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Case Study On Saraf On Ventur Financing
Case Study On Saraf On Ventur Financing
Cornell University Johnson Graduate School of Management NBA 593 International Entrepreneurship
Auke Cnosssen, MBA 04 prepared this case study under the guidance of and with Professor Melvin Goldman as the basis for class discussion rather than to illustrate either effective or ineffective handling of a business situation.1
Venture Capital (VC) was just being experimented with by a development financial organization (DFI) when the World Bank was developing a scheme to promote technology development in the private sector. It identified VC as having enormous potential in India and identified organizations to spearhead the effort including the Gujarat Industrial Investment Corporation. The Government of India announced guidelines for VC funds in India in 1988. With the help of the World Bank the VC industry did eventually gain momentum in the late 1980s and early 90s. The program involved setting up VC firms and recruiting and educating people with proper backgrounds. Internship programs for 18 would-be venture capitalists were set up with US firms in order to introduce the required knowledge and develop the man power. In total nine funds were set up with total capital of $180 million for 350 investments. India generally is considered entrepreneurial. However, industry was very much dominated by the public sector and several family-led large industrial conglomerates like Tata and Mahindra. Entrepreneurs tended to start as traders and build their businesses up based on retained earnings. They needed to learn to deal with inadequate financing and infrastructure and a difficult regulatory environment. For new entrepreneurs, it was particularly difficult to obtain bank finance and there was no services industry to support new entrepreneurs with few resources. The problem was far worse for those starting a business based on new technology and new markets.
should work hand-in-hand with the entrepreneur. GVFL was pioneering in a number of ways. It convinced the parents and lead investors to invest all over India as well as across industries. The first fund (Gujarat Venture Capital Fund 1990) was targeted at start-up companies based on new and untried or closely held technologies, innovative products or processes and services. Since there was no experience in India to build on, GVFL took extra time to invest the funds. The broad based fund was invested in over 25 companies. The total fund size was 240 million Rs. and the fund had an intended life span of 15 years. Exhibit 1 shows the details of the fund. As of 1999, the fund was fully invested and pay-outs to investors had started. Following the success of GVCF-1990, in terms of identifying promising VC investment opportunities, GVCF-1995 was launched. Investors included many of the investors of the earlier fund. The second fund was invested nationwide and shifted in focus towards funding new as well as small to medium sized companies with a sustainable competitive edge. Total fund size was 600 million Rs. and the life span was 12 years. By the end of 1998, 240 million Rs. had been invested in 15 companies. The third fund (GVCF 1997) was started in 1997 with an emphasis on the IT industry. The fund had a size of 400 million Rs. and a life span of 12 years. The fund focused on Software and Information Technology- an area where India has established strong core competencies on a global level. Four investments totaling 71 million Rs. had been made by the end of 1998.
and 30 to 35% of equity would have to be brought in by the promoter of the project. Interest rates in 1991 were on the order of 21%. (inflation was in the double digits). DFIs were focused on industrial projects with significant collateral in the form of assets. Service companies, and software companies in particular, had a hard time securing loans for starting or expanding a business. Since the late 1990s there has been a trend in India of mergers between DFIs and banks. This trend was accompanied by these institutions going public and has led to innovation and to one stop financing of enterprises. Another characteristic of the lending industry in India was that loans were based on a pari pasu agreement, meaning that there was no seniority of debt. All parties involved in investing in a company had the same rights on the assets of the company. In case of financial problems, all parties thus had to agree with each other on the action to be taken. Given the nature of the financial system in India, entrepreneurs faced many difficulties financing new ventures. High tech, service oriented, and high growth companies had very different characteristics than the traditional industrial clients of the DFIs. If financing could not be secured through DFIs or banks, the only remaining source would be family, friends and some rare seed funds for first generation entrepreneurs.
