Financial Management

A Report on Venture Capital in India

Report Submitted On: 06/02/2009

In India, major investment are being made in the knowledge based industry with substantially low investments in land, building, plant and machinery. The asset/collateral-backed lending instruments adopted for the hard for the hard core manufacturing industries, are providing to be inadequate for the knowledge-based industries that very often start with just an idea.

The only way to finance such industries through Ventue capital. Venture capital is instrumental in bringing about industrial development, for it exploits the vast and untapped potentialities and promotes the growth of the knowledge- based industries worldwide.

In India too, it has become popular in different parts of the country. Thus, the role of venture capitalist is very crucial, different, and distinguishable to the role of traditional finance as it deals with others money. In view of the globalization; Venture capital has turned out to be a boon to both business and industry. There is , thus, an intense need to be exploit to the maximum its potential as a new means.

This report deals with the concept of Venture capital, with particular reference to India. The report includes all facts, rules and regulations regarding Venture capital and is written in very comprehensive manner.


This report, which contains in depth study of Venture capital Industry in India, is made with an intension to get through all the aspects relate to the topic and to become able to make some suggestion at the industry. Future of any economy depends on the success of the new technologies and industries and services supporting these technologies. In India, where human, particularly technical and entrepreneurial are abundant and there is shortfall of capital, venture capital has a greater significance. It is observed the new companies, particularly the smaller ones, create more jobs. Venture capital helps employment generation particularly for educated and skilled workers. The financing of domestically developed technologies in general and those developed by the new generation of entrepreneur has always been a problem in both developed and developing countries. This is because domestically developed technologies, either by organized sector or the unorganized sector, are usually perceived to be uncertain by the conventional financial system. In India, since independence, a number of financial institutions have emerged to cater to the needs of the industrial entrepreneurs and these have mainly remained as debt providing organizations. In India, risk finance has always been in short supply. The initial equity for any venture has to be raised by the promoters from their own sources and public financial institutions are not of much help. To overcome this problem venture capital financing made a small beginning in India since 1988. Venture capitalists have been catalytic in bringing forth technological innovation in USA. ASIMOLAR ACT CAN ALSO BE PERFORMED IN India. As venture capital has good scope in India for three reasons: First: The abundance of talent is available in the country. The low cost high quality Indian workforce that has helped the computer user‘s world wide in Y2K project is demonstrated asset. Second: A good number of successful Indian entrepreneurs in SILICON valley should have a demonstration effect for venture capitalists to invest in Indian talent at home. Third: The opening up of Indian economy and its integration with the world economy is providing a wide variety of niche market for Indian entrepreneurs to grow and prove themselves. The topic concentrates on the provision of permanent or equity type capitals i.e. venture capital. In the broad terms, venture capital means long term risk equity finance where the primary reward for its provider is eventual capital gain and not the interest/ dividend yield. India is on the threshold of a high technology revolution and new entrepreneurial growth. Slow growth of significant institutional set up to provide much needed venture capital has hampered the growth of the economy. A radial change in the existing framework of venture capital financing in India is a must to achieve high economic growth. 3

SR NO 1 1.1 1.2 1.3 1.4 2 3 3.1 4 4.1 4.2 5 5.1 5.2 5.3 5.4 5.5 5.6 5.7 5.8 6 6.1 6.2 6.3 6.4 6.5 6.6 7 7.1 7.2 7.3 7.4 7.5 7.6 PARTICULARS Introduction of the subject Research objective Limitations of project Methodology used Scope Introduction to Venture Capital Venture capital Investment process Factors influencing Venture Capitalists choice of investment Different types of venture capital investment Early stage finance Later stage finance Venture capital fund regulations Central Government Guidelines Regulation by SEBI Central Board of Direct Taxes Regulation of Foreign Venture Capital Funds SEBI-Foreign Venture Capital Investor- Regulations, 2000 Self Regulation by IVCA Structuring of Venture Capital in India Limitations of Structuring of Venture Capital in India Alternatives to VC funding Fund from operations Interested partners: Fund it yourself Debt financing Friends, family and angels Comparing the alternatives Venture Capital Operations in India Factors Influencing Venture Capitalists Choice of Investment Structuring A Deal Financing Instruments Monitoring Some of venture capital organisations Where are VC’s Investing In India? PAGE NO 6 7 7 7 7 8 10 12 13 14 16 24 25 26 28 31 32 34 35 37 40 41 41 41 41 41 41 42 43 49 49 50 50 51

8 8.1 8.2 8.3 8.4 8.5 8.6 8.7 8.8 9 9.1 9.2 9.3 9.4 9.5 9.6 10 10.1 11 12 12.1 12.2 12.3 12.4 12.5 12.6 12.7 12.8 12.9 13

Current trends in India Growth of VC in India No. of venture Firms in India Top Venture Capital Investments Investment Pattern Effect of globalisation Emerging sectors Threat from substitutes Indian scenario 2007 Exit Route Buy Back I Shares Repurchase Sale On Shares On The Stock Exchange Initial Public Offer (IPO) Offer For Sale Corporate I Trade Sale Selling To A New Investor Pre-Requite For The Efficient Exit Mechanism Advantages of VC over other forms of finance: Disadvantages Threats Case Studies on VC Successful External Venture Investment by Nortel Tejas Networks India Pvt. Ltd. Strand Genomics Avesthagen Ittiam Systems Mindtree Consulting Pvt. Ltd Network Solutions REVA The Electric Car Company Observations Of The Case Studies Contemporary Issue in Venture Capital Industry Conclusion Bibliography

