to be developed to reduce
risk if funds for venture capital must come from publicly held financial institutions
managed by highly risk-averse managers. In short, “VCF is next engine for
economical growth for all countries in the World”.
Suggestions for growth of VCF:
Venture capital industry is at the take off stage in India. It can play a catalytic role in
the development of entrepreneurship skill that remains unexploited among the young
and energetic technocrats and other professionally qualified talents. It can help
promote new technology and hi-tech industries, which involve high risk but promises
attractive rate of return. In order to ensure success of venture capital in India, the
following suggestions are offered:
(i) Exemption/Concession for Capital Gains:
Capital gains law represents a hurdle to the success of venture capital financing. The
earnings of the funds depend primarily on the appreciation in stock values. Further,
the capital gains may arise only after 3 to 4 years, of investment and that the projects,
being in new risky areas, may not even succeed. Capital gains by corporate bodies in
India are taxed at a much investment risk and long gestation period this is a deterrent
to the development of VCFs.
The benefit of the capital gains, under section 48 of the Act is not significant. Hence,
it would be advisable that all long term capital gains earned by VCCs should be
exempted from tax or subject to concessional flat rate. Further, capital gains
reinvested in new venture should also be exempted from tax. Section 52(E) of the
Act should be amended to give effect to this.
(ii) Development of Stock Markets:
Guidelines issued by finance ministry provides for the sale of investment by way of
public issue at the price to be decided on the basis of book value and earning capacity.
However, this method may not give the best available prices to venture fund as it will
not be able to consider future growth potential of the invested company.
One of the major factors which contributed to the success of venture funds in the West is development of secondary and tertiary stock markets. These markets do not have listing
requirements and are spread over all important cities and towns in the country. These
stock markets provide excellent disinvestments mechanism for venture funds. In
India, however, stock market is not developed beyond a few important cities.
Success of venture capital fund depends very much upon profitable disinvestments
of the capital contributed by it. In US and UK secondary and tertiary markets helped
in accomplishing the above. However, in India, promotion of such maker is not
feasible in the prevailing circumstances as such laissez faire policy may attack
persons with ulterior motives in the business to the determent of general public.
However, stock market operation may be started at man by more big cities where, say,
the number of stock exchanges can be increased to 50. Further, permission to transact
in unlisted securities with suitable regulation will ensure firsthand contact between
venture fund and investors.
(iii) Fiscal Incentives:
Fiscal incentives may be given in the form of lowering the rate of income tax. It can
be accomplished by:
(i) Application of provisions applicable to non-corporate entities for taxing long term
capital gains.
(ii) An allowance to funds similar to section 80-CC of Income Tax Act, say 20
percent of the investment in new venture which can be allowed as deduction from the
income.
(iv) Private Sector Participation
In US and UK where the economy is dominated by private sector, development of
venture fund market was possible due to very significant role played by private sector
which is often willing to put money in high risk business provided higher returns are
expected. The guidelines by finance ministry provide that non- institutional
promoter’s share in the capital of venture fund cannot exceed 20 percent of total
capital; further they cannot be the single largest equity holders. The private sector,
because of this provision, may not like to promote venture fund business.
Promotion of venture funds by private sector, in addition to public financial
institution and banks, is recommended as:
Private sector is in advantageous position as compared to financial institutions and
banks to provide managerial support to new ventures as leading industrial house have
a pool of experienced professional managers in all fields of management viz.
marketing, production and finance. The leading business houses will be able to raise
funds from the investing public with relative ease.
(v) Review the Existing Laws
Today’s need is to review the constrains under various laws of the country and resolve
the issue that could come in the way of growth of the innovative mode of financing.
Suitable exemption should be given from Section 43 A of the companies Act to
venture capital finance companies so that they are not required to comply with
several provisions of the Act applicable to public limited companies.
Amendment of Section 77 of the Companies Act is required to enable the new
venture capital companies to buy back their shares at the time of disinvestments by
VC Finance Companies.
Ceiling on interoperate loans and investment as specified in Section 370 and 372 of
the companies Act should be relaxed in case of VC Finance Companies and Venture
Capital Companies to enable them to invest suitable in newly promoted companies.