In India, the typical J-curve for a start-up company was much longer term as growth tended to be slower. The up-side for a VC was thus also more limited, requiring Indian VC investments to be structured differently compared to US VC investments. Amounts invested in start-ups were much smaller and investments were made in phases, because of the higher risks, lower burn-rates, and longer time-frames to reach maturity. VCs needed to look for other ways of putting in money and generating a return, besides equity investments. Examples were convertible stock, debentures, and royalty payments. Royalties allowed the VC to get a significant up side, while limiting the costs to the entrepreneur during economic downturns. In the latter 1990s, foreign VC groups, particularly angel investors and successful entrepreneurs in the US and UK, began to take a serious interest in India. Most, however, quickly moved to private equity where risks were fewer compared to seed stage VC. Most of the domestic VC firms also changed from seed stage investing to private equity. Although a significant number of seed stage investments had been made, few successful exits had been realized. The shift towards private equity did help develop this industry and would in the long run provide more exit opportunities for VC. However, seed stage investing still had a long way to go as of the late 1990s before being able to attract significant capital from investors. 90% of VC firms were institutional VC firms that were funded by one of the DFIs. Many VC management companies were structured with a CEO with subordinates. The institutional framework hindered the VCs; they were less agile for a dynamic VC industry. People with an institutional background were used to doing larger deals than the typical VC deal. Because the concept of partnership was not fully developed, the incentives for VCs were also not well developed. Cultural issues also complicated VC investments. Indian entrepreneurs were very individualistic, preventing them from being able to let go of their company, hindering an exit in the form of an acquisition or merger. The Indian entrepreneur, typically with an engineering and finance or MBA degree, wanted to control all fields within a company himself. This caused problems when companies grew and were in need of people with more specialized knowledge in for example finance or marketing. The individualistic mindset was overcome by clauses in the term sheet that required the entrepreneur to hire appropriate expertise when requested by the VC. Entrepreneurs frequently came from wealthy and successful business families, the middle class, or were managers from large corporations. Entrepreneurs typically had a high equity stake in their companies as they had difficulties giving up part of their company. In addition, VCs wanted to see a substantial commitment by the entrepreneur. Mr. Varshney commented on how a VC would ensure control over an investment in which it had a minority stake: The large equity stake held by the entrepreneur gives him less incentive to run off with the money invested by the VC and gives him an incentive to work harder. We make sure that we have enough control by making the entrepreneur realize that a VC investment is a partnership and that we are on the same side of the table. A strong relationship with trust is very important. The entrepreneur has to see the benefit of the relationship with the VC.
VCs generally had one or two board seats. However, few decisions were taken by the board. Board meetings were a formality to inform people. Important decisions were made between the entrepreneur and the head of the VC firm. Industries that were attractive for VC, like telecommunications and IT were not well developed, and VCs thus had difficulties creating a good management team and finding experienced board members. Obviously, this gradually changed by the late nineties as IT and telecommunications grew rapidly. Even though the upside of a VC investment in India was limited by slower growth rates and difficulties getting ventures off the ground, many people felt that VC could work in India as the number of companies that reached maturity tended to be higher compared to the Western World. Indian companies were better able to survive a setback or economic down turn because: - Indian entrepreneurs tended to be conservative about spending money; - Burn rates in India were much lower and it was easier to reduce costs during a set back; - Indian entrepreneurs often came from business families and managed to raise funds within their own network/family when needed when they were in financial distress. As a result, the India VC industry saw fewer companies that gave a return of 100x or 200% IRR, but did show more companies returning a 30 to 40 % IRR compared to their Western counterparts.