52 53 54 55 55 56 57 58 61 62 64 65 66 68 70 71 73 74 75 77 78 78 80 82 84 85 88 89 93 97 99 100



Introduction of the Subject


1.1 Research objective:  To understand concept of venture capital  To understand venture capital investment process in India  To study the evolution and need of venture capital industry in India  To understand legal framework formulated by SEBI and income tax department  To understand the rules and regulations for Foreign players investing in Venture capital in India To find out opportunity and threats those hinder and encourage venture capital industry in Indian. 1.2 Limitations of project: A study of this type cannot be without limitations. It has been observed that venture capitals are very secretive about their performance as well as about their investments. This attitude has been a major hurdle in data collection. However venture capital funds/companies that are members of India venture capital association are included in the study. Financial analysis has been restricted by and large to members of IVCA. 1.3 Methodology used: In India neither venture capital theory has been developed nor are there many comprehensive books on the subject. Even the number of research papers available is very limited. The research design used is descriptive in nature. ( The attempt has been made to collect maximum facts and figures available on the availability of venture capital in India, nature of assistance grated, future projected demand for this financing, analysis of the problems faced by the entrepreneurs in getting venture capital, analysis of the venture capitalists and social and environmental impact on the existing framework.) The research is based secondary data collected from the published material. The data was also collected from the publications. 1.4 Scope: The scope of the research includes all type of venture capital firms whether setup as accompany or a trust fund. Venture capital companies and funds irrespective of the fact that they are registered with SEBI of India or not are part of this study. Angel investors have kept out of the study as it was not feasible to collect authenticated information about them.


Chapter2 Introduction to Venture Capital


2. Introduction to Venture Capital
Venture capital financing is commonly associated with provision of equity investment for a time period in small/medium business with high growth potential and high reward but which could entail high risk. Simply stated, Venture Capital (VC) is high-risk, high-return investing in support of business creation and growth. It is money provided, often by professionals, who invest alongside innovative entrepreneurs in young, rapidly growing companies that have a reasonable, though not assured, potential to develop into significantly profitable ventures. Naturally, venture capital financing is very different from traditional sources of investing such as lending and borrowing, developmental financing or stock market investing. Venture capital financing fills a void left by the traditional financial institutions in high risk, high potential and innovative ventures.

The concept of venture capital originated in USA during 19th. And early 20th. Century. European investors along with American natives were involved in backing construction and other new industries viz. Rail, Road, Steel, Oil, Gas and Glass.

VC Specialization
The state of development of Investee Company decided the financing stage as perceived by the venture capitalist. The funds investments size range i.e. minimum/maximum equity percentages also vary from fund to fund. VC funds includes many financing instruments i.e. Shares, Preferred Shares, deferred shares, convertible loan stock. Venture capitalist specializes in specific technology and their portfolio includes a significant proportion of business in the areas of advanced technology. Time scale to realization i.e. early stage financing are inevitably taking a medium to Long-term (5-7 years) and later stage financing will have a 3-5 years time scale. Geographical Limitations i.e. funds say also specialize regionally.


Chapter 3 VC Investment Process


3. VC Investment Process
Venture Capital Investment Process is different from normal project financing. In order to understand the investment process a review of the available literature on venture capital financing is carried out. Tyebjee and Bruno in 1984 gave a model of venture capital investment activity which with some variations is commonly used presently. As per Tyebjee and Bruno venture capital activity is a five step Process as follows: 1. Deal Organization 2. Screening 3. Evaluation or Due Diligence 4. Deal Structuring 5. Post Investment Activity and Exit

Deal Organization
It means sourcing or locating venture capital proposals. Deals can originate from different sources. Most common is their being referred to venture capital funds by their parent or sister organizations, industry associations, consultants and past clients

Preliminary Screening
Instead of evaluating all the proposals received by the venture capitalist, which is a time consuming and costly preposition, the deals are first put through a screening process. Only the proposals passing the screening test are considered for evaluation. This saves the time and cost of the venture capitalist. Each venture capitalist has its own broad criteria for such screening that limit the projects to selected areas in terms of industry sector, technology, product, stage of financing, size of venture / investment, regional preferences etc.

Evaluation or due Diligence
The proposals that have successfully passed through screening process are subjected to detailed evaluation. This process is called Due Diligence. Most of the ventures coming to venture capitalist are new ventures being setup by first time promoters, neither the ventures have any track record nor the entrepreneurs any operating experience. Hence the normal evaluation criteria used for project financing by financial institutions are not of much use. The venture capitalist, to a large extent depends upon his subjective judgment. The exact nature of evaluation differs with the stage of financing. Most of the times venture capitalists evaluate the promoters for his managerial abilities and entrepreneurial qualities. Where possible, the product characteristics and market potential are also evaluated. Evaluation is based upon the business plan provided by the entrepreneurs.

Deal structuring
When the proposal passes through due diligence and is accepted by the venture capitalist. The exact terms of the investment are negotiated between the venture capitalist and investee company. The process is called Deal Structuring. The term includes the amount, form and price of the investment.

Post investment activity and exit

After the terms of assistance are finalized, venture capitalist becomes the partner and collaborator and is involved in development and growth of the investee company. Different venture capitalists have different ways of monitoring the progress of the investee company. The venture capitalists, as and when required, give directives for proper financial and marketing management and in case of managerial crises, venture capitalists go to the extent of changing the management team. Venture capitalists aim at long term capital gain. They plan to en-cash their investments within 5 to 8 years depending upon their policy, the state of economy and stage of financing.

