Professional Documents
Culture Documents
Prepared by:
1. Krunal Shah 6156
2. Gautam Foria 6045
3. Ishita Kohli 6083
4. Niral Chandarana 6023
5. Pratik Parekh 6122
6. Sneha Lalwani 6087
7. Vivek Jain 6064
8. Brinda Jogani 6069
DECLARATION
CERTIFICATE
DATE OF SUBMISSION:
ACKNOWLEDGEMENT
We would like to thank with affection and appreciation and acknowledge our
indebt ness to Prof. Vijay Paradkar, visiting faculty of Mumbai Educational Trust,
Bandra who initiated us in the preparation of a Project on Venture Capital. The
learning and knowledge that we have gained in the process of preparation of this
project has been tremendous and we would like to thank Prof. Vijay Paradkar for
providing us with the opportunity to work on this project.
We owe sincere gratitude towards each and everyone who have given a helping
hand in the completion of this project.
INDEX
Sr. No. TOPICS
I. Executive Summary
II. Indian Financial Sector
III. Concept Of VC
IV. Venture Capital Flow
V. Features of A VC
VI. VC – The History
VII. Private Equity
VIII. Types of VCs
IX. SEBI Regulations For VCs
X. SEBI Regulations For
Foreign VCs
XI. Valuation Methods Used
By VCs
XII. Financial Instruments Used
By VCs
XIII. Stages Of VC Investment
XIV. Documentation
XV. Difference Between A VC &
A Banker/Money Manager
XVI. An Exercise: Launching &
Managing A VCF
XVII. Bibliography
I. EXECUTIVE SUMMARY
A number of technocrats are seeking to set up shop on their own and capitalize
on opportunities. In the highly dynamic economic climate that surrounds us
today, few ‘traditional’ business models may survive. Countries across the globe
are realizing that it is not the conglomerates and the gigantic corporations that
fuel economic growth any more. The essence of any economy today, is the small
and medium enterprises. In the year 2006, venture money invested in India was
$3 bn and is expected to reach $6.5 bn by the end of this year.
This growing trend can be attributed to rapid advances in technology in the last
decade. Knowledge driven industries like InfoTech, health-care, manufacturing,
entertainment and services have become the cynosure of bourses worldwide. In
these sectors, it is innovation and technical capability that are big business-
drivers. This is a paradigm shift from the earlier physical production and
‘economies of scale’ model.
2.1. Size
• Total banking assets stood at around $ 600 billion
• Assets owned by India’s mutual funds crossed the Rs 4 trillion-mark
• India’s entire stock of financial assets--equity, corporate and government debt
and bank deposits--is valued at US$ 1.1 trillion
• More than 80 venture capital and private equity funds operate in India.
2.2. Structure
• Public Sector (Government owned) banks account for 75% of the banking
assets; however, Indian private banks and foreign banks are growing at a
rapid pace.
• Standard Chartered Bank, Citibank and HSBC are the top three foreign banks
in India accounting for more than 65% of the total assets of foreign banks
• Most of the global players in banking & financial services – Morgan Stanley,
Merrill Lynch, JP Morgan, Deutsche Bank, UBS, ABN Amro, Barclays, Calyon
etc. - have presence in India
• The Mutual Funds industry has both domestic and foreign players like - UTI
Mutual Fund, Prudential ICICI, HDFC, Franklin Templeton, Birla and Tata
Funds.
The Reserve Bank of India (RBI) controls and supervises the banking industry. It
also prescribes broad parameters of banking operations within which the
country’s banking and financial system functions.
India is a prime target for venture capital and private equity today, owing to
various factors such as fast growing knowledge based industries, favorable
investment opportunities, cost competitive workforce, booming stock markets and
supportive regulatory environment among others. The sunrise sectors that
attract venture funds are healthcare, education, financial services,
hospitality, media & entertainment, ITES and InfoTech. Indian venture Capital
Association is the apex association of VC funds in the country. India has more
than 80 venture Funds registered with SEBI.
III. CONCEPT OF VC
Venture capital is a growing business of recent origin in the area of industrial
financing in India. The various financial institutions set-up in India to promote
industries have done commendable work. However, these institutions do not
come up to the benefit of risky ventures when new or relatively unknown
entrepreneurs undertake them. They contend to give debt finance, mostly in the
form of term loan to the promoters and their functioning has been more akin to
that of commercial banks. The financial institutions have devised schemes such
as seed capital scheme, Risk capital Fund etc., to help new entrepreneurs.
However, to evaluate the projects and extend financial assistance they follow the
criteria such as safety, security, liquidity and profitability and not potentially. The
capital market with its conventional financial instruments/ schemes does not
come much to the benefit or risky venture. New institutions such as mutual funds,
leasing and hire purchase Company’s have been established as another leasing
and hire purchase Company’s have been established as another source of
finance to industries. These institutions also do not mitigate the problems of new
entrepreneurs who undertake risky and innovative ventures.
The term Venture Capital comprises of two words that is “Venture” and “Capital”.
Venture is defined as a course of processing, the outcome of which is uncertain
but to which is attended the risk or danger of LOSS. Capital means resources to
start an enterprise. To connote the risk and adventure of such a fund, the generic
name Venture Capital was coined.
Venture capital is long-term risk capital to finance high technology projects, which
involve risk, but at the same time has strong potential for growth. Venture
capitalists pool their resources including managerial abilities to assist new
entrepreneur in the early years of the project. Once the project reaches the stage
of profitability, they sell their equity holdings at high premium.
The term venture capital denotes institutional investors that provide equity
financing to young businesses and play an active role advising their
managements.
Venture capital can also include managerial and technical expertise. Most
venture capital comes from a group of wealthy investors, investment banks and
other financial institutions that pool such investments or partnerships. This form
of raising capital is popular among new companies, or ventures, with limited
operating history, which cannot raise funds through a debt issue. The downside
for entrepreneurs is that venture capitalists usually get a say in company
decisions, in addition to a portion of the equity.
Contrary to popular perception, venture capital plays only a minor role in funding
basic innovation. Where venture money plays an important role is the next stage
of innovation life cycle-the period in a company’s life when it begins to
commercialize its innovation. It is estimated that more than 80% of the money
invested by VC goes into building the infrastructure required to grow the business
in expense investments (manufacturing, sales, and manufacturing) and the
balance sheet (providing fixed asset and working capital).
Venture money is not long term money. The idea is to invest in a company’s
balance sheet and infrastructure until it reaches a sufficient size and credibility so
that it can be sold to a corporation or so that an institutional public equity markets
can step in and provide liquidity. In essence VC buys a stake in an
entrepreneur’s idea, nurtures it for a short period of time, and then exits with a
help of Investment Banker.
Venture capitals niche exists because of the structure and rule of capital markets.
Someone with a new idea or technology often has no other institution to turn to.
