NAGINDAS KHANDWALA COLLEGE OF COMMERCE ARTS

AND MANAGEMENT STUDIES MALAD WEST

PROJECT REPORT ON: VENTURE CAPITAL IN INDIA

IN PARTIAL FULFILLMENT OF

T.Y.BCOM (FINANCIAL MARKET) SEMESTER VI

PROJECT GUIDE: PROF.KAVITA SHAHPRESENTED BY: URVI.N.GADA

UNIVESITY OF MUMBAI ACADEMIC YEAR 2014-15

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ACKNOWLEDGEMENT

I would like to acknowledge few people as being idealistic channel and fresh

dimension in the completion of this project.

I take this opportunity to thank the UNIVERSITY OF MUMBAI for giving me

a platform to work on this project.

I would also like to express my sincere gratitude towards my project guide and

coordinator PROF.KAVITA SHAH, whose guidance and care made this project

successful.

I would also like to thank my college library staff for having provided various

reference book and magazines related to my project.

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INDEX

Sr.No CHAPTER Page No.

1 Introduction 4

2 Concept of Venture Capital 8

3 Features of Venture Capital 10

4 Types of Venture Capital Investment 13

5 Stages of Financing by Venture Capital 18

6 Corporate Venturing (Investment Process) 20

7 Exit Routes 29

8 Venture Capital in India 32

9 SWOC Analysis of Indian Venture Capital 36

10 Regulatory Framework for Venture Capital in

India.

41

11 Key Success Factor for Venture Capital Industry in

India

48

12 Suggestion and Conclusion 51

13 Bibliography 54

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CHAPTER 1: INTRODUCTION

EXECUTIVE SUMMERY

Venture capital is a growing business of recent origin in the area of industrial financing in

India. The various financial institution set-ups in India to promote industries have done

commendable work. However, these institutions do not come up to benefit risky ventures

when they are undertaken by new or relatively unknown entrepreneurs. They contend to give

debt finance, mostly in the form of term loans to the promoters and their functioning has been

more akin to that of commercial banks.

Starting and growing a business always require capital. There are a number of alternative

methods to fund growth. These include the owner or proprietor’s own capital, arranging debt

finance, or seeking an equity partner, as is the case with private equity and venture capital.

Venture capital is a means of equity financing for rapidly-growing private companies.

Finance may be required for the start-up, development/expansion or purchase of a company.

Venture Capital firms invest funds on a professional basis, often focusing on a limited sector

of specialization (e.g. IT, Infrastructure, Health/Life Sciences, Clean Technology, etc.).

Indian Venture capital and Private Equity Association(IVCA) is a member based national

organization that represents venture capital and private equity firms, promotes the industry

within India and throughout the world and encourages investment in high growth companies.

IVCA member comprise venture capital firms, institutional investors, banks, incubators,

angel groups, corporate advisors, accountants, lawyers, government bodies, academic

institutions and other service providers to the venture capital and private equity industry.

Members represent most of the active venture capital providers and private equity firms in

India. These firms provide capital for seed ventures, early stage companies, later stage

expansion, and growth finance for management buyouts/buy-ins of established companies.

Venture capitalists have been catalytic in bringing forth technological innovation in USA. A

similar act can also be performed in India. As venture capital has good scope in India for

three reasons:

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First: The abundance of talent is available in the country. The low cost high quality Indian

workforce that has helped the computer users worldwide in Y2K project is demonstrated

asset.

Second: A good number of successful Indian entrepreneurs in Silicon Valley should have a

demonstration effect for venture capitalists to invest in Indian talent at home.

Third: The opening up of Indian economy and its integration with the world economy is

providing a wide variety of niche market for Indian entrepreneurs to grow and prove

themselves.

OBJECTIVES OF THE STUDY

Understand the concept of venture capital. Venture Capital funding is different from

traditional sources of financing. Venture capitalists finance innovation and ideas which have

potential for high growth but with inherent uncertainties. This makes it a high-risk, high

return investment.

Study venture capital industry in India. Scientific, technology and knowledge based ideas

properly supported by venture capital can be propelled into a powerful engine of economic

growth and wealth creation in a sustainable manner. In various developed and developing

economies venture capital has played a significant developmental role. India is still at the

level of ‘knowledge’. Given the limited infrastructure, low foreign investment and other

transitional problems, it certainly needs policy support to move to the next stage. This is very

crucial for sustainable growth and for maintaining India’s competitive edge

Understand the legal framework formulated by SEBI to encourage venture capital

activity in Indian economy.

Promoting sound public policy on issues related to tax, regulation and securities through

representation to the Securities and Exchange Board of India (SEBI), Ministry of Finance

(Move), Reserve Bank of India (RBI) and other Government departments.

Challenges faced by venture capitalist

VCF is in its nascent stages in India. The emerging scenario of global competitiveness has

put an immense pressure on the industrial sector to improve the quality level with

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minimization of cost of products by making use of latest technological skills. The implication

is to obtain adequate financing along with the necessary hi-tech equipments to produce an

innovative product which can succeed and grow in the present market condition.

Unfortunately, our country lacks on both fronts. The necessary capital can be obtained from

the venture capital firms who expect an above average rate of return on the investment. The

financing firms expect a sound, experienced, mature and capable management team of the

company being financed. Since the innovative project involves a higher risk, there is an

expectation of higher returns from the project. The payback period is also generally high (5 -

7 years). The various problems/ queries can be outlined as follows:

Requirement of an experienced management team.

Requirement of an above average rate of return on investment.

Longer payback period.

Uncertainty regarding the success of the product in the market.

Questions regarding the infrastructure details of production like plant location,

accessibility, relationship with the suppliers and creditors, transportation facilities,

labor availability etc.

The category of potential customers and hence the packaging and pricing details of

the product.

The size of the market.

Major competitors and their market share.

Skills and Training required and the cost of training.

Financial considerations like return on capital employed (ROCE), cost of the project,

the Internal Rate of Return (IRR) of the project, total amount of funds required, ratio

of owners investment (personnel funds of the entrepreneur), borrowed capital,

mortgage loans etc. in the capital employed.

RESERCH METHODOLOGY

Study would be mainly focused on the analysis and use of secondary data. Extensive use of

various journals, magazines and different online resources would be used to construct the

investment pattern. The entry strategies of the Venture capital firms with respect to the legal

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structure will be understood. Various surveys and data sources would be used to figure out

the current investments in the economy.

Study would not be limited to the study only; it would also include various regulatory norms

for the Venture capital investment in India and the benefits and hazards of VC over public

equity.

CHAPTER 2: CONCEPT OF VENTURE CAPITAL

The term venture capital comprises of two words that is, “Venture” and “capital”. “Venture”

is a course of processing the outcome of which is uncertain but to which is attended the risk

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or danger of “Loss”. “Capital” means recourses to start an enterprise. To connote the risk and

adventure of such a fund, the generic name Venture Capital was coined.

Venture capital is considered as financing of high and new technology based enterprises. It is

said that Venture capital involves investment in new or relatively untried technology,

initiated by relatively new and professionally or technically qualified entrepreneurs with

inadequate funds. The conventional financiers, unlike Venture capitals mainly finance proven

technologies and established markets. However, high technology need not be prerequisite for

venture capital.

Venture capital has also been described as ‘unsecured risk financing’. The relatively high risk

of venture capital is compensated by the possibility of high return usually through substantial

capital gains in term. Venture capital in broader sense is not solely an injection of funds into a

new firm, it is also an input of skills needed to set up the firm, design its marketing strategy,

organize and manage it. Thus it is a long term association with successive stages of

company’s development under highly risky investment condition with distinctive type of

financing appropriate to each stage of development. Investors join the entrepreneurs as co-

partners and support the project with finance and business skill to exploit the market

opportunities.