significant investments in fixed assets. Besides investing family funds, Saraf needed additional financing to get the venture started and therefore approached GIIC. GIIC concluded that Saraf Foods was too risky: project cost particularly for the equipment was high; there was no experience in India of VFD for fruits and vegetables and there was no marketing experience in the area. In addition, it would take at least a couple of years before the company could launch a product on the market, too long to service a traditional term loan. The difficulty that GIIC saw was that it would be hard to secure any contracts without having built a plant. The company would therefore have to invest much time and money into building the plant and developing the product. Mr. Saraf was found to be a very capable entrepreneur who was open-minded to input from others regarding his business idea. Saraf initially had the ambition to develop a product for the end-consumer. Plans were to launch the companys own product on the shelves of food retailers. It was clear to GIIC that this was too ambitious. GIIC did see the capability of drying tropical fruits (which should be exported to the US) as the competitive edge compared to producers of freeze dried food in the US and Europe. However, capital expenditures would have to be kept low by development of machines in India. Another concern of GIIC was that power was relatively expensive in India (at the time around 10 US cents per kWh). It was also unclear to GIIC if there where any economies of scale. The variable costs, energy and raw materials, didnt decrease much in price if purchased in larger quantities. In addition, VFD drying units had a maximum size and increasing the capacity would simply mean increasing the number of units. The GIIC officers, however, neither rejected nor approved the idea. Through the VC network of GIIC, the business proposal ended up on the desks of Mr. Varshney and his new deputy Trivedi (who knew about the project from his recent work in GIIC) in January 1991. Both recognized that the idea had potential as it involved a new technology, used indigenously sourced raw materials, and was exported oriented. This was in line with the focus of the GVCF - 1990 fund. The project promised a 25+ % IRR with the prices quoted by Saraf. In addition, Saraf came from a trustworthy and successful business family. GVFL put together a due diligence team for evaluating the technology and market prospects. With Saraf, GVFL further developed the business proposal over the next couple of months. GVFL did the required due diligence on Saraf and his familys business and concluded that Saraf was very knowledgeable in the area and had a good understanding of the technology, as initial tests had been conducted at the CFTRI. Examination of the family businesses was satisfactory. An appraisal report was written and sent to the World Bank for approval in April of 1991. After a series of communications in May, the World Bank approved and suggested that the project be divided into two phases. Phase one would involve additional testing at the CFTRI to further develop the process and produce samples and a trip to Europe and the US for market research and to gauge interest with potential buyers. Phase two would be initiated if the results of phase one were satisfactory and involve project implementation during which the factory would be set up.
the most stringent, thereby making it relatively easy to approach other European countries at a later date, once the company had moved into Germany successfully. Given the attractive fruit market compared to the vegetable market in Germany, the company chose to devote 75% of total production to tropical fruits and 25% of production to vegetables. The product mix had been chosen based on local availability, marketability, price competitiveness and seasonal availability. Production would include Mango (75 production days), Sapota (60 production days), Papaya (70 production days), Guava (20 production days), Capsicum (30 production days), Ginger (30 production days), and Coriander (15 production days). The pricing strategy would be based on quotations received from the German buyers Prices quoted to Saraf Foods are shown in Exhibit 2. Exhibit 3 shows the pro-forma income statement for Saraf Foods, as used in the appraisal report. The prices of freeze dried vegetable and fruits were about 8 to 15 times higher than those of air dried products. About 25% of the total costs were budgeted for energy, 20% for raw materials, 20% for labor, and 35% for fixed costs like financing, depreciation, and general expenses.
Commercial production
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On paper, the plant was declared ready in March 1993 in order to receive the subsidy. However, problems were detected in the blast freeze drier supplied by equipment manufacturer Alfa Laval. The defrosting system was not operating properly and the door of the freezer was leaking. Alfa Laval was informed of this problem, however, it took them until July 1993 after intervention of GVFL to rectify the problems. As a result, Saraf Foods suffered significant production losses. Actual production was started in September 1993, eight months behind schedule. The costs associated with the delay was put into expenses, but should have been capitalized. In early 1994, Saraf Foods shipped its first consignments of banana, onion, and okra to the US. The Food and Drug Administration (FDA) detained the load of okra after detecting residues of a banned pesticide. As per the suggestion of GVFL, Saraf Foods subsequently entered into contract farming agreements to minimize future risks regarding pesticides. Saraf Foods offered the customer to destroy the shipment and replace the container free of charges. As a result of all the delays, FY 1993/1994 ended with a loss of Rs. 3,645,000 on sales of Rs. 1,706,000. During 1993, as it became clear that additional financing was needed, GVFL started to sell the venture as an investment opportunity to Canbank Venture Capital Fund (CVCF), a Bangalore based World Bank supported VC. In April 1994, CVCF gave its sanction for funding in the form of equity. CVCF would receive 210,000 shares at a premium of 2 Rs. per share, providing Saraf with Rs 2,592,000 in cash. Exhibit 4 and Exhibit 5 show the balance sheets and income statements of Saraf, respectively.