Usury law, limits the interest banks can charge on loans-and the risk inherent in
start ups justify the higher rates so charged by the banks. This limits a bank to
invest in those projects that secure the debt with hard assets. And in today’s
information based economy, many start ups have few hard assets. Public Equity
and Investment Bank are both constrained by regulations and operating practices
to protect the public investor. Venture Capital fills the gap between innovation
and traditional lower cost sources of capital available for ongoing concerns.
Filling that void successfully requires the venture capital industry to provide a
sufficient return on capital to attract private equity funds, attractive returns for its
own participants, and sufficient upside potential entrepreneurs to attract high
quality ideas that will generate high returns.
IV. VENTURE CAPITAL FLOW
4.1. Venture Capitalist
A venture capitalist (VC) is a person who makes investments in potentially stable
growing companies.
VC is a fund manger who gets a fee to invest in companies that has growth
potential and provides expected returns to its investors.
With venture capital, the venture capitalist acquires an agreed proportion of the
equity of the company in return for the requisite funding.
Investors in venture capital funds are typically very large institutions such as
pension funds, financial firms, insurance companies, and university endowments-
all of which put a small percentage of their total funds into high risk investments.
In return for financing one or two year of financing company’s start ups, VC
expect a ten times return of capital over five years.
Usually VC expects a return of between 25% and 35% per year over the lifetime
of the investment. Because these investments represent such a tiny part of the
institutional investors’ portfolios, venture capitalists have a lot of latitude. What
leads to invest in these funds is not the specific investment but firms overall track
record.
In effect VC focuses on the middle part of classic industry S-Curve. They avoid
both the early stages, when technologies are uncertain and market stages are
unknown and the later stage when competitive shakeouts and consolidations are
inevitable and growth rates slow dramatically.
Growing within high growth segments is a lot easier than doing so in low, no or
negative growth ones as every businessman knows. In other words regardless of
the talent or charisma an individual entrepreneur may posses they rarely receive
backing from VC if they are in low growth industry. During this adolescent period
of high and accelerating growth, it can be extremely hard to distinguish the final
winners from the losers because their financial performance and growth rate
looks strikingly similar. At this stage, all companies are struggling to deliver
products to this product-starved market. Thus the critical challenge for the VC is
to identify competent management that can execute-that is, supply the growing
demand.
This need for high returns makes venture funding an expensive capital source for
companies, and most suitable for businesses having large up-front capital
requirements which cannot be financed by cheaper alternatives such as debt.
That is most commonly the case for intangible assets such as software, and
other intellectual property, whose value is unproven. In turn this explains why
venture capital is most prevalent in the fast-growing technology and life sciences
or biotechnology fields.
Picking the wrong industry or betting on a technology risk is an unproven market
segment is something VC’s avoid. By investing in areas with high growth rates,
VC primarily consign their risk to the ability of the company’s management to
execute.
Venture Capital Fund shall make investment in the venture capital undertaking as
enumerated below:
• 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 lock-in period of one year.
The venture capital fund shall issue a placement memorandum, which shall
contain details of the terms, and conditions subject to which monies are
proposed to be raised from investors.
The Venture Capital Fund shall file with the Board for information, the copy of the
placement memorandum or the copy of the contribution or subscription
agreement entered with the investors along with a report of money actually
collected from the investor.
VCF promotes growth in the companies they invest in and managing the
associated risk to protect and enhance their investors' capital.
VCF typically source most of their funding from large investment institutions.
VCF Invest the amount in companies with high growth potential or in companies,
which have the ability to quickly, repay.
VCF Exit through the company listing on the stock exchange, selling to a trade
buyer or through a management buyout.
Most venture capital funds have a fixed life of 10 years, with the possibility of a
few years of extensions to allow for private companies still seeking liquidity. The
investing cycle for most funds is generally three to five years, after which the
focus is managing and making follow-on investments in an existing portfolio.
Venture capital general partners (also known in this case as "venture capitalists"
or "VCs") are the executives in the firm, in other words the investment
professionals. Typical career backgrounds vary, but many are former chief
executives at firms similar to those which the partnership finances and other
senior executives in technology companies.
Venture capital thrives best where it is not restrictively defined. Both in the
U.S.A., the cradle of modern venture capital industry and U.K. where it is
relatively advance venture capital as n activity has not been defined. Laying
down parameters relating to size of investment, nature of technology and
promoter’s background do not really help in promoting venture proposals.
Venture capital enables entrepreneurs to actualize scientific ideals and enables
inventions. It can contribute as well as benefit from securities market
development. Venture capital is a potential source for augmenting the supply of
good securities with track record of performance to the stock market that faces
shortage of good securities to absorb the savings of the investors. Venture
capital in turn benefits from the rise in market valuation that results from an active
secondary market.
V. FEATURES OF VC
The key terms found in most definition of Venture capital are: high technology
and high risk, equity investment and capital gains, value addition through
participation in management.
Normally three out of every ten units financed by Venture capital succeed.
After the Second World War in 1946 the American Research and Development
was formed as first venture organization that financed over 900 companies.
Venture capital had been a major contributor in development of the advanced
countries like UK, Japan and several European countries.
As late as the 1980s Lester Thurow, a noted economist, decried the inability of
the USA's financial regulation framework to support any merchant bank other
than one that is run by the United States Congress in the form of federally funded
projects. These, he argued, were massive in scale, but also politically motivated,
too focused on defense, housing and such specialized technologies as space
exploration, agriculture, and aerospace. US investment banks were confined to
handling large M&A transactions, the issue of equity and debt securities, and,
often, the breakup of industrial concerns to access their pension fund surplus or
sell off infrastructural capital for big gains.
Not only was the lax regulation of this situation very heavily criticized at the time,
this industrial policy differed from that of other industrialized rivals—notably
Germany and Japan—which at that time were gaining ground in automotive and
consumer electronics markets globally. However, those nations were also
becoming somewhat more dependent on central bank and elite academic
judgment, rather than the more diffuse way that priorities were set by government
and private investors in the United States.
The developmental financial institutions like IDBI, ICICI and State Financial
Corporations possibly did this activity in the past. These institutions promoted
entities in the private sector with debt as an instrument of funding.
For a long time funds raised from public were used as a source of VC. This
source however depended a lot on the market vagaries. And with the minimum
paid up capital requirements being raised for listing at the stock exchanges, it
became difficult for smaller firms with viable projects to raise funds from public.
In India, the need for VC was recognised in the 7th five-year plan and long term
fiscal policy of GOI. In 1973 a committee on Development of small and medium
enterprises highlighted the need to faster VC as a source of funding new
entrepreneurs and technology. VC financing really started in India in 1988 with
the formation of Technology Development and Information Company of India Ltd.
(TDICI) - promoted by ICICI and UTI.