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

that is startup, expansion or to improve a product or process, which are associated with both

risk and reward. The Venture capital gains through appreciation in the value of such

investment when the new technology succeeds. Thus the primary return sought by the

investor is essentially capital gain rather than steady interest income or dividend yield.

Definition of Venture Capital is:-

“The support by investors of entrepreneurial talent with finance and business skills to exploit

market opportunities and thus obtain capital gains.”

Venture capital commonly describes not only the provision of startup finance or ‘seed corn’

capital but also development capital for later stages of business. A long term commitment of

funds is involved in the form of equity investments, with the aim of eventual capital gains

rather than income and active involvement in the management of customer’s business.

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ORIGIN OF VENTURE CAPITAL

The story of venture capital is very much like the history of mankind. In the fifteenth century,

Christopher Columbus sought to travel westwards instead of eastwards from Europe and so

planned to reach India. His far- fetched idea did not find favor with the King of Portugal, who

refused to finance him. Finally, Queen Isabella of Spain decided to fund him and the voyages

of Christopher Columbus are now empanelled in history. And thus evolved the concept of

Venture Capital.

The modern venture capital industry began taking shape in the post World War 2. It is often

said that people decide to become entrepreneurs because they see role models in other people

who have become successful entrepreneurs because they see role models in other people who

have become successful entrepreneurs. Much the same can be said about venture capitalists.

The earliest members of the organized venture capital industry had several role models,

including these three:

American Research and Development Corporation:

Formed in 1946, whose biggest success was Digital Equipment. The founder of ARD was

General Georges Dariot, a French-born military man who is considered “the father of venture

capital”. In the 1950s, he taught at the Harvard Business School. His lectures on the

importance of risk capital were considered quirky by the rest of the faculty, who concentrated

on conventional corporate management.

J.H. Whitney & Co:

Also formed in 1946, one of those early hits was Minute Maid juice. Jock Whitney is

considered one of the industry’s founders.

The Rockefeller Family:

L S Rockefeller, one of those earliest investments was in Eastern Airlines, which is now

defunct but was one of the earliest commercial airlines.

CHAPTER 3: FEATURES OF VENTURE CAPITAL

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High Risk - By definition the Venture capital financing is highly risky and chances of failure

are high as it provides long term startup capital to high risk- high reward ventures. Ventures

capital assumes four types of risks, these are:

o Management risk-Inability of management teams to work together.

o Market risk -Product may fail in the market.

o Product risk- Product may not be commercially viable.

o Operation risk-Operation may not be cost effective resulting in increased cost

decreased gross margin.

High Tech - As opportunities in the low technology area tend to be few of lower order, and

hi-tech projects generally offer higher returns than projects in more traditional area, venture

capital investments are made in high tech. areas using new technologies or producing

innovative goods by using new technology. Not just high technology, any high risk ventures

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High Risk

High Tech

Capital Gain

Participation In Management

Lentgh Of Investment

Illiquid Investment

where the entrepreneur has conviction but little capital gets venture finance. Venture capital

is available for expansion of existing business or diversification to a high risk area. Thus

technology financing had never been the primary objective but incidental to venture capital.

Equity Participation & Capital Gains - Investments are generally in equity and quasi

equity participation through direct purchase of share, options, convertible debentures where

the debt holder has the option to convert the loan instruments into stock of the borrower or a

debt with warrants to equity investment. The funds in the form of equity help to raise term

loans that are cheaper source of funds. In the early stage of business, because dividends can

be delayed, equity investment implies that investors bear the risk of venture and would earn a

return commensurate with success in the form of capital gains.

Participation In management - Venture capital provides value addition by managerial

support, monitoring and follow up assistance. It monitors physical and financial progress as

well as market development initiative. It helps by identifying key resource person. They want

one seat on the company’s board of directors and involvement, for better or worse, in the

major decision affecting the direction of company. This is a unique philosophy of “hand on

management” where Venture capitalist acts as complementary to the entrepreneurs. Based

upon the experience other companies, a venture capitalist advice the promoters on project

planning, monitoring, financial management, including working capital and public issue.

Venture capital investor cannot interfere in day today management of the enterprise but keeps

a close contact with the promoters or entrepreneurs to protect his investment.

Length of Investment - Venture capitalist help companies grow, but they eventually seek to

exit the investment in three to seven years. An early stage investment may take seven to ten

years to mature, while most of the later stage investment takes only a few years. The process

of having significant returns takes several years and calls on the capacity and talent of

venture capitalist and entrepreneurs to reach fruition.

Illiquid Investment - Venture capital investments are illiquid, that is not subject to

repayment on demand or following a repayment schedule. Investors seek return ultimately by

means of capital gain when the investment is sold at market place. The investment is realized

only on enlistment of security or it is lost if enterprise is liquidated for unsuccessful working.

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It may take several years before the first investment starts too locked for seven to ten years.

Venture capitalist understands this illiquidity and factors this in his investment decision.

CHAPTER 4: TYPES OF VENTURE CAPITAL INVESTORS

The “venture funds” available could be from

Incubators

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Angel investors

Venture Capitalists (VCs)

Private Equity Players

Incubators

An incubator is a hardcore technocrat who works with an entrepreneur to develop a business

idea, and prepares a company for subsequent rounds of growth & funding. E-Ventures,

Infinity are examples of incubators in India.

Angel Investors

An angel is an experienced industry-bred individual with high net worth.

Typically, an angel investor would:

Invest only his chosen field of technology

Take active participation in day-to-day running of the company

Invest small sums in the range of USD 1-3 million

Not insist on detailed business plans

Sanction the investment in up to a month

Help company for “second round” of funding

The INDUS Entrepreneurs (TiE) is a classic group of angels like: Vinod dham, Sailesh

Mehta, Kanwal Rekhi, Prabhu Goel, Suhas Patil, Prakash Agrawal, K.B Chandrashekhar. In

India there is a lack of home grown angels except a few like Saurabh Srivastava & Atul

Choksey (ex- Asian paints).

Venture Capitalists (VCs)

VCs are organizations raising funds from numerous investors & hiring experienced

professional managers to deploy the same. They typically:

Invest at “second” stage

Invest over a spectrum over industry.

Have hand-holding “mentor” approach

Insist on detailed business plans

Invest into proven ideas/businesses

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Provide “brand” value to investee

Invest between USD 2-5 million

Private Equity Players

They are established investment bankers. Typically:

Invest into proven/established businesses

Have “financial partners” approach

Invest between USD 5- 100 million

CLASSIFICATION OF VENTURE CAPITAL FUNDS

Venture funds in India can be classified on the basis of:

Base formation

Financial Institutions Led By ICICI Ventures, RCTC, ILFS, etc.

Private venture funds like Indus, etc.

Regional funds like Warburg Pincus, JF Electra (mostly operating out of Hong Kong).

Regional funds dedicated to India like Draper, Walden, etc.

Offshore funds like Barings, TCW, HSBC, etc.

Corporate ventures like Intel.

To this list we can add Angels like Sivan Securities, Atul Choksey (ex Asian Paints) and

others. Merchant bankers and NBFCs who specialized in "bought out" deals also fund

companies. Most merchant bankers led by Enam Securities now invest in IT companies.

Investment Philosophy

Early stage funding is avoided by most funds apart from ICICI ventures, Draper, SIDBI and

Angels. Funding growth or mezzanine funding till pre IPO is the segment where most players

operate. In this context, most funds in India are private equity investors.

Size of Investment

The size of investment is generally less than US$1mn, US$1-5mn, US$5-10mn, and greater

than US$10mn. As most funds are of a private equity kind, size of investments has been

increasing. IT companies generally require funds of about Rs30-40mn in an early stage which

fall outside funding limits of most funds and that is why the government is promoting

schemes to fund start ups in general, and in IT in particular.

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Value Addition-

The venture funds can have a totally "hands on" approach towards their investment like

Draper or "hands off" like 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.