The only investment available to the VC Finance company for investment is equity
shares. This restriction should be relaxed so that VC Finance Company can finance
through preferential issues and conditional loans. The scope of VC should not only be
confirmed to start up finance but also be broadened to development finance,
expansion and growth, buyouts, mergers and amalgamation. The restriction on
investment of 80% of the entire funds within a period of 3 years should be removed.
(vi) Limited Partnership
The Practice of the limited partnership as in vogue in UK should be permitted in order
to promote integration of object between the managers and contributors for the
success of venture capital projects.
Chapter – 8
Annexure
8.1 SEBI Guidelines and Regulations
8.2 Certificate of Registration
8.3 Tax Aspects
8.4 Investment conditions and restrictions
Annexure
8.1 SEBI Guidelines and Regulations:
In the absence of an organised Venture Capital industry till almost 1998, individual
investors and development financial institutions played the role of venture capitalists
in India. Entrepreneurs have largely depended upon private placements, public
offerings and lending by the financial institutions.
In 1973 a committee on Development of Small and Medium Enterprises highlighted
the need to foster venture capital as a source of funding new entrepreneurs and
technology. Thereafter some public sector funds were set up but the activity of
venture capital did not gather momentum as the thrust was on high-technology
projects funded on a purely financial rather than a holistic basis.
Later, a study was undertaken by the World Bank to examine the possibility of
developing Venture Capital in the private sector, based on which the Government of
India took a policy initiative and announced guidelines for Venture Capital Funds
(VCFs) in India in 1988.
However, these guidelines restricted setting up of VCFs by the banks or the financial
institutions only. Thereafter, the Government of India issued guidelines in September
1995 for overseas investment in Venture Capital in India. For tax-exemption
purposes, guidelines were also issued by the Central Board of Direct Taxes (CBDT)
and the investments and flow of foreign currency into and out of India have been
governed by the Reserve Bank of India's (RBI) requirements. Further, as a part of its
mandate to regulate and to develop the Indian capital markets, the Securities and
Exchange Board of India (SEBI) framed the SEBI (Venture Capital Funds)
Regulations, 1996. These guidelines were further amended in Apr 2000 with the
objective of fuelling the growth of Venture Capital activities in India.
In the late 1990s, the Indian government became aware of the potential benefits of a
healthy venture capital sector. Thus in 1999 a number of new regulations were
promulgated. Some of the most significant of these related to liberalizing the
regulations regarding the ability of various financial institutions to invest in venture
capital. Perhaps the most important of these went into effect in April 1999 and
allowed banks to invest up to 5 percent of their new funds annually in venture capital.
The main statutes governing venture capital in India included the SEBI’s 1996
Venture Capital Regulations, the 1995 Guidelines for Overseas Venture Capital
Investments issued by the Department of Economic Affairs in the Ministry of
Finance, and the Central Board of Direct Taxes’ (CBDT) 1995 Guidelines for Venture
Capital Companies (later modified in 1999). In early 2000, domestic venture
capitalists were regulated by three government bodies: the Securities and Exchange
Board of India (SEBI), the Ministry of Finance, and the CBDT. For foreign venture
capital firms there was even greater regulation in the form of the Foreign Investment
Promotion Board (FIPB), which approves every investment, and the Reserve Bank of
India (RBI), which approves every disinvestment.
Since SEBI is responsible for overall regulation and registration of VCF, multiple
regulatory requirements should be harmonized and consolidated within the framework
of SEBI Regulations to facilitate uniform, hassle-free, single window clearance.
Registration of a venture capital fund
Applicant should follow the procedure given below so as to expedite the registration
process. However, SEBI will also guide the applicant step by step after getting
application for registration as a venture capital fund. Normally, all replies are sent
within 21 working days from the date of getting each communication from the
applicant during the process of registration. Thus, the total time period for
registration depends on how fast the requirements are compiled with by the applicant.