The first private VC fund was sponsored by Credit Capital Finance Corporation
(CFC) and promoted by Bank of India, Asian Development Bank and the
Commonwealth Development Corporation viz. Credit Capital Venture Fund. At
the same time state level financial institutions started Gujarat Venture Finance
Ltd. and APIDC VENTURE CAPITAL LTD. Sources of these funds were the
financial institutions, foreign institutional investors or pension funds and high net-
worth individuals. Though an attempt was also made to raise funds from the
public and fund new ventures, the venture capitalists had hardly any impact on
the economic scenario for the next eight years.
India is prime target for venture capital and private equity today, owing to various
factors such as fast growing knowledge based industries, favorable investment
opportunities, cost competitive workforce, booming stock markets and supportive
regulatory environment among others.
The sectors where the country attracts venture capital are IT and ITES, software
products, banking, PSU disinvestments, entertainment and media,
biotechnology, pharmaceuticals, contract manufacturing and retail. An offshore
venture capital company may contribute up to 100 percent of the capital of a
domestic venture capital fund and may also set up a domestic asset
management company to manage the fund. Venture capital funds (VCF) and
venture capital companies (VCC) are permitted up to 40 percent of the paid up
corpus of the domestic unlisted companies. This ceiling would be subject to
relevant equity investment limit in force in relation to areas reserved for SSI.
Investment in a single company by a VCF/VCC shall not exceed 5 percent of the
paid up corpus of a domestic VCF/VCC. The automatic route is not available.
Indian companies received almost no Private Equity (PE) or Venture Capital (VC)
funding a decade ago. This scenario began to change in the late 1990s with the
growth of India’s Information Technology (IT) companies and with the
simultaneous dot-com boom in India. VCs started making large investments in
these sectors, however the bust that followed led to huge losses for the PE and
VC community, especially for those who had invested heavily in start-ups and
early stage companies. After almost three years of downturn in 2001-2003, the
PE market began to recover towards the end of 2004. PE investors began
investing in India again, except this time they began investing in other sectors as
well (although the IT and BPO sectors still continued to receive a significant
portion of these investments) and most investments were in late-stage
companies. Early-stage investments have been dwindling or have, at best,
remained stagnant right through mid-2006.
The Indian private equity (PE) and venture capital (VC) market roughly started in
1996-1997 and it scaled new heights in 2000 primarily because of the success
demonstrated by India in assisting with Y2K related issues as well as the overall
boom in the Information Technology (IT), Telecom and the Internet sectors,
which allowed global business interactions to become much easier. In fact, the
total value of such deals done in India in 2000 was $1.16 billion and the average
deal size was approximately US $4.14 million.
Not surprisingly, the investing in India came “crashing down” when NASDAQ lost
60% of its value during the second quarter of 2000 and other public markets
(including those in India) also declined substantially. Consequently, during 2001-
2003, the VCs and PEs started investing less money and in more mature
companies in an effort to minimize the risks. For example:
(a) The average deal size more than doubled from $4.14 million in 2000 to $8.52
million in 2001
(b) The number of early-stage deals fell sharply from 142 in 2000 to 36 in 2001
(c) Late-stage deals and Private Investments in Public Equity (PIPEs) declined
from 138 in 2000 to 74 in 2001, and
(d) Investments in Internet-related companies fell from $576 million in 2000 to
$49 million in 2001. This decline broadly continued until 2003.
Since India’s economy has been growing at 7%-8% a year, and since some
sectors, including the services sector and the high-end manufacturing sector,
have been growing at 12%-14% a year, investors renewed their interest and
started investing again in 2004. As Figure 1 shows, the number of deals and the
total dollars invested in India has been increasing substantially. For example, US
$1.65 billion in investments were made in 2004 surpassing the $1.16 billion in
2000 by almost 42%. These investments reached US $2.2 billion in 2005, and
during the first half of 2006, VCs and PE firms had already invested $3.48 billion
(excluding debt financing). The total investments in 2006 are likely to be $6.3
billion, a number that is more than five times the amount invested in 2000.
A very important feature of the resurgence in the PE activity in India since 2004
has been that the PEs are no longer focusing only on the IT and the ITES (IT
Enabled Services, commonly known as “Business Process Outsourcing” or BPO)
sectors. This is partly because the growth in the Indian economy is no longer
limited to the IT sector but is now spreading more evenly to sectors such as bio-
technology and pharmaceuticals; healthcare and medical tourism; auto-
components; travel and tourism; retail; textiles; real estate and infrastructure;
entertainment and media; and gems and jewellery. Figure 2 shows the division
across various sectors with respect to the number of deals in India in 2000, 2003
and the first half of 2006.
Early Stage VC Investments during 2000-2006:
Since the Purchase Power Parity (PPP) in India is approximately a factor of 5 (as
in, a factor of 5 is used to normalize the GDPs of US & India on a PPP basis),
analysis shows that early stage VC investments in India should include those that
are $8 million or less. In fact, we can classify early stage investments further into
Seed, Series A and Series B investments depending upon their value.
Figure given below provides a break-up of the total value of investments into
early-stage investments (primarily by VCs) and late-stage investments and
PIPEs (primarily by PEs). Even within early-stage investments, seed investments
declined the most during 2000-2003 and have essentially remained negligible
during 2004-2006.
Figure below shows the break-up of early-stage investments by Seed and Series
A and B investments. In a nuance, perhaps unique to India, since the Indian
upper middle class has become quite affluent during the last 7-10 years, the
entrepreneurs are relying more and more on family and friends for seed funding,
and since emerging entrepreneurs come from this upper middle class, the need
for seed funding from VCs could remain low for many years to come.
In the year 2006 Venture money invested in India was $3bn and
is expected to reach $6.5bn by the end of the year.
VII. PRIVATE EQUITY
Private equity is a broad term that commonly refers to any type of non-public
Ownership Equity securities that are not listed on a public exchange. Since they
are not listed on a public exchange, any investor wishing to sell private equity
securities must find a buyer in the absence of a public marketplace. There are
many transfer restrictions on private securities. Investors in private securities
generally receive their return through one of three ways: an initial public offering,
a sale or merger, or a recapitalization.
Private equity firms generally receive a return on their investment through one of
three ways: an IPO, a sale or merger of the company they control, or a
recapitalization. Unlisted securities may be sold directly to investors by the
company (called a private offering) or to a private equity fund, which pools
contributions from smaller investors to create a capital pool.
If the private equity firm can't find good investment opportunities, they will not
draw on our commitment. Given the risks associated with private equity
investments, you can lose all your money if the private-equity fund invests in
failing companies. The risk of loss of capital is typically higher in venture
capital funds, which back young companies in the earliest phases of their
development, and lower, in mezzanine capital funds, which provide interim
investments to companies which have already proven their viability but have
yet to raise money from public markets.
Consistent with the risks outlined above, private equity can provide high
returns, with the best private equity managers significantly outperforming the
public markets.