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The increased marketing efforts led to the signing of a long term agreement with a German marketer of freeze dried foods in 1995. The contract involved monthly dispatches of one container load of onion and banana.
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7% and GVFL reserved the right to convert an amount not exceeding Rs. 3,700,000 out of the principal amount of the Income Note and / or royalty into equity shares. In FY 1995/1996, the companys sales increased to Rs. 9,870,000. The company also reported a small profit of Rs. 145,000. FY 1996/1997 saw a further increase in revenues to Rs. 12,971,000. Profits improved to Rs. 537,000. Since the second dryer was not in operation until December 1996, the 1996/1997 numbers only included several months of operation of the second dryer. Although turnover had increased, profitability was still low. GVFL advised the company to increase the proportion of exotic products in order to improve the margins. By 1997, most of the production consisted of banana, onion, and okra, which was produced for two customers, one in US and one in Germany. These products represented the largest market volume in the VFD market and were the easiest products to market but they had low margins. By the end of 1997 Saraf had made a proposal to produce freeze dried curries according to traditional Indian recipes. After a pre-launch survey, four freeze dried curries were launched under the Fairies brand name in early 1998. Since this was an innovative product for Indian consumers, the company decided to create awareness through point of sale demonstrations and by deputing personnel in cities. The company also sent samples of these curries to its existing customers abroad for market assessment. The products, however, could not reach projected volumes as the price point was considered too high for the Indian market. As a result, a much lower number of shops displayed the product than was anticipated. In early 1998, the German customer informed Saraf that it could not purchase white onions on a regular basis as they could not create a market for it. 1998 brought another breakdown in one of the dryers, which lasted for a month and resulted in a delayed export consignment. The company was also desperately in need of an in-house laboratory, as both major customers were facing problems with high microbial counts. The laboratory would involve an expenditure of Rs. 600,000. GVFL was once again asked to defer one installment by six months. Even though FY 1997/1998 had shown several problems, the company showed an improvement in the financial results. Turnover and profit increased to Rs. 21,205,000 and Rs. 1,928,000, respectively.
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As a result of the onion crisis, Saraf Foods started to experience liquidity problems starting in mid 1998. The company had difficulties servicing the GVFL and GIIC installments and once again had to request GVFL to reschedule payments. In December 1998, GVFL approved the rescheduling of four quarterly principle and interest installments on the Income Note and two quarterly royalty installments. These dues were rescheduled to be paid in ten quarterly payments starting April 1st 2000 and would carry an interest of 20%. GIIC decided in March 1999 to extend the repayment schedule of Saraf Foods by three quarters. The company encountered further liquidity problems when the US buyer did not purchase the three containers of banana they had indicated they would buy. Saraf Foods had already processed 1.5 containers, valued at 2.1 million Rs. By mid April the working capital limit of 5 million Rs. was fully used. Saraf requested GIIC to delay cashing a 425,000 Rs check made out to them. GIIC did cash the check, however, resulting in an overdraft. The German buyer had placed an order for one container of red onion (Rs. 1.4 million), scheduled for processing during April. The State Bank of India agreed to give an additional overdraft facility of 1 million Rs. needed to process this order. The overdraft would help sustain operations during April and May. However, if the US buyer failed to buy the processed banana, Sarafs position would further deteriorate. GVFL officers prepared a detailed cash flow projection and a proposal for rescheduling of dues. The company would need about 2.5 million Rs. for the first half of