3.1 Factors influencing Venture Capitalists choice of investment
Track record of promoters and the management team Nature of the business and the promoters experience in the proposed or related business Business should meet the investment objectives in terms of risk and return Marketing strategy Technology and technology collaboration A detailed and well organized business plan is the only way to gain a venture capitalist attention and obtain funding. The detailed proposal must cover the following issues:  Business and its future  Management  Financing  Risk factors  Analysis of operations and projections  Product specifications


Chapter 4 Different types of venture capital investments


4.Different types of venture capital investments
4.1 Early Stage Finance Seed Capital Startup capital Early stage capital Later stage capital

4.2 Later Stage finance  Expansion stage capital  Replacement Finance  Management Buy out and buy ins  Turnarounds  Bridge Finance
Not all business firms pass through each of these stages in a sequential manner. For instance seed capital is normally not required by service based ventures. It applies largely to manufacturing or research based activities. Similarly second stage finance does not always follow early stage finance.


The table below shows risk perception and time orientation for different stages of venture capital financing

Financing Stage

Period (funds locked in years) 7-10

Risk perception

Activity to be financed

Early stage finance Seed Start up


For supporting a concept or idea or R&D for product development Initializing operations or developing prototypes Start commercial production and marketing Expand market & growing working capital need Market expansion, acquisition & product development for profit making company Acquisition financing Turning around a sick company Facilitating public issue


Very high

First Stage



Second Stage


Sufficiently high

Later stage finance



Buy out-in Turnaround

1-3 3-5

Medium Medium to high




4.1 Early Stage Finance  Seed Capital Definition: The Company has a concept or product under development, but is probably not fully
operational. Usually, the company has been in existence for less than 18 months.


Differences between Seed Capital Schemes and Venture Capital Scheme
Sr. No. Seed Capital scheme Basis Beneficiaries Income or aid Very small entrepreneurs Venture Capital Scheme Commercial viability Medium and large entrepreneurs are also covered Up to 40% of promoters equity Skilled and specialized 30 % Plus Highly flexible Multiple ways

1 2


Size of assistance

Rs.15 Lakhs ( Max)

4 5 6 7

Appraisal process Estimates returns Flexibility Value addition

Normal 20% Nil Nil


Exit option

Sell back to promoters Owner funds

Several including Public offer Outside contribution allowed Possible Exempted Very satisfactory


Funding sources

10 11 12

Syndication Tax concession Success rate

Not done Nil Not good

The characteristics of the seed capital may be enumerated as follows. i. Absence of ready product market. ii. Absence of complete management team. iii. Product / process still in R & D stage. 16

iv. Initial period / licensing stage of technology transfer. Broadly speaking seed capital investment may take 7 to 10 years to achieve realization. It is the earliest and therefore riskiest stage of Venture capital investment. The new technology and innovations being attempted have equal chance of success and failure. Such projects, particularly hi-tech. projects sink a lot of cash and need a strong financial support for their adaptation, commencement and eventual success. However, while the earliest stage of financing is fraught with risk, it also provides an opportunity for acquiring bargain and thus provides greater potential for realizing significant capital gains in long term. Typically seed enterprises lack asset base or track record to obtain finance from conventional sources and are largely dependent upon entrepreneur‘s personal resources. Seed capital is provided after being satisfied that the entrepreneur has used up his own resources and carried out his idea to a stage of acceptance and has initiated research. The asset underlying the seed capital is often technology or an idea as opposed to human assets (a good management team) so often sought by venture capitalists. Volume of Investment Activity It has been observed that Venture capitalists seldom make seed capital investments and these are relatively small by comparison to other forms of venture finance. The absence of interest in providing a significant amount of seed capital can be attributed to the following three factors: a) Seed capital projects by their very nature require a relatively small amount of capital. The success or failure of an individual seed capital investment will have little impact on the performance of all but the smallest venture capitalist‘s portfolio. Larger venture capitalists avoid seed capital investments. This is because the small investments are seen to be cost inefficient in terms of time required to analyze, structure and manage them. b) The time horizon to realization for most seed capital investments is typically 7-10 years which is longer than all but most long-term oriented investors will desire. c) The risk of product and technology obsolescence increases as the time to realization is extended. These types of obsolescence are particularly likely to occur with high technology investments particularly in the fields related to Information Technology. Conclusion A small amount of capital provided to an entrepreneur, usually for product development, beta stage development, pilot project, etc., not covering launch expenses, commercial production, or marketing is Seed Capital. The principal conclusion is that while opportunity for profitable seed capital investment may exist, in practice venture capitalist tends to apply high discount rate against investment proposals at this stage because of: 1) Difficulty in evaluating the viability of seed capital projects 2) Changes in technology becoming obsolete while the product is at prototype stage 3) Commercial failure due to high product cost or unacceptability by consumers. Hence venture capitalists look for following attributes while considering a seed capital project. 17

•Project management skills of the entrepreneurs •Technical competence on the part of investors •A very long horizon for investment • Ability of venture capitalist to work with scientists and technologists as opposed to managers. The time required for analysis, time to realisation and risk inherent in seed capital investment makes it unattractive to most venture capital firms.