Main requirements under SEBI (Venture Capital Funds) Regulations, 1996:
The following are the eligibility criteria for grant of a certificate of registration as per
regulation 4 of SEBI (Venture Capital Funds) Regulations 1996. For the purpose of
grant of a certificate of registration, the applicant has to fulfil the following, namely:-
(a) If the application is made by a company, -
(i) Memorandum of association has as its main objective, the carrying on of
the activity of a venture capital fund;
(ii) It is prohibited by its memorandum and articles of association from
making an invitation to the public to subscribe to its securities;
(iii) Its director or principal officer or employee is not involved in any
litigation connected with the securities market which may have an
adverse bearing on the business of the applicant;
(iv) Its director, principal officer or employee has not at any time been
convicted of any offence involving moral turpitude or any economic
offence.
(v) It is a fit and proper person.
(b) If the application is made by a trust -
(i) The instrument of trust is in the form of a deed and has been duly
registered under the provisions of the Indian Registration Act, 1908 (16
of 1908);
(ii) The main object of the trust is to carry on the activity of a venture capital
fund;
(iii) The directors of its trustee company, if any, or any trustee is not
involved in any litigation connected with the securities market which
may have an adverse bearing on the business of the applicant;
(iv) The directors of its trustee company, if any, or a trustee has not at any
time, been convicted of any offence involving moral turpitude or of any
economic offence;
(v) The applicant is a fit and proper person.
(c) If the application is made by a body corporate
(i) It is set up or established under the laws of the Central or State
Legislature.
(ii) The applicant is permitted to carry on the activities of a venture capital
fund.
(iii) The applicant is a fit and proper person.
(iv) The directors or the trustees, as the case may be, of such body corporate
have not been convicted of any offence involving moral turpitude or of
any economic offence.
(v) The directors or the trustees, as the case may be, of such body corporate,
if any, is not involved in any litigation connected with the securities
market which may have an adverse bearing on the business of the
applicant.
(d) The applicant has not been refused a certificate by the Board or its certificate has
not been suspended under regulation 30 or cancelled under regulation 31.
Application for Registration:
An applicant should apply for registration in form a prescribed under First Schedule of
SEBI (Venture Capital Funds) Regulations 1996 along with requisite fees. All
documents should be enclosed as specified in the form.
Additional information:
1. A complete list of your associate companies registered with SEBI, and also
indicate the capacity in which they are registered along with the SEBI
Registration number;
2. State whether the applicant is registered with SEBI in any capacity.
3. A complete list of your group companies registered with SEBI, and also indicate
the capacity in which they are registered with SEBI along with their SEBI
Registration number.
4. Whether the applicant or the intermediary, as the case may be or its whole time
director or managing partner has been convicted by a Court for any offence
involving moral turpitude, economic offence, securities laws or fraud
5. Whether any winding up orders have been passed against the applicant or the
intermediary.
6. Whether any orders under the Insolvency Act have been passed against the
applicant or any of its directors, or person in management and have not been
discharged.
7. Whether any order restraining prohibiting or debarring the applicant or its whole
time director from dealing in securities in the capital market has been passed by
SEBI or any other regulatory authority and a period of three years from the date
of the expiry of the period specified in the order has not elapsed;
8. Whether any order canceling the certificate of registration of the applicant on the
ground of its indulging in insider trading, fraudulent and unfair trade practices or
market manipulation has been passed by SEBI and a period of three years from
the date of the order has not elapsed ;
9. Whether any order, withdrawing or refusing to grant any license/ approval to the
applicant or its whole time director which has a bearing on the capital market, has
been passed by SEBI or any other regulatory authority and a period of three years
from the date of the order has not elapsed.
10. (a) Details of registration of your company/associate/group companies (to be given
separately), which are registered/ required to be registered with Reserve Bank of India
(RBI) as a Banking company or Non Banking Finance Company or in any other capacity
and address(es) of concerned branch office(s) of RBI.
(b) Details of disciplinary action taken by RBI against you or any of your
group/associate companies. Please also inform us in case there is any default in
repayment of deposits by you or any of your group / associate companies.
Applicant can submit ‘no objection certificate’ from RBI for getting registered with
SEBI, to expedite the registration process.
Other Documents to be submitted to SEBI
1) Memorandum and Articles of Association of applicant company, executed
copy of trust deed if the fund is being set up as a trust and main objective of
constitution in case of body corporate.
2) Executed copy of Investment Management Agreement, if applicable.