FY 1999-2000, over and above the rescheduling of income notes. Projected sales for the first quarter of FY 1999-2000 were 3 million Rs., while break even sales were 5.5 million Rs. The resulting cash losses would be around 500,000 Rs. In addition, the company needed between 1.5 million and 2 million Rs. to pay overdue creditors and 425,000 for the GIIC installment. As of mid 1999, the US buyer had placed an order for banana and Okra, totaling 1.7 million Rs. The German buyer had placed an order for banana and white onion, totaling 800,000 Rs. The company had earlier stopped ordering white onions on account of high microbial count. Projected sales for the second quarter were still far below breakeven sales, however. Domestically, the marketing of the curries was still going slow. Several marketing firms, one of which was planning on selling this product in the US, had shown interest but had not given any feedback or placed orders yet. Saraf had also started discussions with the Indian army for the supply of VFD curries, however, there were no firm commitments as of august 1999. It was clear that the company would need additional funding in order to survive. Saraf could request GVFL for funding, but GVFL would demand that Saraf put in a similar about as they put in. Saraf estimated the amount needed from GVFL to be around Rs. 3 million. In addition, Saraf would have to request GIIC to defer an additional four installments on top of three installments that were already deferred. While contemplating the additional investment, GVFL started negotiations with GIIC and SBI to discuss the possibility of increasing the working capital limits. GVFL was concerned that the attitude of the financiers would not be sympathetic, as the companys turnover for FY 1998/1999 had decreased to Rs. 19,352,000 with a profit of only Rs. 920,000. Exhibit 6 shows the cash disbursements and payments received from Saraf. Saraf had made interest payments to GVFL and paid off a portion of the income notes and the bridge loan. Even
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if the company would survive the current crises, it would take several more years before an exit could even be considered.
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Questions
Group A: GVFLSummarize the situation today from GVFLs point of view. Discuss the options available to GVFL (put in the requested money, write-off the investment, find other sources of capital, etc). What should you do? Group B. Suresh Saraf and family membersSummarize the situation as you see it today. Discuss your options. What should you do? Group C. GIIC and SBI. Summarize the situation from your standpoint. What should you do? The following questions should be addressed by all groups: 1. What do you think of the way the investment was structured? Did GVFL function as a true VC firm or were they acting more like a bank? Could GVFL and Saraf have done things differently with regards to financing the venture? 2. What is there in the company that is of any value? How would you go about valuing the company? 3. Looking back, was this a potential VC investment to begin with? What were the strengths and weaknesses of the venture? 4. Does VC have an opportunity to succeed in this difficult environment?
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Exhibit 1. Gujarat Venture Capital Fund 1990 (GVCF 1990) Date of establishment Date of maturity Authorized capital Pay-outs to investors Investment philosophy Preferred stage of investment Target return and period Monitoring Syndications preferred Instruments of finance November 1990 November 2005 Rs. 240 million Rs. 96 million Start-up / early stage 25%, 15 years Hands-on Yes Instruments Equity shares Convertible pref. shares Convertible debt Income note loan Other (temp., bridge loan) Total Stages Seed stage Start-up Other early stage Later stage Turnaround financing Total Number 2 13 2 7 1 25 Rs. million 120,01 15.55 12.90 52.05 32.40 232.91 Rs. million 37.81 115.61 12.85 53.79 12.85 232.91 Rs. million 5.00 12.85 38.25 21.65 3.75 25.88 13.45 9.13 102.95 232.91
Stages of investment
Investment by industry
Industry Number Biotechnology 1 Computer software, service 1 Consumer related 6 Food & food processing 2 Industrial products 1 Medical 2 Other electronics 2 Tel. & data communications 1 Other 9 Total 25 Source: Venture Activity Report 1998. Indian Venture Capital Association.