A list of the members registered with the IVCA as of June 1999, has been provided in the

Annexure. However, in addition to 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

SQL Star, Hyderabad based training and software Development Company

Microland, networking hardware and Services Company based in Bangalore

Satyam Infoway, the first private ISP in India

Hinditron, makers of embedded software

PowerTel Boca, distributor of telecommuting products for the Indian market

Rediff on the Net, Indian website featuring electronic shopping, news, chat, etc

Entevo, security and enterprise resource management software products

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Planetasia.com, Microland’s subsidiary, one of India’s leading portals

Torrent Networking, pioneer of Gigabit-scaled IP routers for inter/intra nets

Selectica, provider of interactive software selection

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.

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 might act in consortium with

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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.

CHAPTER 5: STAGES OF FINANCING BY VENTURE CAPITALIST

Venture capital can be provided to companies at different stages. These include:

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I. Early- stage Financing

Seed Financing: Seed financing is provided for product development & research and to

build a management team that primarily develops the business plan.

Startup Financing: After initial product development and research is through, startup

financing is provided to companies to organize their business, before the commercial launch

of their products.

First Stage Financing: Is provided to those companies that have exhausted their initial

capital and require funds to commence large-scale manufacturing and sales.

II. Expansion Financing

Second Stage Financing: This type of financing is available to provide working capital for

initial expansion of companies, that are experiencing growth in accounts receivable and

inventories, and is on the path of profitability.

Mezzanine Financing: When sales volumes increase tremendously, the company, through

mezzanine financing is provided with funds for further plant expansion, marketing, working

capital or for development of an improved product.

Bridge Financing: Bridge financing is provided to companies that plan to go public within

six to twelve months. Bridge financing is repaid from underwriting proceeds.

III.Acquisition Financing

As the term denotes, this type of funding is provided to companies to acquire another

company. This type of financing is also known as buyout financing. It is normally advisable

to approach more than one venture capital firm simultaneously for funding, as there is a

possibility of delay due to the various queries put by the VC. If the application for funding

were finally rejected then approaching another VC at that point and going through the same

process would cause delay. If more than one VC reviews the business plan this delay can be

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avoided, as the probability of acceptance will be much higher. The only problem with the

above strategy is the processing fee required by a VC along with the business plan. If you

were applying to more than one VC then there would be a cost escalation for processing the

application. Hence a cost benefit analysis should be gone into before using the above

strategy.

Normally the review of the business plan would take a maximum of one month and disbursal

for the funds to reach the entrepreneur it would take a minimum of 3 months to a maximum

of 6 months. Once the initial screening and evaluation is over, it is advisable to have a person

with finance background like a finance consultant to take care of details like negotiating the

pricing and structuring of the deal. Of course alternatively one can involve a financial

consultant right from the beginning particularly when the entrepreneur does not have a

management background.

CHAPTER 6: CORPORATE VENTURING (INVESTMENT PROCESS)

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Even though investor and the entire process that goes into the wooing the venture capital with

your plan.

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.

The venture capital investment process has variances/features that are context specific and

vary from industry, timing and region. However, activities in a venture capital fund follow a

typical sequence. The typical stages in an investment cycle are as below:

Generating a deal flow

Due diligence

Investment valuation

Pricing and structuring the deal

Value Addition and monitoring

Exit

I] Generating A Deal Flow

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In generating a deal flow, the venture capital investor creates a pipeline of ‘deals’ or

investment opportunities that he would consider for 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. Successful venture capital investors in the

USA examine hundreds of business plans in order to make three or four investments in a

year.-It is important to note the difference between the profile of the investment opportunities

that a venture capital would examine and those pursued by a conventional credit oriented

agency or an investment institution. By definition, the venture capital investor focuses on

opportunities with a high degree of innovation.

The deal flow composition and the technique of generating a deal flow can vary from country

to country. In India, different venture capital funds/companies have their own methods

varying from promotional seminars with R&D institutions and industry associations to direct

advertising campaigns targeted at various segments. A clear pattern between the investment

focus of a fund and the constitution of the deal generation network is discernible even in the

Indian context.

II] Due Diligence

Due diligence is the industry jargon for all the activities that are associated with evaluating an

investment proposal. It includes carrying out reference checks on the proposal related aspects

such as management team, products, technology and market.

The important feature to note is that venture capital due diligence focuses on the qualitative

aspects of an investment opportunity. It is also not unusual for venture capital

fund/companies to set up an ‘investment screen’. The screen is a set of qualitative (sometimes

quantitative criteria such as revenue are also used) criteria that help venture capital

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funds/companies to quickly decide on whether an investment opportunity warrants further

diligence. Screens can be sometimes elaborate and rigorous and sometimes specific and brief.

The nature of screen criteria is also a function of investment focus of the firm at that point.

Venture capital investors rely extensively on reference checks with ‘leading lights’ in the

specific areas of concern being addressed in the due diligence.

A venture capitalist tries to maximize the upside potential of any project. He tries to structure

his investment in such a manner that he can get the benefit of the upside potential i.e. he

would like to exit at a time when he can get maximum return on his investment in the project.

Hence his due diligence appraisal has to keep this fact in mind.

New Financing

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.

Inter-Company Transactions

When investments are made in a company that is part of a group, inter-company transactions

must be analyzed.

III] 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:

Evaluate future revenue and profitability

Forecast likely future value of the firm based on experienced market

capitalization or expected acquisition proceeds depending upon the

anticipated exit from the investment.

Target an ownership position 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.

Symbolically the valuation exercise may be represented as follows

NPV = [(Cash)/ (Post)] x [(PAT x PER)] x k, where

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NPV = Net Present Value of the cash flows relating to the investment

comprising outflow by way of investment and inflows by way of

interest/dividends (if any) and realization on exit. The rate of return used for

discounting is the hurdle rate of return set by the venture capital investor.

Post = Pre + Cash

Cash represents the amount of cash being brought into the particular round of

financing by the venture capital investor.

‘Pre’ is the pre-money valuation of the firm estimated by the investor. While

technically it is measured by the intrinsic value of the firm at the time of raising

capital. It is more often a matter of negotiation driven by the ownership of the

company that the venture capital investor desires and the ownership that

founders/management team is prepared to give away for the required amount of

capital

PAT is the forecast Profit after tax in a year and often agreed upon by the founders

and the investors (as opposed to being ‘arrived at’ unilaterally). It would also be the

net of preferred dividends, if any.

PER is the Price-Earning multiple that could be expected of a comparable firm in the

industry. It is not always possible to find such a ‘comparable fit’ in venture capital

situations. That necessitates, therefore, a significant degree of judgement on the part

of the venture capital to arrive at alternate PER scenarios.

‘K’ is the present value interest factor (corresponding to a discount rate ‘r’) for the

investment horizon.

It is quite apparent that PER time PAT represents the value of the firm at that time and the

complete expression really represents the investor’s share of the value of the investee firm.

The following example illustrates this framework:

Example: Best Mousetrap Limited (BML) has developed a prototype that needs to be

commercialized. BML needs cash of Rs2mn to establish production facilities and set up a

marketing program. BML expects the company will go public in the third year and have

revenues of Rs70mn and a PAT margin of 10% on sales. Assume, for the sake of

convenience that there would be no further addition to the equity capital of the company.

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Prudent Fund Managers (PFM) propose to lead a syndicate of like minded investors with a

hurdle rate of return of 75% (discounted) over a five year period based on BML’s sales and

profitability expectations. Firms with comparable sales and profitability and risk profiles

trade at 12 times earnings on the stock exchange. The following would be the sequence of

computations:

In order to get a 75% return p.a. the initial investment of Rs2 million must yield an

accumulation of 2 x (1.75)5 = Rs32.8mn on disinvestment in year 5.

BML’s market capitalization in five years is likely to be Rs (70 x 0.1 x 12) million =

Rs84mn.