For the above-mentioned reasons, private equity fund investment is for those
who can afford to have their capital locked in for long periods of time and who are
able to risk losing significant amounts of money. This is balanced by the potential
benefits of annual returns, which range up to 30% for successful funds. Most
private equity funds are offered only to institutional investors and individuals of
substantial net worth. The law often requires this as well, since private equity
funds are generally less regulated than ordinary mutual funds.
VIII. TYPES OF VCS
8.1. Incubators
Incubator is a company or facility designed to foster entrepreneurship and help
startup companies usually technology-related, to grow through the use of shared
resources, management expertise and intellectual capital.
Kanwal Rekhi School of Information Technology (KReSIT) is a business
incubators at IIT Mumbai is the best example of business incubators in India.
In addition to these venture capital firms there are individual private investors and
finders. Finders, which can be firms or individuals, often know the capital industry
and may be able to help the small company seeking capital to locate it, though
they are generally not sources of capital themselves. Care should be exercised
so that a small business owner deals with reputable, professional finders whose
fees are in line with industry practice. Further, it should be noted that venture
capitalists generally prefer working directly with principals in making investments,
though finders may provide useful introductions.
2. Venture Capitalists
He is the one who supports the idea of the entrepreneur and in turn makes fund
available to the entrepreneur. Venture capitalist posses a good experience of his
area and provide expertise to the entrepreneur. Venture capitalist makes money
for themselves by making market for entrepreneurs, investors and bankers
Venture capitalist will raise money from the investors who expect high returns.
Venture capitalist takes the help of bankers to issues IPOs and in turn received
the initial outflow.
3. Investors
These are the private investors who expect high return as they invest in the
business which is full of risk. They invest in from of money and received return in
form of money as well. Venture capitalists raise money from these investors to
invest in entrepreneur’s idea.
4. Bankers
An investment banker helps the venture capitalist to float the IPOs in the market.
They are the one who help the venture capitalist to exit from the VC.
8.7. How funds flow between the parties
IX. SEBI REGULATIONS FOR VCs
9.1. DEFINITIONS:
“Venture capital fund” means a fund established in the form of a trust or a
company including a body corporate and registered under these regulations
which—
(i) Has a dedicated pool of capital;
(ii) Raised in a manner specified in the regulations; and
(iii) Invests in accordance with the regulations;
Eligibility Criteria:
For the purpose of the grant of a certificate by the Board the applicant shall have
to fulfill in particular the following conditions, namely:—
(d) The applicant has not been refused a certificate by the Board or its certificate
has not been suspended or cancelled under regulation.
Consideration of application:
An application which is not complete in all respects shall be rejected by the
Board:
Provided that, before rejecting any such application, the applicant shall be given
an opportunity to remove, within thirty days further on being satisfied that it is
necessary to extend the period by such further time not exceeding ninety days.
Prohibition on listing:
No venture capital fund shall be entitled to get its units listed on any recognized
stock exchange till the expiry of three years from the date of the issuance of units
by the venture capital fund.
Private placement:
A venture capital fund may receive monies for investment in the venture capital
fund only through private placement of its units.
Winding-up:
(a) A scheme of a venture capital fund set up as a trust shall be wound up,
(i) When the period of the scheme, if any, mentioned in the placement
memorandum is over;
(ii) If it is the opinion of the trustees or the trustee company, as the case may be,
that the scheme shall be wound up in the interests of investors in the units;
(iii) If seventy-five per cent of the investors in the scheme pass a resolution at a
meeting of unit-holders that the scheme be wound up; or
(iv) If the Board so directs in the interests of investors.
(b) A venture capital fund set up as a company shall be wound up in accordance
with the provisions of the Companies Act, 1956.
(c) The trustees or trustee company of the venture capital fund set up as a trust
or the Board of Directors in the case of the venture capital fund is set up as a
company (including body corporate) shall intimate the Board and investors of the
circumstances leading to the winding up of the Fund or Scheme.
Effect of winding-up:
(a) On and from the date of intimation, no further investments shall be made on
behalf of the scheme so wound up.
(b) Within three months from the date of intimation, the assets of the scheme
shall be liquidated, and the proceeds accruing to investors in the scheme
distributed to them after satisfying all liabilities.
(c) Notwithstanding anything as asset and subject to the conditions, if any,
contained in the placement memorandum or contribution agreement or
subscription agreement, as the case may be, in specie distribution of assets of
the scheme, shall be made by the venture capital fund at any time, including on
winding up of the scheme, as per the preference of investors, after obtaining
approval of at least 75% of the investors of the scheme.
"Investible funds" means the fund committed for investments in India net of
expenditure for administration and management of the fund.
Consideration of application
An application which is not complete in all respects shall be rejected by the
Board:
Provided that, before rejecting any such application, the applicant shall be given
an opportunity to remove, within thirty days of the date of receipt of
communication, the objections indicated by the Board.
Provided further that the Board may, on being satisfied that it is necessary to
extend the period specified above may extend such period not beyond ninety
days.
Suspension of certificate
The Board may suspend the certificate where the Foreign Venture Capital
Investor:
(a) Contravenes any of the provisions of the Act or these regulations;
(b) Fails to furnish any information relating to its activity as a Foreign Venture
Capital Investor as required by the Board;
(c) Furnishes to the Board information which is false or misleading in any
material particular;
(d) Does not submit periodic returns or reports as required by the Board;
(e) Does not co-operate in any enquiry or inspection conducted by the Board;
Cancellation of certificate
The Board may cancel the certificate granted to a Foreign Venture Capital
Investor: -
(a) When the Foreign Venture Capital Investor is guilty of fraud or has been
convicted of an offence involving moral turpitude;
Explanation: The expression "fraud" has the same meaning as is assigned to it in
section 17 of the Indian Contract Act, 1872. (9 of 1872)
(b) The Foreign Venture Capital Investor has been guilty of repeated defaults. or
(c) Foreign Venture Capital Investor does not continue to meet the eligibility
criteria laid down in these regulations;
(d) Contravenes any of the provisions of the Act or these regulations.
In late 2000, Sebi issued the Foreign Venture Capital Investor Regulations, 2000.
They apply to foreign venture capital investors (FVCI) incorporated and
established outside India and which propose to invest in India. Until recently,
FVCIs avoided registering themselves with Sebi due to the extremely confusing
regulatory and tax position. FVCIs preferred to operate from overseas, usually
through a liaison office in India. However, this was no longer the case following
the enactment of the Regulations, and also amendment to the Indian Income Tax
Act, 1961 (IT Act).
This view proceeds on the assumption that a distinction must be made between
a non-resident making a foreign direct investment (FDI) and an FVCI. This
distinction is established from the nature of the agreements entered into by a
foreign investor with the Indian investee companies and its promoters, and also
whether the foreign investor otherwise carries on the business of being a venture
capital fund outside India.