3) Disclose in detail the investment strategy as required under regulation 12(a) of
the SEBI (Venture Capital Funds) Regulations, 1996. Also state the target size
of the fund along with the profile of the investors of the fund.
4) An undertaking to the effect that the fund will not enter into any venture
capital activity if it fails to raise a commitment of at least Rs. five crore as
required under Regulation 11(3) of SEBI (Venture Capital Funds)
Regulations, 1996.
5) Copies of letters of commitment from investors in support of the target
amount proposed to be raised by the fund.
6) Undertaking that the venture capital fund will not make investment in any area
listed under Third Schedule to SEBI (Venture Capital Funds) Regulations,
1996.
7) Venture Capital Fund shall disclose the duration/ life cycle of the fund.
Grant of Certificate of Registration
Once all above requirements have been complied with and requisite fees as per
Second Schedule to Regulations have been paid, SEBI will grant certification of
registration as a venture capital fund.
8.2 Certificate of Registration
2006Certificate of registration as venture capital fund
I. In exercise of the powers conferred by sub-section (1) of section 12 of the securities
And exchange Board of India Act, 1992, (15 of 1992) read with the regulation made
There under, the board hereby grants a certificate of registration to
-------------------------
------------------------------------------------as a venture capital fund subject to the
conditions specified in the Act and in the regulations made there under.
II. The Registration Number of the venture capital fund is IN/VC/ /
Date:
Place: MUMBAI
By order
Sd/-
For and on behalf of
Securities and Exchange Board of India
Income Tax benefits
In order to encourage the development of venture capital funds, the income Tax Act,
1961 exempts the income of a venture capital fund from Income Tax.
Income of a venture capital fund [section 10(23FB)] (on and from Financial Year
1999-2000)
Any income of a venture capital fund (VCF) or a venture capital company (VCC)
set up to raise funds for investment in a venture capital undertaking (VCU) is
exempt.
VCC means a company which has been granted a certificate of registration by SEBI
and which fulfils the conditions laid down by SEBI with the approval of the Central
Government.
VCU means a domestic company whose share are not listed in a recognized stock
exchange in India and which is engaged in the business for producing services,
production or manufacture of an article or thing but does not include activities or
sectors which are specified by SEBI with a approval of the Central Government.
8.3. Tax Aspects:
VCFs have been provided complete income tax relaxation (July 1995) and exemption
from long-term capital gains tax after they are listed on stock exchanges. Shares have
to be held for at least 12 months to enjoy tax exemption. A lock-in period of three
years is however applicable for unlisted shares.
The Finance Act, 1995 provided [Section 10 (23 F) of the IT Act] income tax
exemption on any income by way of dividends or long-term capital gains of a
venture capital fund or a venture capital company from investments made by way
of equity shares in a venture proposal. To enjoy tax exemption the venture capital
company has to obtain approval and satisfy prescribed conditions. The Central Board
of Direct Taxes (CBDT) issued guidelines, on 18-7-1995 specifying that the
prescribed authority for approval for exemption under Section 10 (23F) of Income
Tax Act is Director of Income Tax (Exemption). The conditions for approval are:
it is registered with the SEBI (guidelines of 13.2.1996 discussed
below);
it invests 80 percent of its total monies by acquiring equity shares of
venture capital undertakings;
it invest 80 percent of its total paid-up capital in acquiring equity
share of the venture capital undertakings;
it shall not invest more than 20 percent (Budget for 1997-8 raised it
from 5 to 20 percent.)it shall not invest more than 40 percent in the equity
capital of one venture undertakings
it shall maintain books of account, and submit audited accounts to the
Director, Income Tax (Exemption).
8.4 . Investment conditions and restrictions
A venture capital fund may raise money from any source, whether Indian, foreign or
non resident Indian by way of issue of units. No venture capital fund shall accept any
investment from any investor less than Rs5,00,000. However this condition is not
applicable to:-
8.2.1 employees or the principal officer or directors of the
venture capital fund has been established as a trust
8.2.2 employees of the fund manager or asset management
company for the purpose of the se regulations, fund raised means actual money raised
from investors for subscribing to the securities of the venture capital fund and
includes money that is raised from the author of the trust (in case the venture capital
fund has been established as a trust) but does not include the paid up capital of the
trustee company, if any.