 Startup capital It is the stage 2 in the venture capital cycle and is distinguishable from seed capital investments. An entrepreneur often needs finance when the business is just starting. The start up stage involves starting a new business. Here in the entrepreneur has moved closer towards establishment of a going concern. Here in the business concept has been fully investigated and the business risk now becomes that of turning the concept into product. Start up capital is defined as ―Capital needed to finance the product development, initial marketing and establishment of product facility.‖ The characteristics of start-up capital are: I. Establishment of company or business. The company is either being organised or is established recently. New business activity could be based on experts, experience or a spin-off from R & D. ii. Establishment of most but not all the members of the team. The skills and fitness to the job and situation of the entrepreneur‘s team is an important factor for start up finance. iii. Development of business plan or idea. The business plan should be fully developed yet the acceptability of the product by the market is uncertain. The company has not yet started trading. In the start up preposition venture capitalists‘ investment criteria shifts from idea to people involved in the venture and the market opportunity. Before committing any finance at this stage, Venture capitalist however, assess the managerial ability and the capacity of the entrepreneur, besides the skills, suitability and competence of the managerial team are also evaluated. If required they supply managerial skills and supervision for implementation. The time horizon for start up capital will be typically 6 or 8 years. Failure rate for start up is 2 out of 3. Start up needs funds by way of both first round investment and subsequent follow-up investments. The risk tends to be lower relative to seed capital situation. The risk is controlled by initially investing a smaller amount of capital in start-ups. The decision on additional financing is based upon the successful performance of the company. However, the term to realization of a start up investment remains longer than the term of finance normally provided by the majority of financial institutions. Longer time scale for using exit route demands continued watch on start up projects. Despite potential for specular returns most venture firms avoid investing in start-ups. One reason for the paucity of start up financing may be high discount rate that venture capitalist applies to venture proposals at this level of risk and maturity. They often prefer to spread their risk by sharing the financing. Thus syndicates of investors often participate in start up finance.

Early stage capital


Definition: The company‘s product or service is in testing or pilot production. In some cases, the product may be
commercially available. The company may or may not be generating revenues. Usually, the company has been in business for less than three years.

Early Stage Finance, also called first stage capital is provided to entrepreneur who has a proven product, to start commercial production and marketing, not covering market expansion, de-risking and acquisition costs. At this stage the company passes into early success stage of its life cycle. A proven management team is put into this stage, a product is established and an identifiable market is being targeted. British Venture Capital Association has vividly defined early stage finance as ―Finance provided to companies that have completed the product development stage and require further funds to initiate commercial manufacturing and sales but may not be generating profits.‖

The characteristics of early stage finance may be: i. Little or no sales revenue. ii. Cash flow and profit still negative. iii. A small but enthusiastic management team which consists of people with technical and specialist background and with little experience in the management of growing business. iv. Short term prospective for dramatic growth in revenue and profits. The early stage finance usually takes 4 to 6 years time horizon to realization. An early stage finance is the earliest in which two of the fundamentals of business are in place i.e. fully assembled management team and a marketable product. A company may need this round of finance because of any of the following reasons: Project overruns on product development. Initial loss after start up phase. The firm needs additional equity funds, which are not available from other sources thus prompting venture capitalist who, have financed the start up stage to provide further financing. The management risk is shifted from factors internal to the firm (lack of management, lack of product etc.) to factors external to the firm (competitive pressures, in sufficient will of financial institutions to provide adequate capital, risk of product obsolescence etc.). The following risks are normally associated to firms at this stage: a) The early stage firms may have drawn the attention of and incurred the challenge of a larger competition. b) There is a risk of product obsolescence. This is more so when the firm is involved in high- tech. business like computer, information technology etc. Conclusion The absence of either profits or positive cash flows continue to make early stage investment too risky. However the existence of a product and a management team considerably reduces the fundamental risk facing the equity investor. Generally, the shorter time horizon and decreased fundamental risk associated with early stage firm makes them more attractive as venture investments than either seed capital or start up situations. 19

Later stage capital Definition: The Company‘s product or service is widely available. The company is generating ongoing revenue
and is probably cash-flow positive. It is more likely to be profitable, but not necessarily.

It is the capital provided for marketing and meeting the growing working capital needs of an enterprise that has commenced production but does not have positive cash flows sufficient to take care of its growing needs. Second stage finance, the second trench of Early State Finance is also referred to as follow on finance and can be defined as the provision of capital to the firm which has previously been in receipt of external capital but whose financial needs have subsequently exploded. This may be second or even third injection of capital. The characteristics of a second stage finance are: i. A developed product on the market. ii. A full management team in place. iii. Sales revenue being generated from one or more products. iv. There are losses in the firm or at best there may be a break even but the surplus generated is insufficient to meet the firm‘s needs. Second round financing typically comes in after start up and early stage funding and so have shorter time to maturity, generally ranging from 3 to 7 years. This stage of financing has both positive and negative reasons. Negative reasons include. I. Cost overruns in market development. II. Failure of new product to live up to sales forecast. III. Need to re-position products through a new marketing campaign. IV. Need to re-define the product in the market place once the product‘s deficiency is revealed.

Positive reasons include. I. Sales appear to be exceeding forecasts and the enterprise needs to acquire assets to gear up for production volumes greater than forecasts. II. High growth enterprises expand faster than their working capital permit, thus needing additional finance. Aim is to provide working capital for initial expansion of an enterprise to meet needs of increasing stocks and receivables. It is an additional injection of funds and is an acceptable part of venture capital. Often provision for such additional finance can be included in the original financing package as an option, subject to certain management performance targets. 20

Conclusions With respect to second or follow on finance, following conclusions can be drawn. a) As a shareholder rather than a creditor, it may be necessary to provide financing to the investee on more than one occasion prior to realization. b) Second round or latter round financing should be supplied only if the additional capital commitment shows quantifiable benefits in the future. This can be judged by analyzing the prospects of the venture.