This contention was reinforced when India's central bank, the Reserve Bank of
India (RBI), amended the Foreign Exchange Management (Transfer or Issue of
Security by a Person Resident outside India) Regulations, 2000, to specifically
bring within its fold investments by a Sebi-registered FVCI in a domestic, Sebi-
registered venture capital fund or an unlisted Indian company. The effect of the
amendment is that such an investment will no longer be regarded as FDI, but as
a separate category of investment. The advantage of such treatment is that
shares issued by unlisted Indian companies to an FVCI will not be subject to
compliance with the usual price guidelines and the FVCI may acquire or
purchase the shares issued by unlisted Indian companies at a price that is
mutually agreed between the buyer and the seller or issuer.
Advantages of Regisration
The obvious advantage of registration is that, under the IT Act, its income is tax
free. But another advantage is that under the normal FDI rules, all FDI investors
require the central government's prior permission to invest in a similar field to any
of its previous investments or tie ups. In other words, automatic approval is not
allowed and a no-objection certificate of the Indian investee company (with whom
there is an existing tie up) is required. However, Sebi-registered FVCIs are
exempted from this requirement.
Taxation of FVCI
Under Section 90(2) of the IT Act, a non-resident assessee based in a country
with which India has a double taxation avoidance agreement (DTAA), may opt to
be taxed either under the IT Act or the DTAA, whichever is more beneficial?
Under Section 10(23FB) of the IT Act, any income of a registered FVCI is exempt
from income tax. The FVCI can carry on business in India through a permanent
establishment in India, and yet its entire income would be tax free. On the other
hand, if the FVCI opts to be taxed under the DTAA and it has a permanent
establishment in India, its Indian income will not be tax free.
The tax exemption under section 10(23FB) has to be read with section 115U of
the IT Act, which confers a pass-through status on Sebi-registered venture funds.
Investors in such funds would be liable to tax in respect of the income received
by them from the FVCI in the same manner as it would have been, had the
investors invested directly in the venture capital undertaking. In other words,
income earned by an FVCI by way of dividend, interest or capital gains, upon
distribution, would continue to retain the same character in the hands of its
investors.
Are non-resident investors in an FVCI, therefore, liable to pay Indian income tax
on what they receive from the FVCI as business profits, even though the FVCI
itself does not have to pay any tax? Although Section 115 U begins with the
words ‘Notwithstanding anything contained in any other provisions of this Act',
and it would override the normal provisions relating to taxability of individual
items of income, it cannot override Section 90(2) relating to DTAA provisions.
India is a signatory to the Vienna Convention on the Law of Treaties and,
therefore, tax treaties have a special status as compared to domestic tax
legislation and would prevail unless there is an express specific domestic
provision to override the treaty. In the present case, it does not appear to be the
intention of the legislature that Section 115 U should override Section 90(2).
Structuring FVCI’s
On account of its favorable DTAA with India, Mauritius has become a favorite
jurisdiction for investing into India. An obvious question arises. If the FVCI is to
avail of the total tax exemption under Section 10(23FB), why does it require to be
incorporated in Mauritius or any other country with which India has a favorable
DTAA? The answer is, that having regard to the legislative fickleness with which
the IT Act is amended annually, even if the tax exemption provisions contained in
Section 10(23FB) are withdrawn, the FVCI could then rely upon the provisions of
the DTAA, so that its income continues to be tax free. So, there is dual
protection. Of course, in such an event, the FVCI cannot have a permanent
establishment in India.
The FVCI can be incorporated as a Mauritius offshore company and will be a tax
resident of Mauritius. This process is quick and user friendly. The second step is
to register with Sebi as an FVCI. If the FVCI intends to have a place of business
in India, under the Foreign Exchange Management (Establishment in India of
Branch or Office or other place of Business) Regulations, 2000, it will require RBI
approval.
Before investing in a venture capital undertaking, the FVCI will have to apply to
RBI, through Sebi, for permission. Given the manner in which these Regulations
are drafted, it appears that the FVCI may have to obtain such permission on a
case-by-case basis, every time it makes an investment. However, in practice,
RBI may grant a general or blanket permission as in the case of foreign
institutional investors.
Conclusion
As is evident from the above analysis, there are still a couple of grey areas which
require tax planning for FVCI and their investors. While Sebi efficiently handles
registration, formal permissions under Exchange Control Laws are still required.
However, the entire process of setting up an FVCI is much simpler now and can
be completed in as little as 90 days. The total tax exemption makes these
investments very attractive indeed.
Other than investment, the permitted activities of a fund, however, are limited. No
services such as incubation services may be provided. A separate entity would be needed
in order to provide such services. There may also be restrictions on where the fund can
raise money. There are two additional advantages of investment through a SEBI
registered fund. Upon an IPO in India, all shares held pre-IPO are locked up for one year.
This lock up requirement does not apply to shares held by SEBI registered VC funds
provided such shares have been held for at least one year prior to the IPO. Secondly,
there is a proposal to treat nominee directors of SEBI registered funds as independent
directors under the corporate governance guidelines for listed companies which could
help in complying with the guidelines.
The tax residency certificate is sufficient evidence for India tax authorities to
accept the status of Mauritius tax residence according to Union of India vs. Azadi
Bachao Andolan, 2003 SOL 619.
The Indian government is advocating changes in the Treaty which would reduce
the tax benefits of using Mauritius. As of February 2007, Mauritius has agreed to
have tax residency certificates be effective for only one year at a time and to
impose new undertakings as a condition for issuing a certificate
A U.S. investor should not underestimate the legal and operating requirements of
the Mauritius structure. For example, funds to be invested in or loaned to the
India subsidiary should be wired first to the Mauritius company prior to
investment in India as opposed to a wire transfer of funds directly from the U.S.
investor to the India company. A wire transfer directly from the U.S. to India is an
investment in the India company by the U.S. company not the Mauritius
company. The Board of Directors of the Mauritius company should approve the
investment and funds should be wired to the Indian company from the Mauritius
company. All such actions take time and documentation in order to comply with
corporate governance requirements.
There are several recent tax rulings that need to be considered in avoiding
permanent establishment status. Under Rulings 442 and 566 of the India Tax
Authority for Advance Rulings (“AAR”), activities such as the Mauritius company
engaging an Indian firm for providing custodial services for securities or being an
investment adviser that has no decision making authority will not by themselves
constitute having a permanent establishment in India. Investment decisions must,
however, be made outside of India.