Percentage ownership in BML that is required to yield the desired accumulation will be

(32.8/84) x 100 = 39%

Therefore the post money valuation of BML At the time of raising capital will be equal to Rs

(2/0.39) million = Rs5.1 million which implies that a pre-money valuation of Rs3.1 million

for BML

Another popular variant of the above method is the First Chicago Method (FCM) developed

by Stanley Golder, a leading professional venture capital manager. FCM assumes three

possible scenarios – ‘success’, ‘sideways survival’ and ‘failure’. Outcomes under these three

scenarios are probability weighted to arrive at an expected rate of return: In reality 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.

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The standing of the individual venture capital Well established venture capitals

that 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.

Quite obviously, valuation is one of the most critical activities in the investment process. It

would not be improper to say that the success for a fund will be determined by its ability to

value/price the investments correctly.

Sometimes the valuation process is broadly based on thumb rule metrics such as multiple of

revenue. Though such methods would appear rough and ready, they are often based on fairly

well established industry averages of operating profitability and assets/capital turnover ratios

Such valuation as outlined above is possible only where complete freedom of pricing is

available. In the Indian context, where until recently, the pricing of equity issues were heavily

regulated, unfortunately valuation was heavily constrained.

IV] 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. To do a good

job in structuring, one needs to be knowledgeable in areas of accounting, cash flow, finance,

legal and taxation. Also the structure should take into consideration the various commercial

issues (i.e. what the entrepreneur wants and what the venture capital would require protecting

the investment). Documentation refers to the legal aspects of the paperwork in putting the

deal together.

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 satisfies the entrepreneur’s requirements. The instruments could be

as follows:

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Instrument Issues

Loan clean vs. secured

Interest bearing vs. non interest bearing

convertible vs. one with features (warrants)

1st Charge, 2nd Charge,

Stock maturity

Preference shares redeemable (conditions under Company Act)

Participating

Par value

nominal shares

Warrants exercise price, expiry period

Common shares New or vendor shares

Par value

partially-paid shares

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 % age 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

26

the stage at which the company is in and other factors relating to the project. (E.g. exit

problems, etc).

Promoter Shares

As venture capital is to finance growth, venture capital investment should ideally be used for

financing expansion projects (e.g. new plant, capital equipment, additional working capital).

On the other hand, entrepreneurs may want to sell away part of their interests in order to lock-

in a profit for their work in building up the company. In such a case, the structuring may

include some vendor shares, with the bulk of financing going into buying new shares to

finance growth.

Handling Director’s and Shareholder’s Loans

Frequently, a company has existing directors and shareholder’s loans prior to inviting venture

capitalists to invest. As the money from venture capital is put into the company to finance

growth, it is preferable to structure the deal to require these loans to be repaid back to the

shareholders/directors only upon IPOs/exits and at some mutually agreed period (e.g. 1 or 2

years after investment). This will increase the financial commitment of the entrepreneur and

the shareholders of the project.

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.

V] 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.

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Venture capitalists monitor and evaluate projects regularly. They keep a hand on the pulse of

the project. They are actively involved in the management of the of the investee 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 investee company.

VI] Exit

One of the most crucial issues is the exit from the investment. After all, the return to the

venture capitalist can be realized only at the time of exit. Exit from the investment varies

from the investment to investment and from venture capital to venture capital. There are

several exit routes, buy-buck by the promoters, sale to another venture capitalist or sale at the

time of Initial Public Offering, to name a few. In all cases specialists will work out the

method of exit and decide on what is most profitable and suitable to both the venture

capitalist and the investee unit and the promoters of the project.

At present many investments of venture capitalists in India remain on paper as they do not

have any means of exit. Appropriate changes have to be made to the existing systems in order

that venture capitalists find it easier to realize their investments after holding on to them for a

certain period of time. This factor is even more critical to smaller and midsized companies,

which are unable to get listed on any stock exchange, as they do not meet the minimum

requirements for such listings. Stock exchanges could consider how they could assist in this

matter for listing of companies keeping in mind the requirement of the venture capital

industry

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CHAPTER 7: EXIT ROUTES

After the unit has settled down to a profitable working and the enterprise is in a position to

raise funds through conventional resources like capital market, financial institution or

commercial banks, the venture capitalist liquidate their investment and make an exit from the

investee company.

The ultimate objective of a Venture Capitalist is to realize from his investment by selling off

the same at a substantial capital gain. Infect at the time of making their investment, the

venture capitalist plan their potential exit.

The investee company has to prepare and make suitable adjustments in its capital structure at

the time of realization by the venture capitalist. The convertible preference shares and

convertible loans must be converted to ordinary equity before the exit by the venture

capitalist. In case of non- convertible preference shares and loans by the venture capitalist

these are to be redeemed. At exit the special rights granted to the venture capitalist cease to

operate and venture capital firms normally withdraw their nominees from the board of the

investee company.

The venture capitalist firms have a motto ‘exit at the maximum possible profit or at a

minimum possible loss’ – in case of a failed investment. The exit can be voluntary or

involuntary. Liquidation or receivership of a failed venture is a case of involuntary exit. The

voluntary exit can have four alternative routes for disinvestment:

Buy back of shares by promoters or company.

Sale of stock (shares)

Selling to a new investor

Strategic/ Trade sale

BUY BACK / SHARES REPURCHASE

Buy back or shares repurchase has the following forms:

The investee company has to buy back its own shares for cash from its venture

capitalist using its internal accruals

The promoters and their group buys back the equity stake of venture capitalist.

The employees’ stock trusts are formed which, in turn, buy the share holding of the

venture capitalist in the company.

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The route is suited to the Indian conditions because it keeps the ownership and control of the

promoters intact. Indian entrepreneurs are often very touchy about ownership and control of

their business. Hence in India, first a buy back option is normally given to the promoters or to

the company and only on their refusal the other disinvestments routes are looked into. The

exact price is mutually negotiated between the entrepreneur and the venture capitalist. The

price is determined considering the book value of shares, future earning potential of the

venture, Price/Earning ratio of similar listed companies.

The companies were not allowed to buy back their shares in India; however, with effect from

the amendment in the companies act (1999) the companies can do so now.

SALE OF SHARES ON THE STOCK EXCHANGE

The venture capitalist can exit by getting the company listed on the stock exchange and

selling his equity in the primary or secondary market using any of the following three

methods:

Sale of shares on stock exchange after listing shares.

Venture capitalists generally invest at the start up stage and propose to disinvest their

holding after the company brings out an IPO for raising funds for expansion. This

listing on stock exchange provides an exit route from investment.

Initial Public Offer (IPO)/ Offer for sale

When the existing entrepreneurs opt out of buy back, the venture capitalists opt for

disinvesting their stocks through public offering.

Disinvestments on OTC

An active capital market supports the venture capital activities. It enables the venture

capitalists to get a suitable valuation for their investment. Besides the regular stock

exchange a well developed OTC market where dealers can trade in shares. The OTC

market enables the new and smaller companies not eligible for listing on a regular

stock exchange to be listed at an OTC exchange and thus provide liquidity to the

investors.

As per the recommendations of a number of committees, an OTC exchange was

required in India. As a result ‘Over the Counter Exchange of India (OTCEI)’ was set

up.

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SELLING TO AN INVESTOR`

Many a times for their exit venture capitalist and /or the promoters locate a new investor, a

corporate body or another venture capital firm. The new investors are normally those who

find some sort of synergy between the investee company and their existing operations such

that the relationship is useful to both the companies. This route is also used when the

promoters want to get rid of the venture capitalist.

Some venture capitalists, as a policy concentrate their activities to startups and early stage

investments. Such venture capital funds exit paving way for the venture capital fund

specializing in the later stage investment or buy out deals. Often a growing venture needs

second stage financing, if the existing venture capitalist as a policy does not commit funds for

the second stage it normally locates another venture capitalist that finds the investment

attractive enough to enter.