4.2 Later Stage finance
Later Stage Financing also called third stage capital is provided to an enterprise that has established commercial production and basic marketing set-up, typically for market expansion, acquisition, product development etc. It is provided for market expansion of the enterprise. The enterprises eligible for this round of finance have following characteristics. i. Established business, having already passed the risky early stage. ii. Expanding high yield, capital growth and good profitability. iii. Reputed market position and an established formal organization structure. ―Funds are utilized for further plant expansion, marketing, working capital or development of improved products.‖‘2 Third stage financing is a mix of equity with debt or subordinate debt. As it is half way between equity and debt in US it is called ―mezzanine‖ finance. It is also called last round of finance in run up to the trade sale or public offer. Venture capitalists prefer later stage investment vis a vis early stage investments, as the rate of failure in later stage financing is low. It is because firms at this stage have a past performance data, track record of management, established procedures of financial control. The time horizon for realization is shorter, ranging from 3 to 5 years. This helps the venture capitalists to balance their own portfolio of investment as it provides a running yield to venture capitalists. Further the loan component in third stage finance provides tax advantage and superior return to the investors.

Conclusions: Later stage finance is development finance for business expansion. Venture capitalists prefer this because: 1. It provides immediate income besides high capital gains. 2. It has a balancing effect on their own portfolio because of low risk and shorter realization period.

Following are the subdivision of Later Stage Finance  Expansion stage capital


Definition: The company‘s product or service is in production and commercially available. The company

demonstrates significant revenue growth, but may or may not be showing a profit. Usually, the company has been in business for more than three years. Expansion/Development Finance an enterprise established in a given market increases its profits exponentially by achieving the economies of scale. This expansion can be achieved either through an organic growth, that is by expanding production capacity and setting up proper distribution system or by way of acquisitions. Any how, expansion needs finance and venture capitalists support both organic growth as well as acquisitions for expansion. At this stage the real market feed back is used to analyze competition. It may be found that the entrepreneur needs to develop his managerial team for handling growth and managing a larger business. Realization horizon for expansion/development investment is 1 to 3 years. It is favoured by venture capitalist as it offers higher rewards in shorter period with lower risk. Funds are needed for new or larger factories and warehouses, production capacities, developing improved or new products, developing new markets or entering exports by enterprises with established business that has already achieved break even and has started making profits. Conclusion: To hedge against their investment in earlier stages, venture capitalist invests a small portion of their capital in expansion / development stage both for organic growth and or merger / take-over. Financing need at this stage is generally larger than earlier stages, demands lesser time and skills of the investors. Hands on management are not needed and a board level representation is sufficient.

Replacement Finance

Replacement Finance means substituting one shareholder for another, rather than raising new capital resulting in the change of ownership pattern. Venture capitalist purchase shares from the entrepreneurs and their associates enabling them to reduce their shareholding in unlisted companies. They also buy ordinary shares from non-promoters and convert them to preference shares with fixed dividend coupon. Later, on sale of the company or its listing on stock exchange, these are re-converted to ordinary shares. Thus Venture capitalist makes a capital gain in a period of 1 to 5 years.

Management Buy out and buy ins

Buyout Financing is a recent development and a new form of investment by venture capitalist. The funds provided to the current operating management to acquire or purchase a significant share holding in the business they manage are called management buyout. Management Buy-in refers to the funds provided to enable a manager or a group of managers from outside the company to buy into it. It is the most popular form of venture capital amongst later stage financing. It is less risky as venture capitalist invests in solid, ongoing and more mature business. The funds are provided for acquiring and revitalizing an existing product line or division of a major business. MBO (Management buyout) has low risk as enterprise to be bought have existed for some time besides having positive cash flow to provide regular returns to the venture capitalist, who structure their investment by a judicious combination of debt and equity. Of late there has been a gradual shift away from start up and early finance to wards MBO 22

opportunities. This shift is because of lower risk than start up investments. Venture capitalist should build portfolios by balancing early stage investments with MBOs. Thus they strike a balance between early return through MBO with late pay off by early stage investment. Some financial experts feel that MBO is not a venture capital activity. However during 1998/99 25 percent of venture capital funds of UK were invested in MBO / MBI providing assistance to 11 percent of assisted units.14

Turnaround Finance

Turnaround Finance is a rare form of later stage finance which most of the venture capitalist avoid because of higher degree of risk. When an established enterprise becomes sick, it needs finance as well as management assistance for a major restructuring to revitalize growth of profits. Unquoted company at an early stage of development often has higher debt than equity; its cash flows are slowing down due to lack of managerial skill and inability to exploit the market potential. The sick companies at the later stages of development do not normally have high debt burden but lack competent staff at various levels. Such enterprises are compelled to relinquish control to new management. The Venture capitalist has to carry out the recovery process using hands on management in 2 to 5 years. The risk profile and anticipated rewards are akin to early stage investment.

Bridge Finance

Bridge Finance is the pre-public offering or pre-merger/ acquisition finance to a company. It is the last round of financing before the planned exit. Venture capitalist helps in building a stable and experienced management team that will help the company in its initial public offer. Most of the time bridge finance helps improves the valuation of the company. Bridge finance often has a realization period of 6 months to one year and hence the risk involved is low. The bridge finance is paid back from the proceeds of the public issue.