8.2.3 Each scheme launched or fund set up by a venture
capital fund shall have firm commitment from the investors for contribution by the
venture capital fund.
All investment made or to be made by a venture capital fund shall be subject to the
following conditions, namely:-
a. venture capital fund shall disclose the investment strategy at the time of
application for registration;
b. venture capital fund shall not invest more than 25% corpus of the fund in one
venture capital undertaking ;
c. shall not invest in the associated companies; and
d. venture capital fund shall make investment in the venture capital undertaking as
enumerated below
(i). at least 75% of the investible funds shall be invested in unlisted equity shares or
equity linked instruments. However, if the venture capital und seeks avail of benefits
under the relevant provisions of the Income Tax Act applicable to a venture capital
fund, it shall be required to disinvest from such investments within a period of one
year from the Date on which the shares of the venture capital undertaking are listed.
In a recognized stock Exchange.
(ii). Not more than 25% of the investible fund may be invested by way of:
a. subscription to initial public offer of a venture capital
undertaking whose shares are proposed o 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.
List of Venture Capital Companies in India :-
1.20th Century Finance Corporation LimitedCentre Point Dr.Ambedkar Road Parel Mumbai - 400012
2. AIG Investment Corporation (Asia) LimitedIndia - Representative Office 2634 Oberoi Towers Nariman Point Mumbai - 400021
3. Acuity Strategic Financials Private Limited14 Santosh, 2nd floor 242 Lady Jamshedji Road Mumbai - 400028
4. AIA Capital India Private Limited 9B Hansalaya Barakhamba Road New Delhi - 110001
5.Alliance DLJ Private Equity Fund 404 / 405 Prestige Centre Point 7 Edward Road Bangalore - 560052
6. Alliance Venture Capital Advisors Limited607 Raheja Chambers Free Press Journal Road, Nariman Point Mumbai - 400021
7. APIDC Venture Capital Limited 1102 Block A, 11th floor Babukhan Estate, Basheerbagh Hyderabad - 500001
8. Canbank Venture Capital Fund Limited
2/F Kareem Towers, 11th floor 19/5 -19/6 Cunningham Road Bangalore - 560052
9. Draper International (India) Private LimitedV203 Prestige Meridian -1 M.G. Road Bangalore - 560001
10. eVentures India (Consultair Investments Private Limited)Khetan Bhavan 8 Jameshedji Tata Road Churchgate Mumbai - 400020
11. GE Capital Services India Limited AIFACS Building 1 Rafi Marg New Delhi - 110001
12. Gujarat Venture Finance LimitedPremchand House Annexe, 1st floor Behind Popular House Ashram Road Ahmedabad - 380009
13. HSBC Private Equity Management Mauritius LimitedAshoka Estate, 3rd floor 24 Barakhamba Road New Delhi - 110001
14. ICICI Securities and Finance Company Limited41/44 Strand Palace M.Desai Marg Colaba Mumbai - 400005
15. ICICI Venture Funds Management Company Limited (formerly TDICI) Raheja Plaza, 4th floor 17 Commissariat Road D'Souza Circle Bangalore - 560025
16. IFB Venture Capital Finance Limited8/1 Middletown Row Calcutta - 700071
17. Industrial Development Bank of India
IDBI Tower Cuffe Parade Mumbai - 400005
18. Small Industries Development Bank of India (SIDBI) SIDBI Venture Capital LimitedNariman Bhavan 227 Vinay K. Shah Marg Nariman Point Mumbai - 400021
19. Tata Investment Corporation Limited
Ewart House, 3rd floor Homi Modi Street Fort Mumbai - 400001
20. Templeton India Private Equity Fund125 Free Press House Nariman Point Mumbai - 400021
21. Vista Ventures DBS Corporate Club 26 Cunningham Road Bangalore - 560052
22. Walden-Nikko India Management Company Limited One Silverstone 294 Linking Road Khar (West) Mumbai - 400052
Bibliography
Books
Indian venture capital market, - Evalueserve Indian Venture Capital Association - IVCA Venture Activity
Websites
www.sebi.gov.in www.wikipedia.com
www.economicstimes.com
www.venturecapital.com
www.investopedia.com
Newspapers
Economic Times Times of India
.