In the case of Morgan Stanley & Co v. DIT, the AAR examined whether a U.S.
company had a permanent establishment in India under the Treaty based on (1)
outsourcing certain services to its subsidiary in India and (2) deputation of
personnel to the subsidiary. The personnel deputed to India were engaged either
for providing stewardship services to the Indian company or to work under the
control of the Indian company. The AAR held that the outsourcing activity by the
U.S. company to its subsidiary did not result in the parent having a permanent
establishment in India. The AAR, however, held that the deputation arrangement
in India would result in a permanent establishment of the parent. Therefore, the
income deemed to have been derived by the U.S. company from the deputation
activity in India would be taxable in India. Until March 31, 2009, income arising
from export revenues from software and BPO activities rendered from a
“Software Technology Park Unit,” is liable to be taxed only at the minimum
alternative tax rate of 11.33% instead of the normal corporate tax rate of 33.99%
provided the transactions between parent and subsidiary are at arms length
prices. It is not clear whether this benefit will be extended beyond March 31,
2009.
Another alternative would be to route investment into India through Cyprus rather
than through Mauritius. India and Cyprus are also parties to a tax treaty. The tax
treatment for capital gains
from the sale of shares in an Indian company held by a Cyprus holding company
is the same as through Mauritius so long as the Cyprus company does not have
a “permanent establishment” in India. There is no capital gains tax in either India
or Cyprus on the sale of the shares.
Cyprus has a slight economic advantage over Mauritius when an investment is
by way of a mix of equity and debt.
As with Mauritius and Cyprus, the primary benefit under the India-Singapore
Double Taxation Agreement (the “Agreement”); which became effective on
August 1, 2005, is no capital gains tax in either India or Singapore on the sale of
the shares of the Indian company by a Singapore company so long as the
Singapore company does not have a “permanent establishment” in India.
The requirements for Singapore tax residency are much greater than in Mauritius
or Cyprus. The Singapore company must satisfy expenditure requirements and
likely have sustainable and continuous business operations in Singapore. Annual
expenditures on operations in Singapore must be at least $200,000 (SGD) in the
24 months immediately prior to when the gains are realized.
First on the pass through benefits: The Finance Bill, 2007 proposes to restrict the
pass through status for Venture Capital Funds ("VCFs")/Venture Capital
Companies ("VCCs") to only income from investment in domestic unlisted
company engaged in certain specified businesses such as IT, bio-tech etc
("VCU").
Venture capital is not suitable for all businesses, as a venture . capitalist typically
seeks:
Superior businesses Venture capitalists look for companies with superior
products or services targeted at fast-growing or untapped markets with a
defensible strategic position. Alternatively, for leveraged management
buyouts, they are seeking companies with high borrowing capacity, stability
of earnings and an ability to generate surplus cash to quickly repay debt.
Exit plan Lastly, venture capitalists look for clear exit routes for their
investment such as public listing or a third¬party acquisition of the investee
company.
Origination of deal
A continuous flow of deal is essential for the venture capital business. Deals may
originate in various ways: (i) referral system, (ii) active search and (iii)
intermediaries. Referral system is an important source of deals. Deals may be
referred to VCFs by their parent organisations, trade partners, industry
associations, friends etc. Yet another important source of deal flow is the active
search through networks, trade fairs, conferences, seminars, foreign visits etc. A
third source, used by venture capitalists in developed countries like USA, is
certain intermediaries who match VCFs and the potential 'entrepreneurs.
Through this screening the venture firm builds an initial overview about the
Technical skills, experience, business sense, temperament and ethics of the
promoters
The stage of the technology being used, the drivers of the technology and the
direction in which it is moving
Location and size of market and market development costs, driving forces of
the market, competitors and share, distribution channels and other market
related issues
Financial facts of the deal
Competitive edge available to the company and factors affecting it
significantly
Advantages from the deal for the venture capitalist
Exit options available
Due Diligence
Once a proposal has passed through initial screening, it is subjected to a detailed
evaluation or due diligence process. Most ventures are new and the
entrepreneurs may lack operating experience. Hence, a sophisticated, formal
evaluation is neither possible nor desirable. The venture capitalists, thus, may
rely on a subjective, but comprehensive, evaluation. They evaluate the quality of
entrepreneur before appraising the characteristics of the product, market or
technology. Most venture capitalists ask for a business plan to make an
assessment of the possible risk and return on the venture. Business plan
contains detailed information about the proposed venture.
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 ie 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.
• Detailed evaluation Once the project has crossed the qualifying hurdle
through initial evaluation, the proposal is evaluated in greater detail. A lot of
stress is placed on techno-economic evaluation. Most of the VCFs involve
experts for the technical appraisal, whenever necessary. The venture
evaluation in India, after receipt of the business plan, starts with a detailed
evaluation of the entrepreneur's background. VCFs in India expect the
entrepreneur to have:
integrity
long-term vision
urge to grow
managerial skills
commercial orientation.
It can be seen that the project ranking is reversed when the discount rate is
changed from 5 per cent to 10 per cent. The reason lies in the cash flow patterns.
The impact of the discounting becomes more severe for the cash flow occurring
later in the life of the project; the higher is the discount rate, the higher would be
the discounting impact. In the case of Project B, the larger cash flows come later
in the life. Their present value will decline as the discount rate increases.
• Time value The IRR method recognizes the time value of money.
• Profitability measure It considers all cash flows occurring over the entire
life of the project to calculate its rate of return.
• Acceptance rule It generally gives the same acceptance rule as the NPV
method.
• Shareholder value It is consistent with the shareholders' wealth
maximization objective. Whenever a project's IRR is greater than the
opportunity cost of capital, the shareholders' wealth will be enhanced.
Like the NPV method, the IRR method is also theoretically a sound investment
evaluation criterion. However, IRR rule can give misleading and inconsistent
results under certain circumstances.
Profitability Index
Another time-adjusted method of evaluating the investment proposals is the
benefit-cost (B/e) ratio or profitability index (PI). Profitability index is the ratio of
the present value of cash inflows, at the required rate of return, to the initial cash
outflow of the investment The formula for calculating benefit-cost ratio or
profitability index is as follows:
N
PV of cash PV(Cr) ∑ Cr
PI= inflows = = r +C0 (5)
r
Initial cash =1 (1+k)
outlay
Acceptance Rule
The following are the PI acceptance rules:
• Accept the project when PI is greater than one PI > 1
• Reject the project when PI is less than one. PI < 1
• May accept the project when PI is equal to one PI = 1
The project with positive NPV will have PI greater than one.
PI less than means that the project's NPV is negative.
Evaluation of PI Method
Like the NPV and IRR rules, PI is a conceptually sound method of appraising
investment, it projects. It is a variation of the NPV method, and requires the same
computations as the NPV method.
Like NPV method, PI criterion also requires calculation of cash flows and
estimate of the discount rate. However, in practice, estimation of cash flows and
discount rate pose problems.
While there are good reasons for using PE ratios, there is wide potential for
misuse.
Expected growth rate in earnings in other the high growth and stable periods: the
PE ratio increases as the growth rate increase, in either period.
Second, the volatility of earnings can cause the PE ratio to change dramatically
from period to period. For cyclical firms, earnings will follow the economy,
whereas the prices reflect expectation about the future. Thus, it is not uncommon
for the PE ratio of a cyclical firm to peak at the depths of a recession and bottom
out at the peak of an economic boom.