Risk Perception and Activity to be financed


Chapter 5 Venture Capital Fund Regulation


5. Venture Capital Fund Regulation Regulatory Structure
Venture capital industry in India is relatively in a nascent stage. It was started in India during late eighties and regulated by central government guidelines issued on 25th November 1988. The concept of venture capital in India was a logical sequence to the seed capital offered by the public financial institutions for broadening the entrepreneurial base in the country by providing finance to primarily technology oriented projects promoted by technocrat promoters. These guidelines focused on projects promoted by the first generation entrepreneurs. The requisite powers under the guidelines were vested with the Controller of Capital Issues (CCI). With the abolition of the office of CCI with effect from May 1992, the powers of CCI were vested in SEBI. SEBI Act 1992 was amended on 25 January 1995, which empowered SEBI to register and regulate the working of venture capital funds. The government guidelines were revoked in 1995 when venture capital investments came under the preview of SEBI. Indian Venture Capital Association (IVCA) is a self — regulatory body of the venture capitalist in India. It helps in setting up of the professional standards and practices in venture capital industry. Central Board of Direct Taxes through Income Tax Act also regulates the activities of the venture capital firms. Broadly there are two types of Venture capital funds/Venture capital companies. These are 1. Domestic Venture capital funds/Venture capital companies: and 2. Offshore or foreign Venture capital funds/Venture capital companies investing in India. Domestic Venture capital funds / Venture capital companies organized in India are governed by three sets of guidelines as follow: i. MoF / Central Government guidelines; ii. Securities and Exchange Board of India (Venture Capital Funds) Regulation 1996; and iii. Central Board of Direct Taxes / Income Tax Rules.

5.1 Central Government Guidelines
The focus of these guidelines was on enterprises where the risk element was relatively high due to technology involved being relatively new, untried or very closely held. It allowed venture capital to be set up as a Venture Capital Company or a Venture Capital Fund. As per these guidelines the Venture capital companies/funds were to invest in new companies to become eligible for concessional treatment of capital gains available to non-corporate entities. For this the Venture capital assistance was to be provided to the enterprises fulfilling the following criteria. Size: Total investment in an assisted unit was not to exceed Rs. 10 crores. Eligible Enterprises were to be established as limited companies. They were also requires to employ professionally qualified accountants for maintaining their accounts. Enterprises engaged in trading, broking, investment or financial services were not eligible. 25

Technology involved should be new or relatively untried or very closely held or being upgraded from a pilot plant to commercial scale for the first time. Even the cases where there was a significant improvement or an up gradation in the existing technology in India were eligible. Promoters/Entrepreneurs: The first generation entrepreneurs who were relatively new and technically or professionally qualified but non-affluent with inadequate resources and financial backing for the project were eligible for assistance. Secondary Investment The units already assisted by the venture capitalist were eligible for the second round of financing for expansion or strengthening. Even the sick units were eligible for assistance under these guidelines. All venture capital companies / funds needed to be approved by CCI. Only all India public sector financial institutions, scheduled banks including SBI and foreign banks operating in India and their subsidiaries were eligible to set up venture capital companies or funds. Private promoters were permitted in the joint ventures if the equity stake did not exceed 20 percent of the total equity and was not the largest single holding. The venture capital company or fund was required to be managed by professionals such as bankers, managers and administrators with adequate experience of industry, finance, accounts etc. A venture capital company was required to maintain its independence and an arms length relationship with its parent company. A venture capital company or fund was required to have a minimum corpus of Rs. 10 crore. A minimum promoter share of 40 percent was mandatory. NRIs were permitted to invest up 74 percent on nonrepatriable basis and up to 25 percent on a repatriable basis. Multilateral, international financial organizations, development finance institutes, foreign mutual funds were permitted 25 percent of equity as a medium to long-term investment. Debt could be raised with debt equity ratio not exceeding 1.5. The venture capital company or fund was required to progressively invest at least 75 percent of its funds in venture capital activities by the end of fifth year. For a venture capital company or fund to obtain tax concessions all the units provided the equity support were to be certified by IDBI / ICICI / IFCI as eligible units for venture capital financing. With effect from May 1992 when the office of Controller of Capital Issues was abolished, the function of regulating the venture capital companies and funds came under the preview of Securities and Exchange Board of India.

5.2 Regulation by SEBI
SEBI Act empowered SEBI to inter-alia regulate the venture capital funds as these funds are a part of the overall securities market and is a source of capital. Members of the scientific community form a part of SEBI‘s advisory panel and it also invites top notch venture capitalists to be on the committees. It announced the regulations for venture capital funds in 1996, with a primary objective of protecting the interest of investors and providing enough flexibility to fund managers to make suitable investment decisions. Since this is considered to be a high risk high return business, the participation by the very 26

small investors has been restricted and only high net-worth individuals and institutions, both domestic and foreign, are allowed to participate with a minimum investment of Rs. 5 lakh.

Setting up a Venture Capital Fund
The eligibility criteria have been relaxed and now active participation by private sector is allowed. A venture capital fund can be constituted in the form of a trust or a company. Venture capital fund appoints an asset management company to manage the portfolio of the fund. A venture capital company may take up the activity of venture capital fund and an asset management company. Earlier guidelines prescribed a prior approval from the Department of Economic Affairs, Ministry of Finance. Similarly SEBI regulations stipulate the registration of the organisation with SEBI and grant of certificate for commencement of the business of venture capital financing. Application for registration and grant of certificate are to made alongwith an application fee of Rs.25000/- in the prescribed form as given in the annexure. A Venture capital fund should have a minimum corpus of Rs. 5 crore before it can start Venture capital activities. As per these guidelines and the guidelines issued by the Central Board of Direct Taxes (CBDT) a venture capital fund could invest up to 40 percent of the paid-up capital of Investee Company or up to 20 percent of the corpus of the fund in one venture.