CORPORATE / TRADE SALE

The venture capital firm and the entrepreneur together sell the enterprise to a third party

mostly a corporate entity. Herein the promoters also exit from the venture along with the

venture capitalist. This is called a corporate, strategic or trade sale. The reasons for this sale

can be varied, difficulty in running the business profitability or a perceived competition from

more established big business houses having huge resources and business synergy.

On the other hand, where operations of an existing venture are modest, a higher exit valuation

may be achieved in the market rather than by a trade sale, as the market investors are usually

swayed by the appeal of the sector in which the venture operates rather than the quality of its

specific business operations.

Modalities

The modalities of the trade sale differ from case to case depending upon the nature of

operations, its size, the requirements of the buyer, etc. The sale can be in cash, against the

shares of the acquiring company or the combination of the two. The equity owners get the

shares of the buyer company in lieu of the shares been sold by them. Such sales have the

advantage that the seller does not have to pay any tax as the transaction involves only

exchange of shares.

At times, it is through a management buy- out or buy-in, which in turn may be financed

partially by another venture capital fund. It is important to note that in India if the investee

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company is a listed company at the time of trade sale, then the provisions of listing agreement

are attracted besides the provisions of the SEBI regulations of merger and acquisitions are

also applicable.

Management Buy-Outs

Venture capital buy-outs are both a successful investment strategy for venture capital

investment as well as an efficient exit route. Buy-out financed by another venture capitalist

primarily by providing debt is known as leveraged buy-out. Buy-out without participation by

another investor is called management buy-out. Here in the current management group

purchases the stake of the venture capitalist. The stock options and sweat equity have made

management buy-out possible in India.

Management buy-outs are important in venture capital market for various reasons:

MBO’s provide an opportunity to managers to become entrepreneurs.

Venture capital investment in buy-out has a lower investment risk than early stage

investment.

MBO’s help smaller enterprises to adapt to technological changes.

Buy-in is similar to buy-out but involves new management from outside and improvement in

the operations of the venture. Incoming new management is often unfamiliar with the

operations of the venture hence the acquiring company may feel that the continuity of the

existing entrepreneur will be beneficial for the business; the services of the original

entrepreneur are retained. This helps in implementing the remaining parts of the original

ideas and also provides continuity to the venture.

PRE-REQUISITE FOR THE EFFICIENT EXIT MECHANISM

Legal framework

Smooth procedures for sale / transfer of enterprises

Efficient stock market

Mechanism for listing and trading of equity of smaller companies.

CHAPTER 8: VENTURE CAPITAL IN INDIA

The first major analysis on risk capital for India was reported in 1983. It indicated that new

companies often confront serious barriers to entry into capital market for raising equity

finance which undermines their future prospects of expansion and diversification. It also

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indicated that on the whole there is a need to review the equity cult among the masses by

ensuring competitive return on equity investment. This brought out the institutional

inadequacies with respect to the evolution of venture capital.

In India, the Industrial Finance Corporation of India (IFCO) initiated the idea of Venture

Capital when it established the Risk Capital Foundation in 1975 to provide seed capital to

small and risky projects. However the concept of venture capital financing got statutory

recognition for the first time in the fiscal budget for the year 1986-87.

The venture Capital companies operating at present can be divided into four groups:

Promoted by All-India Development Financial Institutions

Promoted by State Level Financial Institutions

Promoted by Commercial Banks

Private Venture Capitalists.

Promoted by all India Development Financial Institutions

The IDBI started a Venture Capital in 1976 as per the long term fiscal policy of government

of India, with an initial of Rs. 10 Cr. which raised by imposing a chess of 5% on all payment

made for the import of technology know-how projects requiring funds from Rs.5 Lacks to

Rs.2.5Cr. Were considered for financing. Promoter’s contribution ranged from this fund was

available at a concessional interest rate of 9% (during gestation period) which could be

increased at later stages.

The ICICI provided the required impetus to Venture Capital activities in India, 1986 it started

providing venture Capital finance in 1998 it promoted, along with the Unit trust of India

(UTI) Technology Development and information Company of India (TDICI) as first venture

Capital company registered under the companies act, 1956. The TDICI may provide financial

assistance to venture capital undertaking which are set up by technocrat entrepreneurs, or

technology information and guidance services.

The risk capital foundation established by the industrial finance corporation of India (IFCI) in

1975, was converted in 1988 into the Risk Capital and Technology Finance Company

(RCTC) as a subsidiary company of the IFCI the rate provides assistance in the form of

conventional loans, interest free conditional loans on profit and risk sharing basis or equity

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participation in extends financial support to high technology projects for technological up

gradations. The RCTC has been renamed as IFCI Venture Capital Funds Ltd. (IVCF)

Promoted by State Level Financial Institutions

In India, the State Level Financial Institutions in some states such as Madhya Prades, Gujarat,

Uttar prades, etc., have done an excellent job and have provided venture capital to a small

scale enterprise. Several successful entrepreneurs have been the beneficiaries of the liberal

funding environment. In 1990, the Gujarat Industrial Investment Corporation, promoted the

Gujarat Venture Financial Ltd (GVFL) along with other promoters such as the IDBI, the

World Bank, etc., the GVFL provides financial assistance to business in the form of equity,

conditional loans or income notes for technologies development and innovative products. It

also provides finance assistance to entrepreneurs.

The government of Andhra Pradesh has also promoted the Andhra Pradesh Industrial

Development Corporation (APIDC) venture capital ltd. to provide venture capital financing

in Andhra Pradesh.

Promoted by Commercial Banks

Canbank Venture Capital Fund, State bank Venture Capital Fund and Grindlays bank

Venture Capital Fund have been set up the respective commercial banks to undertake venture

capital activities.

The State bank Venture Capital funds provides financial assistance for bought out deal as

well as new companies in the form of equity which it disinvests after the commercialization

of the project.

Canbank Venture Capital Funds provides financial assistance for proven but yet to be

commercially exploited technologies. It provides assistance both in the form of equity and

conditional loans.

Private venture Capital Funds

Several private sector venture capital funds have been established in India such as the 20 th

Centure Venture Capital Company, Indus venture capital Funds, Infrastructure Leasing and

financial Services Ltd.

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Some of the companies that have received funding through this route include:

o Mastek, one of the oldest software house in India

o Ruskan software, Pune based software consultancy

o SQL Star, Hyderabad based training and software development consultancy

o Satyam Infoway, the first private ISP in India

o Hinditrom, makers of embedded software

o Selectia, provider of interaction software selector

o Yantra, ITL Infosy’s US subsidiary, solution for supply chain management

o Rediff on the Net, India website featuring electronic shopping, news, chat etc.

CHAPTER 9: SWOC ANALYSIS OF INDIAN VENTURE CAPITAL

A SWOC (Strengths, Weaknesses, Opportunities, and Challenges) analysis is often used to

determine what the internal and external factors are that can be a benefit or a risk to a

35

business venture. For a FIRST Team, the SWOC analysis can be used to address the team’s

challenges for sustainment and growth.

A SWOC analysis is best done with a representative group from the team. If possible, the

whole team should participate to be sure all ideas are captured and everyone on the team

understands the risks to the team. Following the SWOC analysis, the team should then put

together action plans to address the issues identified. Taking these steps can improve the

likelihood of success and sustainment for the team.

Strengths and Weaknesses are usually focused on issues “inside” the organization, while

Opportunities and Challenges are usually focused on “external” factors. However, both

internal and external factors can be in any of the four categories.

Strength

An effort initiated from within – Home grown

Increased awareness of venture capital

More capital under management by VCFs Industry crossed learning curve.

More experienced Venture Capitalists, Intermediaries, and Entrepreneurs.

Growing number of foreign trained professionals.

Global competition growing.

Moving towards international standards

Offshore funds bring strong foreign ties

Matured towards market system

Electronic trading – through NSE & BSE.