Conclusion:
The PE ratio and the other earnings multiples which are widely used in
valuations, have the potential to be misused. These multiples are ultimately
determined by the same fundamentals that determine discounted cash flow value
- expected growth, risk, and payout ratios to the extent that there are differences
in fundamentals across countries, across time and across companies, the
multiples will also be different. A failure to control for these differences in
fundamentals can lead to erroneous conclusions based purely upon a direct
comparison of multiples.
Conclusion:
The relationship between price and book value is much more complex. The PBV
ratio of a firm is determined by its expected payout ratio, its expected growth rate
in earnings, and its riskiness.
The most important determinant, however, is the return on equity earned by the
firm – higher returns lead to higher PBV ratios and lower returns lead to lower
PBV ratios.
The mismatch that should draw investor attention is the one between return on
equity and PBV ratios – high PBV ratios with low returns on equity are
overvalued and low PBV ratios with high returns on equity are undervalued.
2. RISK
Risk is also one of the important factors to value the business of an entrepreneur.
The various aspects to be looked for are
• The external and the internal risk that is the price risk .
• The manageable and non-managable risk.
• The mitigatin factors that is the brand and distribution risk.
3. MANAGEMENT QUALITY
Management quality is also to be evaluated properly before valuing a business.
The important factors to be considered in evaluating management quality are
• the reputation of the management
• the competence of the management
• the vision of the company
• the corporate governance of the management
The venture companies like deal to be structured in such a way that their interest
are protected. They would like to earn reasonable returns, minimize taxes, have
enough liquidity to operate their businesses and remain in commanding position
of their businesses.
There are number of common concerns shared by both the venture capitalist and
the venture companies. They should be flexible, and have a structure that
protects their interest and provides enough incentives to both to co – operate
with each other.
Preference Shares
Redeemable Preference Shares
These shares are redeemed as Preference shares when the Venture has
been established, providing an easy exit
2. Conditional Loan
It is a Quasi Equity Instrument, which does not carry a fixed rate of interest
or a pre determined repayment schedule but is liquidated by payment of
Royalty on sales. It is akin to Equity in the sense that the returns to the
financer are performance based. The Royalty is payable only if the
Venture succeeds and the investee company makes Sale
3. Income Notes
This is a type of loan that carries a flexible nominal interest. The
repayment of the principal is specified over a period besides there is a
Royalty on Sales
Off late, VC’s have started using a variety of innovative Quasi Equity
Instruments. The important ones are as follows:
3. Bridge Loans
These are Short Term Loans provided to a company contemplating a
Public Issue to increase its Valuation
4. Shares Warrants
This is a Right granted to the investor to purchase Equity Shares at a pre
determined price on a later date. This normally provides for the expansion
finance required by the investee company and ensures capital gains from
successful Ventures
In Accordance with the world wide practice the bulk of VC investment in
India is in Equity shares. Initially there was a higher proportion of
conventional loan but later it was reduced and its place is been taken by
various innovative Quasi Equity Instruments. With VC financing getting
mature, Preference Shares and Convertible Debts are becoming more
popular. Today VC funds use more than one instrument for their
investments
13.1.Seed Stage
Financing provided to new companies for use in product development and initial
marketing constitutes Seed Stage. Eligible companies may be in the process of
being setup or may have been in business for a short time or may not have sold
their product commercially. This is the financing provided to companies when the
Initial Concept of the business is being formed
13.2.Startup
Financing provided to new companies, for manufacturing and commercializing
the developed products, represent Startup. The companies may be in their initial
stages of development and finance may be extended for creation of new
infrastructure and meeting the Working Capital Margin
13.5.Turnaround Financing
Capital provided for companies that are in operational or financial difficulties
where the additional funds would help in Turnaround Situations
Earlier VC funds use to invest in Seed and Startup stages and very rarely in
Turnaround Stages, but off late the trend is changing and VC funds are a part of
every stage and are also actively participating in Turnaround Stages through
buyouts and takeovers.
XIV. DOCUMENTATION
The different legal documents that are to be created and executed by the
venture firm are
a. Capital structure
b. Transfer of shares: This lays the condition for transfer of equity between
the equity holders. The promoters cannot sell their shares without the prior
permission of the venture capitalist.
c. Appointment of Board of Directors
d. Provisions regarding suspension / cancellation of the investment:
The issues under which such cancellation or suspension takes place are
default of covenants and conditions, supply of misleading information,
inability to pay debts, disposal and removal of assets, refusal of disbursal
by other financial institutions, proceedings against the company, and
liquidation or dissolution of the company.
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:
1. Buy back of shares by promoters or company
2. Sale of stock (shares)
3. Selling to a new investor
4. Strategic / Trade sale
1. BUY BACK / SHARES REPURCHASE
Buy back or shares repurchase has the following distinct forms:
The investee company has to buyback 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.
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 disinvestment 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.
b. Book Value
A less common formula is based on book value of the company. It’s simple to
compute the book value per share for stock owned by the venture capitalist. That
would be the price the entrepreneur or the company would pay for the shares
owned by the venture capital company. Book value per share is seldom used
because in the early years of a company’s development the company usually has
a small book value. It’s only in older companies that have been around long
enough to establish a good book value that this becomes the method of valuing
the venture capitalist’s equity position.
c. Percentage of Sales
Sometimes it is inappropriate to use the earnings of the company in a price-
earnings formula because in the early years of development, particularly in a
start-up company, the earnings may be low owing to heavy depreciation or
research and development expenses. It may take several years for the company
to become profitable. Using pretax earnings may seem to be more appropriate.
However, pretax earnings are held low often because of heavy salaries or heavy
expenditures for promotion. In such a case, it may be easier for the entrepreneur
to take the normal profit before tax as a percentage of sales typical for the
industry. Find statistics on the industry in publications on business statistics. It is
found that most companies similar to the entrepreneurs have a pre-tax earnings
of 10 percent of sales. It would be simple, then, to take 10 percent of this
company’s sales and pretend that number is the profit before taxes. Then the
entrepreneur would determine earnings per share by using the hypothetical profit
before taxes. Using the industry price-earnings ratio, he could easily determine
what the value of the stock owned by the venture capital company would be
worth if the hypothetical earnings existed. This can be the method used for
buying back the shares owned by the venture capital firm.
Using the percentage of sales formula to value and buy back the shares owned
by the venture capitalist can be very expensive.
e. Multiple of Sales
The value of some companies in certain industries is based on a multiple of
sales. Radio stations traditionally sell at two to three times gross sales. If you
determine the value of a company to be two and a half times gross sales, it
would be simple then to compute the value of the venture capitalist’s percentage
of equity ownership and pay him that amount for his ownership in the company.
As in the percentage-of-sales calculation above, the multiple-of-sales valuation
also means you will be paying for a company that may or may not have earnings.