Investment Conditions and Restrictions
Restrictions: SEBI Regulations requires that at least 80 percent of the corpus of the fund should be invested in unlisted shares of the venture capital assisted companies. Earlier investment restrictions like: i) Maximum permissible investment of Rs. 10 crore per venture. ii) Investment only in new and relatively untried technology; iii) Requirement that the promoters be new and professionally and technically qualified, has been done away in these guidelines. Now a venture capitalist has a freedom to invest in any new enterprise without regards to newness of either the technology or any consideration for first generation entrepreneurs or even insisting on professional or technical qualification of the promoters. The venture capital funds are however prohibited from investing in the share capital of companies providing financial services. This means all non-banking finance companies, hire purchase, leasing, housing finance companies are debarred from receiving the venture capital assistance. A venture capital fund is not allowed to carry activity other than venture capital financing. Support for later stage and turnaround financing The regulation permits investment by venture capital funds in equity shares or equity related securities of financially weak and sick companies who may or may not be listed. Companies having eroded their net worth by more than 50 percent but not less than 100 percent in previous year are considered as financially weak and are eligible for this purpose. Thus the regulation supports later stage and turnaround financing by the venture capitalists. The venture capitalists are also free to finance any company that has already been provided venture capital assistance.


Investment in listed companies Venture capitalists can invest the balance 20 percent of the venture capital fund in any listed company‘s securities. This balance of 20 percent can also be in non-equity securities besides loans and intercorporate deposits.

Financing Venture Capital Funds
In addition to its corpus the venture capital funds can mobilize resources from Indian and foreign including nonresident, investors. It can raise resources through private placement of its securities or units but only after completion of three years. For this the venture capitalist has to submit a placement memorandum to SEBI. The memorandum should contain the detailed terms like maturity period, mode of distributing benefits to the investors, winding up procedure etc. On the expiry of 21 days of its submission if no objection is raised by SEBI, such private placement can be done with institutions and high net-worth individuals. Even the earlier guidelines permitted venture capitalists to raise funds through private placement. The investment by Indian nationals other than employees, directors and trustee of venture capital funds should not be less than Rs. 5 lakhs. However a venture capital fund is prohibited from raising capital from general public by issuing securities or units through a public offer. Mutual funds can invest five percent of the corpus of an open-ended scheme in a venture capital fund. It is ten percent in case of close-ended schemes. This allows retail investor to invest in venture capital.

Winding Up and Other Provisions
The regulations provide different schemes for winding up of the venture capital funds set up as trust or company. A venture capital company is wound up as per the provisions of the Companies Act, 1956. The trust can be wound up as per the trust laws on the expiry of the scheme or earlier if the trustees consider winding up is in investors‘ interest and inform SEBI of the same. Trusts can be wound up if 15 percent of the investors pass a resolution for winding up and forward the same to SEBI. The regulation also provides for inspection and investigation besides action in case of default by the venture capitalist. Recent Revisions: These regulations have been amended on 17th November 1999 by Securities and Exchange Board of India (Venture Capital Funds) (Amendment) Regulations, 1999. The amended regulations provide for a body corporate set up under an Act of Parliament or State Legislature to make an application for grant of a certificate of registration to start a venture capital fund. The minimum corpus of the venture capital funds has now been fixed as Rs. 5 cores.

5.3 Central Board of Direct Taxes

The government of India had announced tax concessions for investment by venture capital funds subject to compliance with the guidelines issued the Central Board of Direct Taxes (CBDT) Hence CBDT also regulates the venture capital industry. The guidelines issued by CBDT have been relaxed from time to time, as it removed the condition of time bound investment by the venture capital funds and also the lock in period of three years. The venture capital funds desiring to claim exemption from income tax were required to follow CBDT rules as under: • Registration with SEBI. • Claiming income tax exemption in respect of dividend and capital gains income. • Not to invest in more than 40 percent in equity of an assisted unit this restriction has now been removed. • Investment in a single company should not exceed 20 percent of the corpus of the fund. This restriction has now been removed. • Venture capital investments are required to be restricted to domestic companies engaged in business of 1) software; ii) Information Technology iii) production of basic drugs; iv) biotechnology; v) agriculture and allied sector; vi) such other sectors as may be notified by the central government in this behalf vii) production or manufacture of any article or substance for which the patent has been granted to the National Research Laboratory or any other scientific research institution approved by the Department Of Science and Technology. This restriction has now been superceded by a negative list. • 80 percent of the investible funds are to be invested in equity shares of domestic companies whose shares are not listed on a recognized stock exchange. • Since dividend income in India is already tax exempted, the tax break is basically a 10 percent capital gain tax. • They pay maximum marginal tax (35%) in respect of non exempt income such as interest through Debentures etc. Venture Capital Funds Regulations As per SEBI Regulation Scope and Definitions Venture Capital Fund Fund established in the form of a company or a trust which raises funds through loans, donations, issue of securities or units as the case may be or makes or proposes to make investment as per SEBI regulation Venture capital company or venture capital fund operating under trust deeds registered under Registration Act, established to raise funds by trustees for investment mainly by way of acquiring shares of venture capital under-takings in Income tax provisions require registration of trust deed. As per Income Tax Rules Remarks


accordance with the prescribed regulations Venture Capital Undertaking Venture Capital Undertaking is not defined It is an unlisted domestic company that is engaged in manufacture of notified articles or things. For tax exemption the venture funds should invest in domestic companies engaged in production / manufacture of notified products / articles