Weakness

Faddish

Limited exit option

Uncertainties

Policy repatriation, taxation

Bureaucratic meddling and rigid official attitude

Industry fragmented and polarized- Mixed V.C culture

Smaller funds with illiquid investments

Domestic fund raising difficult

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Lack of transparency & corporate governance

Accounting standards

Poor legal administration

Difficult due diligence

Inadequate management depth

Valuation expectations unrealistic

Technical and Market evaluation difficult

Opportunities

Growth capital for strong companies and Buyouts of weak companies due to growing

global competition

Financial restructuring have over leveraged companies taking place.

Acquisition of quoted small/ medium cap companies.

Pre money valuations low

Vast potential exists in turn around, MBO, MBI.

Challenges

Change in government policies with respect to –

1. Structuring

2. Taxation

Threats from within Explosive expansion and over Exuberance of investors

Greed fro very high returns.

Issues faced by venture capital in India

The Indian venture capital industry, at the present, is at crossroads. Following are the major

issues faced by this industry.

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Limitation on structuring of Venture Capital Funds (VCFs): VCFs in India are

structured in the form of a company or trust fund and are required to follow a three-tier

mechanism-investors, trustee company and AMC. A proper tax-efficient vehicle in the form

of ‘Limited Liability Partnership Act’, which is popular in USA, is not made applicable for

structuring of VCFs in India. In this form of structuring, investors’ liability towards the fund

is limited to the extent of his contribution in the fund and also formalities in structuring of

fund are simpler.

Problem in raising of funds: In USA primary sources of funds are insurance companies,

pensions funds, corporate bodies etc; while in Indian domestic financial institutions,

multilateral agencies and state government undertakings are the main sources of funds for

VCFs. Allowing Pension funds, Insurance companies to invest in the VCFs would enlarge the

possibility of setting up of domestic VCFs. Further, if Mutual Funds are allowed to invest up

to 5 percent of their corpus in VCFs by SEBI, it may lead to increased availability of fund for

VCFs.

Lack of Inventive to Investors: Presently, high net worth individuals and corporate are not

provided with any investments in VCFs. The problem of raising funds from these sources

further gets aggravated with the differential tax treatment applicable to VCFs and mutual

funds. While the income of the Mutual funds is totally tax exempted under Section 10(23D)

of the Income Tax Act income of domestic VCFs, which provide assistance to small, and

medium enterprise is not totally exempted from tax. In absence of any inventive, it is

extremely difficult for domestic VCFs to raise money from this investor group that has a good

potential.

Absence of ‘angel investors’: In Silicon Valley, which is a nurturing ground for venture

funds financed IT companies; initial/ seed stage financing is provided by the angel investors

till the company becomes eligible for venture funding . There after Venture Capitalist through

financial support and value-added inputs enables the company to achieve better growth rate

and facilitate its listing on stock exchanges. Private equity investors typically invest at

expansion/ later stages of growth of the company with large investments. In contrast to this

phenomenon, Indian industry is marked by an absence of angel investors.

Limitations of investment instruments: As per the section 10(23FA) of the Income Tax

Act, income from investments only in equity instruments of venture capital undertakings is

38

eligible for tax exemption; whereas SEBI regulations allow investments in the form of equity

shares or equity related securities issued by company whose shares are not listed on stock

exchange. As VCFs normally structure the investments in venture capital undertakings by

way of equity and convertible instruments such as optionally/ Fully Convertible Debentures,

Redeemable Preference shares etc., they need tax breaks on the income from equity linked

instruments.

Domestic VCFs vis-à-vis Offshore Funds: The domestic VCFs operations in the country are

governed by the regulations as prescribed by SEBI and investment restrictions as placed by

CBDT for availing of the tax benefits. They pay maximum marginal tax 35 percent in respect

of non-exempt income such as interest through Debentures etc., while off- shore funds which

are structured in tax havens such as Mauritius are able to overcome the investment restriction

of SEBI and also get exemption from Income Tax under Tax Avoidance Treaties. This denies

a level playing field for the domestic investors for carrying out the similar activity in the

country.

Limitation on industry segments: In sharp contrast to other countries where telecom,

services and software bag the largest share of venture capital investments, in India other

conventional sectors dominate venture finance. Opening up of restrictions, in recent time, on

investing in the services sectors such as telecommunication and related services, project

consultancy, design and testing services, tourism etc, would increase the domain and growth

possibilities of venture capital.

Anomaly between SEBI regulations and CBDT rules: CBDT tax rules recognize

investment in financially weak companies only in case of unlisted companies as venture

investment whereas SEBI regulations recognize investment in financially weak companies,

which offers an attractive opportunity to VCFs. The same may be allowed by CBDT for

availing of tax exemption on capital gains at a later stage. Also SEBI regulations do not

restrict size of an investment in a company. However, as per Income tax rules, maximum

investment in a company is restricted to less than 20 per cent of the raised corpus of VCF and

paid up share capital in case of Venture Capital Company. Further, investment in company is

also restricted up to 40 per cent of equity of Investee Company. VCFs may place the

investment restriction for VCFs by way of maximum equity stake in the company, which

could be up to 49 per cent of equity of the Investee Company.

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Limitations on Exit Mechanism: The VCFs, which have invested in various ventures, have

not been able to exit from their investments due to limited exit routes and also due to

unsatisfactory performance of OTCEI. The threshold limit placed by various stock exchanges

acts as deterrent for listing of companies with smaller equity base. SEBI can consider

lowering of threshold limit for public/listing for companies backed by VCFs. Buy-back of

equity shares by the company has been permitted for unlisted companies, which would

provide exit route to investment of venture capitalists.

Legal Framework: Lack of requisite legal framework resulting in adequate penalties in case

of suppression of facts by the promoters-results in low returns even from performing

companies. This has bearing on equity investments particularly in unlisted companies.

CHAPTER 10: REGULATORY FRAMEWORK FOR VENTURE

CAPITAL IN INDIA.

In his budget speech for 1988-89, the finance minister declared that a scheme will be

formulated under which Ventures Capital Companies / Funds will be enabled to invest in new

40

companies and be eligible for the concessional treatment of capital gains available to non-

corporate entities. Such companies will have to comply with the following guidelines.

The minimum size of a venture capital company would be Rs.10 core. If it desires to raise

fund from the public the promoter’s share shall be less than 10%.Venture capital assistance

should go mainly to enterprises where the risk element is comparatively high due to the

technology involved being relatively new, untried or very closely held, and/or the

entrepreneur being relatively new and not affluent though otherwise qualified and the size

being modest. The assistances should be mainly for equity support though loan support to

supplement this may also be given.

Thus, venture capital assistance will be given to those entrepreneurs who satisfy the

following parameters.

Total investment not to exceed Rs.10 crores. New or relatively untried or very closely held or

being taken from pilot to commercial state or which incorporate some significant

improvement over the existing ones in India.

Relatively new, professionally or technically qualified with inadequate resources or banking

to finance the project.

A venture capital is required to invest at least 75 per cent of its funds in venture capital

activity. A venture capital is firm can raise funds through pubic issues and/or private

placement to finance VCF/VCCs. Foreign equity up to 25 per cent multilateral / international

financial organizations, development finance institutes, reputed mutual funds, etc., would be

permitted provide these are management neutral and are for medium to long-term

investments.

A venture capital fund will be managed by professional such as bankers, managers and

administration and persons with adequate experience of industry, finance, accounts etc.

The changed financial and fiscal environment during post liberalization period holds out

bright future of venture capital in India. With falling tax rates equity becomes attractive, and

promoters want to put in maximum funds. In new companies today. The debt-equity ratio is

generally 2:1. The promoter has to compulsorily contribute 25 percent of the projects cost,

not just the equity. However because industry is more competitive today promoters are

willing to contribute as much as 40 per cent of the project cost. Banks and other finance

institutions being risk averse will fund a new venture.