Many investors in the radio business buy a poorly-run station on a multiple- of-
sale calculation knowing full well that the station’s earnings cannot possibly pay
back the investment. The investor who is buying the station must put in enough
money to carry the station until its sales and earnings can be increased. In fact,
the earnings must increase drastically if he is to pay back any debt and get an
adequate return on the money invested.
f. Appraised Value
It is often easy to find an expert individual or a stock brokerage firm to appraise
the value of the equity ownership held by the venture capital company. The
appraisal will probably be based on a combination of some of the items above.
Appraisals are usually computed by two methods. First, the value of the company
is determined by its earning power, both past and future. This formula is similar
to the price earnings ratio used above. Second, the values of the assets (bricks
and mortar) are determined as if they were sold at auction as part of an orderly
liquidation. From this liquidation the appraiser subtracts all debts outstanding,
and the remaining value is the appraised value. The bricks-and-mortar formula is
similar to the book-value calculations, except there it includes an appraisal of the
assets and a restated new book value based on their appraised value. When
these two figures do not agree, the appraiser usually selects something close to
the higher of the two. For example, if the bricks-and-mortar formula was higher
than the earnings formula, the appraiser would assume that the highest and best
use of the company was to sell all of its assets.
b. The process establishes the fair price of the company’s securities. Venture
capitalist can obtain a higher price for his equity and the same is useful for the
promoters as it increases the valuation of the company.
c. Quite often the new stock is offered for sale rather than the venture capitalist’s
equity or sometimes a part of venture capitalist’s equity is clubbed with the new
equity. This on one hand improves the company’s net worth and provides funds
for growth and expansion, one the other enables the venture capitalists to get a
higher price of its equity after listing.
d. It paves the way for the company to raise funds for future growth, as it is
easier and less costly for the listed companies to raise capital from the market.
e. The company may get a tax break as listed companies usually pay tax at a
lower rate.
d. The listed companies are required to disclose sufficient information about their
operations. The competitors can abuse this information. The knowledge
about the company’s profitability sometimes leads co labour problems with
workers demanding higher wages.
Disinvestment 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. This imparts liquidity and breadth to the market. 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 provides liquidity to the
investors. For instance in U.S. the National Association of Securities Dealers
Automated Quotation System (NASDAQ) is an important OTC market. Today
NASDAQ has a concentration of technology stocks and is considered the hub of
venture capital activity in U.S.
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.
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 being 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. There are occasions when the equity is sold by the owners against notes
to be received from the buyer. These notes are often secured by the assets of
the company and are redeemed at the predetermined intervals. The deferred
payment through notes is popular as it helps in tax planning by the seller.
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. For instance Bhatia remained his company’s top
executive after it became a subdivision of Microsoft’s Web basics.
Investment Focus:
They strongly believe in the entrepreneurial skills of young Indians and would like to
support new ventures. They believe that they can help budding entrepreneurs and also
create decent amount of wealth by leveraging their knowledge and contacts in the
industry. They also believe that there is a huge need for early stage financing in the
industry today as most of the VCs & PEs are interested mainly in later stage financing
due to higher returns in lesser time period.
After working through the numbers, they decide to start their firm by raising $100 million
to invest. They name their fund as Venture Capital Fund of India (VCFI). They decide to
form a Pvt. Ltd. Co. to limit personal liability as this involves huge amount of money.
They appoint themselves as the directors of the company with a fixed salary.
Gathering Funds:
Aman & Shivam who have great convincing power use their contacts in the industry to
gather the funds from investors like the corporates, individuals, and banks for their VC
fund.
Promising returns:
From VCFI’s perspective these investors are their customers and Aman & Shivam have
promised to invest their money wisely and fetch them higher returns than what they
would have got by investing in other avenues like MFs, stock markets, debt markets or
even any other venture capital fund. Now as they will be investing in early stage
companies the risk will be more and hence the returns expected by their investors would
also be higher. Suppose the investors expect an average return of 20% y-o-y from a
venture fund which invests in later stage of companies, then they might expect a return
of at least 25% from VCFI, excluding the fees paid to them.
Setting up the fund:
Once the money is received from the investors the four put it in a ‘fund’ which will invest
in young companies. They decide that the fund will be a “closed ended fund” with a 10
year duration, which means that they can not add any more funds to this fund until the
end of 10 years when it matures. At the end of 10 years VCFI will have to give the
money back to the investors plus what they have earned, minus their fees, their share
from profits and any money that they might have lost. VCFI may also decide to return the
money back to investors the interim period.
25% Technology
Retail
Biotech
25% 30%
Power (non-
20% convnetional)
Structuring deals:
The promoters of VCFI decide to use both debt and equity instruments, to structure their
deals which they enter into with young companies. The criteria for choosing the type of
instruments it uses to design a deal will depend on factors like perceived risk of the
business, current size of the company, financial strength of the promoters, experience,
skills and credibility of promoters, standing of the company as compared to its
competitors, expected returns from business and so on.
In accordance with the general market practice VCFI would like to keep majority of their
investments in equity shares. They plan to use equity and quasi equity instruments like
Preference Shares and Convertible Debts respectively.
“You’re only as good as your last exit,” explained a leading venture capitalist to the
newcomers at VCFI. The implicit requirement in delivering returns is, of course, that the
venture capitalist has to “realize” his return. In other words, it’s not good enough to point
to a fast growing company and a fast growing balance sheet. Venture capitalists have to
actually hand cash or freely tradable shares back to their Limited Partners during or at
the end of the 10 year fund.
Therefore, VCFI must be able to “exit” their investments in order to capture the upside
from their deals. You only get into a deal, if you can see several good ways to get out.
The promoters of VCFI divide responsibility of monitoring and also help in managing the
companies whom they finance. They set themselves a target to handle 2-3 new
investments each year for the duration of the fund. So if they finance 32 ventures in total,
then they assign 8 companies to each promoter, over the life of the fund, to monitor and
work closely with. Off course they can take each others help if they feel that the skills or
knowledge of the other person can help the company that they have financed as a VC.
Thus, by diversifying their portfolio, dividing the work and keeping the number of
investments at manageable levels they not only can minimize risk but also make sure
that they do not allow things to go out of hands.
While doing the math, they also realize that if each partner can only invest in 8 deals,
with 4 promoters at VCFI, the average deal size will have to work out to just over $3
million over time. If some deals fail, that means that the companies have to be able put
$5 million to effective use, with the investments in each company staged over time.
With these assumptions and projections the four promoters at VCFI close their fund and
start the process of analyzing and selecting companies in which they would like to
invest.
XVII. BIBLIOGRAPHY
References :
1. www.sebi.gov.in
2. Principles of Financial Management by I.M. Pandey
3. www.indiavca.org
4. www.nenindia.org
5. Investment Valuation by Aswath Damodaran