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Exhibit 2. Prices in US dollars per kilogram quoted to Saraf Foods in 1991 for VFD foods Prices assumed by GITCO1 Prices quoted by German importers Prices assumed by SFPL2 19 11 12 8 11 10 12
Mango 19 18.9 Papaya 12 11.7 Sapota Guava 8 14.8 Capsicum 11 Coriander 12 Ginger 12 Source: Appraisal report 1 Technical consultancy agency 2 Saraf Foods Private Ltd. Exhibit 3. Pro-forma forecasts for Saraf Foods at project inception
Year Production Capacity (metric ton / year) Utilization (%) Production (ton / year) Costs Raw materials Power, fuel, water Wages and salaries Repairs and maintenance Manufacturing overhead Selling/General/Admin. Royalty to GVFL Total cost of production Total sales realization Gross Margin Interest on term loan Interest on working capital Total interest Depreciation Profit before tax Profit after tax 1 2 3 4 5 6 7
10
61 60% 36.6
61 70% 42.7
61 80% 48.8
61 90% 54.9
61 90% 54.9
61 90% 54.9
61 90% 54.9
61 90% 54.9
61 90% 54.9
61 90% 54.9
1,170 840 850 429 362 571 438 5,593 9,284 3,691 752 84 836 1,543 1,312 1,312
1,365 980 935 433 412 650 511 6,348 10,832 4,484 752 97 849 1,543 2,092 2,092
1,560 1,120 1,029 437 462 732 584 7,118 12,380 5,262 694 109 803 1,543 2,916 2,916
1,755 1,260 1,132 441 512 816 657 7,901 13,928 6,027 544 122 666 1,543 3,818 3,818
1,755 1,260 1,245 441 512 849 657 8,080 13,928 5,848 394 122 516 1,543 3,789 3,789
1,755 1,260 1,370 441 512 886 657 8,279 13,928 5,649 244 122 366 1,543 3,740 3,740
1,755 1,260 1,507 441 512 926 657 8,496 13,928 5,432 94 122 216 1,543 3,673 3,673
1,755 1,260 1,658 441 512 970 657 8,735 13,928 5,193 0 122 122 1,543 3,528 3,528
1,755 1,260 1,824 441 512 1,019 657 8,999 13,928 4,929 0 122 122 1,309 3,498 3,498
1,755 1,260 2,006 441 507 1,073 657 9,279 13,928 4,649 0 122 122 61 4,466 4,466
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Current Assets, Loans and Advances Inventory Debtors Cash & Bank Balance 183 Loans & Advances 2,897 Less: Current Liabilities Net Current Assets Total Shareholders Funds Saraf GVFL Canbank Total share capital Reserve & Surplus Net Shareholders Funds Loan Funds Secured Funds Unsecured Funds Miscellaneous Expenditure To the extent not written off Profit & Loss Account Total 14 3,066 4,287
2,600
2,600 2,600
1,683 16
7,995 16
12,098 292
13,897 1,307
8,770 245
17,758 642
15,341 626
18,967 5
(12)
4,287
19
0 0 0
4 2 14
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Exhibit 6. Cash disbursements and payments received from Saraf Foods by GVFL
(amounts in Rupees) Fiscal Year Equity Income Note Disbursement Interest Repayment Brigde Loan Disbursement Interest (25%) Repayment Soft Loan Disbursement Interest (10%) Repayment Fees and Upfront Charges Interest on Funded Interest Other Interest Repayment of NCDs Royalty Net Annual Cash Flow (9,982,500) (1,803,565) 304 (2,253,786) 58,893 (1,339,700) 470,275 2,611,531 691,509 5,176,190 1,114,503 3,825,229 1,028,768 1,660,015 3,364,252 17,500 11,250 135,960 5,849 39,000 486,867 12,393 27,332 56,663 67,750 650,159 74,905 (3,000,000) 210,548 37,743 1,379,040 1,500,000 93,493 1,500,000 (3,000,000) 1,720,824 3,000,000 (7,500,000) 435,185 535,362 41,855 628,956 375,000 1,682,193 1,125,000 710,726 2,000,000 131,247 500,000 (7,500,000) 4,165,524 4,000,000 91-92 (2,500,000) May 92-93 (2,250,000) Aug 93-94 94-95 (1,620,000) Mar 95-96 (2,280,000) Dec 96-97 97-98 98-99 (8,650,000) Total
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