41

Under the circumstances these entrepreneurs will be left with no option but to resort to

venture capital firm, to fill the gap in their contribution to project cost. This is very likely to

continue as professional start their contribution to project cost. This is very likely to continue

as professional start their own units, ancillarisation takes place and large companies began

sourcing their requirement rather than making everything themselves.

REGULATORY AND LEGAL FRAMEWORK

At present, the Venture Capital activity in India comes under the purview of different sets of

regulations namely:

The SEBI (Venture Capital Funds) Regulation, 1996[Regulations] lays down the

overall regulatory framework for registration and operations of venture capital

funds in India.

The Indian Trust Act, 1882 or the company Act, 1956 depending on whether the

fund is set up as a trust or a company.

The foreign investment Promotion Board (FIPB) and the RBI in case of an

offshore fund. These funds have to secure the permission of the FIPB while

setting up in India and need a clearance from the RBI for any repatriation of

income.

The Central Board of Direct Taxation (CBDT) governs the issues pertaining to

income tax on the proceed from VC funding activity. The long term capital gain

tax is at around 10% in India and the relevant clauses to VC may be found in

Section 10(sub section 23)

Overseas venture capital investments are subject to the Government of India

Guidelines for Overseas Venture Capital Investment in India dated September 20,

1995.

For tax exemptions purposes venture capital funds also needs to comply with the

Income Tax Rules made under Section 10(23FA) of the Income Tax Act.

MAJOR REGULATORY FRAMEWORKS FOR VENTURE CAPITAL

INDUSTRY

42

VC & FVCI

SEBI RBI FIPB TAX

SEBI (VCF) Reg. 1996

SEBI(FVCI) Reg.2000

SCR Act.1956 SEBI(SAST)

Reg.1997 SEBI(DIP)Guidelin

es,2000 SEBI Act,1992

FEMA, 1999 Transfer or issue

of security by a person resident outside India regulation 2000

FDI policy Investment

approvals Press Notes

IT Act, 1961 DTAA

Singapore Mauritius Others

Major Regulatory frameworks for venture capital industry

In addition to the above, offshore funds also require FIPB/RBI approval for investment in

domestic funds as well as in Venture Capital Undertakings (VCU). Domestic funds with

offshore contributions also require RBI approval for the pricing of securities to be purchased

in VCU likewise, at the time of disinvestment, RBI approval is required for the pricing of the

securities.

Definition of venture capital fund: The Venture Capital Fund is now defined s a fund

established in the form of a Trust, a company including a body corporate and registered with

SEBI which:

Has a dedicated pool of capital;

Raised in the manner specified under the regulations; and

To invest in venture capital undertaking in accordance with the regulation.

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Definition of Venture Capital Undertaking: Venture Capital Undertaking means a

domestic company:-

Whose share are not listed on a recognized stock exchange in India

Which is engaged in business including such activities or sectors which are specified

in the negative list by the Board with the approval of the Central Government by

notification in the Official Gazette in this behalf? The negative list includes real

estate, non-banking financial services, gold financing, activities not permitted under

the Industrial Policy of the Government of India.

Minimum contribution and fund size: the minimum investment in a Venture Capital Fund

from any investor will not be less than Rs.5 lacks and the minimum corpus of the fund before

the fund can start activities shall be at least Rs.5 corers.

Investment Criteria: The earlier investment criterion has been substituted by new

investment criteria which has the following requirements:

Disclosure of investment strategy;

Maximum investment in single venture capital undertaking not to exceed 25% of the

corpus of the fund;

Investment in the associated companies not permitted;

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

linked instruments;

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

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

to be listed subject to lack in period of one year;

Debt or debt instrument of a venture capital undertaking in which the venture capital funds

has already made an investment by way of equity.

It has also been provided that Venture Capital Fund seeking to avail benefit under the

relevant provisions of the Income Tax Act will be required to divest from the investment

within a period of one year from the listing of the Venture Capital Undertaking.

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Disclosure and Information to Investors: in order to simplify and expedite the process of

fund raising, the requirement of filing the Placement memorandum with SEBI is dispensed

with and instead the fund will be required to submit a copy of Placement Memorandum/ copy

of contribution agreement entered to with the investors along with the details of the fund

raiser for information to SEBI. Further, the contents of the Placement Memorandum are

strengthened to provide adequate disclosure and information to investors. SEBI will also

prescribe suitable reporting requirement from the fund on their investment activity.

QIB status for Venture Capital funds: the venture capital funds will be eligible to

participate in the IPO through book building route as qualified Institutional Buyer subject to

compliance with the SEBI (Venture Capital Fund) Regulations.

Relaxation in Takeover Code: the acquisition of share by the company or any of the

promoters from the Venture Capital Funds under the terms of agreement shall be treated on

the same footing as that of acquisition of shares by promoters/companies from the state level

financial institutions and shall be exempt from making an open offer to other shareholders.

Investment by Mutual Funds in Venture capital Funds: in order to increase the resources

for domestic venture capital funds, Mutual Funds are permitted to invest up to 5% of its

corpus in the case of open ended schemes and up to 10% of its corpus in the case of close

ended schemes. A part from raising the resources for Venture Capital Funds this would

provide an opportunity to small investors to participate in venture capital activities through

Mutual funds.

Government of India Guidelines: the Government of India (MOF) Guidelines for Overseas

Venture Capital Investment in India dated September20, 1995 will be repealed by the MOF

on notification of SEBI Venture Capital Fund Regulations.

The following will be the salient features of SEBI (foreign Venture Capital Investors)

Regulations, 2000:

Definition of Foreign Venture capital Investor: any entity incorporated and established

outside India and proposes to make investment in Venture Capital Fund or Venture Capital

Undertaking and registered with SEBI.

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Eligibility Criteria: entity incorporated and established outside India in the form of

Investment Company, Trust, Partnership, Pension Fund, Mutual Fund, University Fund,

Endowment Fund, Asset Management Company, Investment Manager, Investment

Management Company or other Investment Vehicle Incorporated outside India would be

eligible for seeking registration from SEBI. SEBI for the purpose of registration shall

consider whether the applicant is regulated by an appropriate foreign regulatory authority; or

is income tax payer; or submits a certificate from its banker of its or its promoters, track

record where the applicant is neither a regulated entity nor an income tax payer.

Investment Criteria:

Disclosure of investment strategy;

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

the funds committed for investment to India however it can invest its total fund

committed in one venture capital fund;

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

equity linked instruments.

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

o Subscription to initial offer of a venture capital undertaking whose shares

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

o Debt or debt instrument of a venture capital undertaking in which the

venture capital funds has already made an investment by way of equity.

Hassle Free Entry and Exit: the Foreign Venture Capital Investors proposing to make

venture capital investment under the Regulations would be granted registration by SEBI.

SEBI Registered Foreign Venture Capital Investors shall be permitted to make investment on

an automatic route within the overall sect oral ceiling of foreign investment under Annexure

III of statement of Industrial Policy without any approval from FIPB. Further, SEBI

registered FVCIs shall be granted a general permission from the exchange control angle for

inflow and outflow of funds and no prior approval of RBI would be required for pricing,

however, there would be export reporting requirement for the amount transacted.

Trading in Unlisted Equity: the board also approved the proposal to permit OTCEI to

develop a trading window for unlisted securities where Qualified Institutional Buyers (QIB)

would be permitted to participate.

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CHAPTER 11: KEY SUCCESS FACTOR FOR VENTURE CAPITAL

INDUSTRY IN INDIA

Knowledge becomes the key factor for a competitive advantage for company. Venture

Capital firms need more expert knowledge in various fields. The various key success factors

for venture capital industry are as follow:

Knowledge about Govt. changing policies:

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Investment, management and exit should provide flexibility to suit the business requirements

and should also be driven by global trends. Venture capital investments have typically come

from high net worth individuals who have risk taking capacity. Since high risk is involved in

venture financing, venture investors globally seek investment and exit on very flexible terms

which provides them with certain levels of protection. Such exit should be possible through

IPOs and mergers/acquisitions on a global basis and not just within India. In this context the

judgment of the judiciary raising doubts on treatment of tax on capital gains made by firms

registered in Mauritius gains significance - changing policies with a retrospective effect is

undoubtedly acting as a dampener to fresh fund raising by Venture capital firms.

