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Venture Capital and Innovation:The Indian Experience

B. Bowonder and Sunil Mani

Biographical Notes

Dr. B. Bowonder is Dean of Research and Chairperson of the Centre for Technology Management at the Administrative Staff College of India. He has aPhD in engineering from the Indian Institute of Science, Bangalore. His contactaddress is Administrative Staff College of India, Hyderabad-500 082, India, Tel:+91-40-3310952, Fax: +91-40-3312954, E-mail: bowonder@asci.org.inDr. Sunil Mani is Researcher at the United Nations University/Institute for NewTechnologies (UNU/INTECH) Keizer Karelplein 196211 TC Maastricht, The Netherlands, Tel: +31-43-3506331, Fax: +31-43-3506399, E-mail: Mani@intech.unu.edu

Venture Capital and Innovation:The Indian Experience

B. Bowonder and Sunil Mani

Abstract

This paper presents an overview of evolution of venture capital support for innovation in India. There are three governmental supported schemes and alarge number of venture funds currently in operation. An analysis of venturecapital funding trends indicates that venture capital also has strong linkages withinnovation-based clusters. The paper also summarizes the support provided bythe venture funds to innovative firms. It has been observed that though they aremany determinants the two major elements that contributed to the success of venture capital assisted firms are:

providing market linkages

and

sharpening the business plan

. From the firm side, experiential base of the entrepreneursand clarity of the market are the factors that reduced the market uncertainty. Theanalysis shows that linkages between innovation, clusters and venture supportare becoming tighter. This has got immense importance in public policy arena.Support for creating clusters and developing high-tech entrepreneurs are likely tobe the interventions that are effective.

Keywords

Venture capital, innovation, financing innovation and clusters

BACKGROUND OF THE INDUSTRY

In the last decade, one of the most admired institutions among industrialists andeconomic policy makers around the world has been the US venture capitalindustry [Dossani and Kenney 2002]. The sensitivity of venture capital processto government policies and other factors that influence entrepreneurship andinnovation was highlighted in a study by the US General Accounting office onbehalf of the Joint Economic Committee [Premus 1985]. Venture capital

entrepreneurship and innovation have been closely connected. Entrepreneurshave long had ideas that require substantial capital to implement but lacked thefunds to finance these projects themselves [Gompers and Lerner 2002]. Venturecapital evolved as a response to this felt need. Venture capital represent onesolution to financing the high risk, potentially high-reward projects [Gompers andLerner 2002]. The experience of US, Taiwan and Israel show that technologicalinnovation and the growth of venture capital markets are closely interrelated[Premus 1985]. It has been reported that capital markets overlook smallbusiness opportunities because of high information and transaction costs,generally known as capital gap problem [Premus 1985, Smith and Smith 2002].Though venture capital can meet this gap to some extent, venture capital is aspecial form of venture financing. In the case of venture capital, the capitalmarket has to be conducive for supporting venture funding. At some level,entrepreneurship occurs in nearby every society, but venture capital can onlyexist when there is a constant flow of opportunities that have great upside

potential [Dossani and Kenney 2002]. This study is a country overview of theventure capital industry supported by a set of case studies.

Evolution of VC Industry in India

The first major analysis on risk capital for India was reported in 1983 [Chitale1983]. It indicated that new companies often confront serious barriers to entryinto capital market for raising equity finance which undermines their futureprospects of expansion and diversification. It also indicated that on the wholethere is a need to revive the equity cult among the masses by ensuringcompetitive return on equity investment. This brought out the institutionalinadequacies with respect to the evolution of venture capital. The role of venturecapital was met initially by the following institutions:

Industrial Development Bank of India.

Industrial credit and investment corp of India

State Finance Corporations and

Small Industries Development Bank of IndiaThe first origins of modern venture capital in India can be traced to the setting upof a Technology Development Fund in the year 1987-88, through the levy of access on all technology import payments [IVCA, 2000]. TechnologyDevelopment Fund was started to provide financial support to innovative andhigh risk technological programmes through the Industrial Development Bank of India. Subsequently, Government of India gave the procedures that can be usedfor starting venture funding.

The growth of VC in India has three separate phases. The first phase was theinitial phase in which the concept of VC got wider acceptance. The first perioddid not really experience any substantial growth of VCs’. The 1980’s weremarked by an increasing disillusionment with the trajectory of the economicsystem and a belief that liberalization was needed. The liberalization processstarted in 1985 in a limited way. The concept of venture capital received officialrecognition in 1988 with the announcement of the venture capital guidelines.

During 1988 to 1992 about 9 venture capital institutions came up in India.Though the venture capital funds should operate as open entities, Government of India controlled them rigidly. One of the major forces that induced Governmentof India to start venture funding was the World Bank. The initial funding hasbeen provided by World Bank. World Bank reported that India will require $67 to133 million per annum as venture capital. It gave a total of US $45 million for starting VC funds in India. The most important feature of the 1988 rules was thatventure capital funds received the benefit of a relatively low capital gains tax ratewhich was lower than the corporate rate [Dossani and Kenney 2002]. The 1988guidelines stipulated that VC funding firms should meet the following criteria:

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

promoters / entrepreneurs using the technology should be relatively new,professionally or technically qualified, with inadequate resources tofinance the project.

Between 1988 and 1994 about 11 VC funds became operational either through reorganizing the businesses or through new entities and they aregiven in

Table.1

.All these followed the Government of India guidelines for venture capital activitiesand have primarily supported technology oriented innovative businesses startedby first generation entrepreneurs [Verma 1997]. Most of these were operatedmore like a financing operation. The main feature of this phase was that theconcept got accepted. VCs became operational in India before the liberalizationprocess started. The context was not fully ripe for the growth of VCs. Till 1995,the VCs operated like any bank but provided funds without collateral. The firststage of the venture capital industry in India was plagued by in experiencedmanagement, mandates to invest in certain states and sectors and generalregulatory problems. Many public issues by small and medium companies haveshown that the Indian investor is becoming increasingly wary of investing in theprojects of new and unknown promoters [Ramesh and Gupta 1995]. Theliberation of the economy and toning up of the capital market changed theeconomic landscape. The decisions relating to issue of stocks and shares washandled by an office namely: Controller of Capital Issues (CCI). According to1988 VC guideline, any organization requiring to start venture funds have toforward an application to CCI. Subsequent to the liberalization of the economy in1991, the office of CCI was abolished in May 1992 and the powers were vestedin Securities and Exchange Board of India. The Securities and Exchange Board

of India Act, 1992 empowers SEBI under section 11(2) thereof to register andregulate the working of venture capital funds. This was done in 1996, through agovernment notification. The power to control venture funds has been given toSEBI only in 1995 and the notification came out in 1996. Till this time, venturefunds were dominated by Indian firms. The new regulations became theharbinger of the second phase of the VC growth. The notification had the