Quick Response time:

The companies have flat organization structure results in quicker decision making. The

entrepreneur is relieved of the trauma that one normally goes through in an interface with a

funding institution or a development agency. They follow a clearly defined decision making

process that works with clock like precision, which means that if they agree on a funding

schedule entrepreneur can count on them to stick it.

Knowledge about Global Environment

With increasing global integration and mobility of capital it is important that Indian venture

capital firms as well as venture financed enterprises be able to have opportunities for

investment abroad. This would not only enhance their ability to generate better returns but

also add to their experience and expertise to function successfully in a global environment.

Good Human Resource:

Venture capital should become an institutionalized industry financed and managed by

successful entrepreneurs, professional and sophisticated investors. Globally, venture capitalist

are not merely finance providers but are also closely involved with the investee enterprises

and provide expertise by way of management and marketing support. This industry has

developed its own ethos and culture. Venture capital has only one common aspect that cuts

across geography i.e. it is risk capital invested by experts in the field. It is important that

venture capital in India be allowed to develop via professional and institutional management.

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Balance between three factors

Venture Capital backed companies can provide high returns. However, despite of success

stories like Apple, FedEx of Microsoft, a lot of these deals fail. It is said that only one out of

ten companies succeed. That's why every deal has an element of potential profit and an

element of risk, depending on the deals size. To be successful, a Venture Capital Company

must manage the balance between these three factors.

FRAME WORK FOR KEY SUCCESS FACTOR

Knowledge is key, to get the balance in this "Magic Triangle". With knowledge we

mean knowledge about the financial markets and the industries to invest in, risk management

skills and contacts to investors, possible investees and external expertise. High profits,

achievable by larger deals, are not only important for the financial performance of the

Venture Capital Company. As a good track record they are also a vital argument to attract

funds which are the basis for larger deals. However, larger deals imply higher risks of losses.

Many Venture Capital companies try to share and limit their risks. Solutions could be

alliances and careful portfolio management. There are Venture Capital firms that refuse to

invest in e-start-up because they perceive it as too risky to follow today's type.

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Knowledge

Risk management skills and contacts to investors

Possible investees and external expertise

Financial markets and the industries to invest in

CHAPTER 12: SUGGESTION AND CONCLUSION

SUGGESTION

THE Indian venture capital (VC) industry has witnessed considerable turmoil in the last two

years. Consider this: At least seven VC funds (VCFs) shut shop. Many others simply ran out

of funds. A few set up high-cost Indian operations, with no funds raised or allocated for

investment. The rest of the industry appears to be busy, `restructuring' their investment focus,

making very few new investments.

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After a period of hectic investing, from 1998 to 2000, the Indian VC industry appears to be

going through difficult times. This is a time for the industry to engage in some serious

reflection. Managers in the industry may possibly disagree with me. They might argue that

the developments in the Indian industry are a mere reflection of a larger global phenomenon.

After all, have the American and European VC industries not slowed down? That comparison

though, is inappropriate. The slow down and the poor performance of many funds in the

Western world are part of a cyclical phenomenon. The Indian industry, on the contrary, faces

issues of a fundamental nature. Let us examine four issues of concern.

First, there is a serious mismatch between the kind of venture capital available in India and

what the market demands. Almost all VCFs in India have been targeting their capital at

companies in the information technology, pharmaceuticals and some services industries,

looking for expansion financing of Rs 15 crores or more. Now, this is a limited market

segment. Most of the industries mentioned above are relatively young. There are very few

firms in these sectors, seeking large amounts of capital for expansion financing. At the same

time, a large number of aspiring entrepreneurs, start-ups, early- stage companies and Old

Economy firms, which are fundamentally sound businesses, are unable to attract the VC

financing that they badly need in order to grow. Apart from the relatively smaller amounts of

funding that they seek, on average start-ups require considerable post-funding support from

the investor to grow their businesses. That is painstaking work, for which Indian VCF

managers have demonstrated neither experience nor training nor temperament. Old Economy

firms do not provide the quick or glamorous exits that VCFs often desire.

Second, most VCFs in India are an extended arm or a division of global investment

institutions. International funds represent more than 95 per cent of the VC invested in India.

Two consequences follow from this near-total dependence on foreign capital. One, the

investment mandates of these VCFs are often driven by the parent institutions' global world

view, which often ignores local market needs. The homogenous investment preferences of

VCFs outlined earlier follow from the parent institutions' global investment strategies. Two,

at a portfolio level, every international VC investor in India has been a victim of the

depreciation of the rupee against the dollar. The returns produced by Indian VCFs, measured

in US dollars or other Western currencies, turn out to be considerably less attractive than that

measured in Indian currency. Many nations such as the Netherlands, Portugal, Finland,

Norway and Israel recognized the limitations of depending on foreign funds at the time of

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evolving a policy for developing a local VC industry. Their first step was to kick start VCFs

in the private sector with funds from domestic institutions. Over a decade, or even less, they

succeeded in creating a local VC industry that depended less and less on government support

and international investors.

The third issue is the poor quality of corporate governance and lack of sensitivity among

entrepreneurs and investors, to each other's legitimate business aspirations. This is a universal

problem and not unique to India. What is however unique to India is the hopeless system of

legal redress of grievances when partners renege on contractual obligations. Often,

Aggrieved parties in India agree to settlements that are unfair to them, apprehending that

litigation in Indian courts could be dysfunctional. This situation may not change in the

foreseeable future. The alternative to litigation and unfair bad investments would be to invest

more effort in better identification and selection of investments and supervision of the

portfolio. Indian VCF managers need to ask themselves if they are prepared to put in that

extra effort to minimize prospects for litigation in the first place.

Last, but not the least, the industry lacks a broad-based and effective trade association. The

Indian Venture Capital Association (IVCA) does not represent a large proportion of the VCFs

who are active in India. I am not sure of the IVCA's contributions to the VC industry either,

in the ten years since it was formed. For some years initially, the IVCA used to produce a

delightfully uninformative annual report, many months after the end of the year. For the past

four years even those reports do not appear to have been published! Venture capital has been

a remarkable catalyst of entrepreneurial activity, after the Second World War, in many

developed countries. It has led to significant growth in industry and innovation. The

prospects for the Indian VC industry are no less humongous. It is up to the industry to reflect

on its current predicament and evolve a strategy to seize the opportunity

CONCLUSION

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

imminent.

Venture Capitalists in Indian have notice of newer avenues and regions to expand. VCs have

moved beyond IT service but are cautious in exploring the right business model, for finding

opportunities that generate better returns for their investors.

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

political and regulatory environment compared to other countries, difficulty in achieving

successful exists and administrative delays in documentation and approval.

In spite of few non attracting factors, Indian opportunities are no doubt promising which is

evident by the large number of new entrants in past years as well in coming days.

Nonetheless the market is challenging for successful investment.

Therefore Venture capitalists responses are upbeat about the attractiveness of the India as a

place to do the business.

BIBLIOGRAPHY

BOOKS:

Taneja Satish, “Venture Capital in India”.

Chary T Satyanarayana, “Venture Capital – Concepts & Applications ”

Sharma Kapil, an Analysis of Venture Capital Industry in India.

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REPORT :

Trends of Venture Capital in India, survey Report by Deloitte, 2009.

Global Trends of Venture Capital, survey report by Deloitte, 2009.

Economic survey 2008-09,

WEBSITE :

www.ivca.org

www.indiavca.org.

www.vcindia.com

www.ventureintelligence.in

www.nvca.org

www.economictimes.indiatimes.com

www.100ventures.com

www.deloitte.com

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