Investment Norms Venture capital Funds are barred from investment in any company providing financial services. When seeking tax exemptions VC Funds to invest 20 % of the funds raised in that year, 50% of the funds raised in succeeding At least 80% of the funds shall be year, 80% of the funds raised in invested in equity or equity next succeeding year are to be related securities of unlisted invested in approved VC companies undertakings. Equity investment is permissible in listed or unlisted financially weak and sick companies In case of companies 20%, 50%, 80% of total paid up capital has been referred. SEBI regulation does not prescribe any time frame for achieving investment levels. Norms regarding achieving investment levels up to 20% and 50% were relaxed. CBDT recognises investment only in financially weak unlisted companies while SEBI recognizes the same irrespective of listing status

Minimum Investment in A Venture Fund Min Rs. 5 lakhs by one person Not prescribed

Minimum Holding Period for Investment Not prescribed At least 3 years or till listing of securities if earlier.

Maximum investment in a company Not prescribed Not more than 5% of the funds raised in case of trust or paid share capital of venture company can be invested in a single venture At least 80% of the funds shall be invested in equity or equity related securities of unlisted

No restriction on max investment size by SEBI. The prevalent 5% limit has been increased to 20%


companies. Venture funds can invest up to 40% of the paid up capital of a company. Exit Norms Not prescribed One year after the SEBI does listing of the not favor investee company, this venture capital fund will have to exit or give up tax pass through benefit. SEBI does not favor this

5.4 Regulation of Foreign Venture Capital Funds
Reserve Bank of India (RBI) regulates the flow of foreign currency into and out of India. SEBI regulations were not applicable to foreign venture funds and these were not registered with SEBI. These operate as Foreign Investment Institutions and are regulated by Government of India Guidelines issued on 20th September 1995. The offshore investors are permitted to invest up to 100 percent in an approved domestic venture capital fund or company after obtaining an approval from Foreign Investment Promotion Board FIPB. They could also set up a domestic asset management company to manage the Fund. However establishment of an asset management company with foreign investment to manage such funds would require FIPB approval and many a times, while granting approval, the FIPB may not permit the offshore venture capital to be managed from outside India. SEBI regulations do not insist of a two tier system of a trust and asset management company. Thus the domestic vehicle can either be a trust and be managed by the trustees or can be structured as a company where a committee looks after investments. The asset management companies so formed are treated as NBFCs that can act as foreign holding companies. These foreign NBFCs are permitted to invest in down stream subsidiaries in India with minimum of 25 percent domestic equity. An initial amount of 10 percent of this domestic equity is to be brought by front and the balance is to be added within 24 months. Once approved by FIPB such domestic venture capital funds do not need any more approval from FIPB for further venture capital investment but are subjected to normal restrictions on venture capital funds. The maximum investment is subject to relevant equity investment limits that may be in force from time to time in relation to areas reserved for the Small Scale sector. Taxation: The tax exemptions available to domestic venture capital fund or company is extended to venture capital which attract overseas investments provided these venture capital funds or companies conform to the guidelines applicable for domestic venture capital. Income earned by the funds from Indian venture capital fund is subject to tax as per the normal rate applicable to foreign investors or the rates specified in the tax treaties.


Offshore investors may also invest directly in the equity of unlisted Indian companies without going through the route of domestic venture capital fund or company. Offshore venture capital is often organized as a foreign company that invests in unlisted Indian companies; sometimes the funds are organized as offshore funds and are managed by asset / investment management companies (AMC/IMC) set up in any tax favorable jurisdiction. The AMC could manage the fund and be advised by an Indian advisory company. The fund thus undertakes venture capital activities following direct investment route (FDI). In such cases each investment will be treated as a separate foreign investment and will require separate approval as required under the general policy for foreign investment proposals. Investment by NRIs: Non resident Indians and corporate bodies including trusts, societies partnerships etc. that have at least 60 percent equity holding by NRIs (OBCs) are allowed to invest 100 percent in Annex III industries on an automatic basis with full repatriation benefits. They can invest up to 24 percent in India in any other business except agriculture and plantation. The main advantage on such a structure is saving time on government approvals which at times is an important factor. India Investment Fund of ANZ Grindlays 3i/Investment Services was structured as an OBC Offshore Fund. Taxation: As discussed earlier dividend income is tax exempt. For offshore funds operating as an FII long term capital gain from disinvestments in listed and unlisted securities is taxed at 10 and 20 percent respectively. Short term capital gains arising from disinvestments in listed and unlisted Indian companies are taxed at the maximum rate of 45 percent. Interest income on foreign currency denominated loans is charged to tax at the rate of 20 percent. All other income earned by the fund is taxed at 48 percent. Since most of the offshore investments are routed through tax havens and get exemption from income tax under tax avoidance treaties they are able to bypass the investment restrictions as prescribed by SEBI and CBDT for availing of the tax benefits. A special tax treaty between India and Mauritius gives funds registered in Mauritius a special tax-exempt status for all long term and short term capital gains in India. This denies a level playing field for domestic venture capitalists. The finance minister in the budget speech on 29th February 2000 that SEBI will be a single point nodal agency for registration and regulation for both domestic and overseas venture capital funds. He stated that tax laws and SEBI guidelines were being formulated accordingly. Foreign venture capital funds can exit from an Indian company only at a price worked out on the basis of a formula that came into effect during the time of the Controller of Capital Issues and had remained since then. The Reserve Bank of India (RBI) has recently relaxed its rule for foreign venture funds registered with SEBI. Now these funds can exit at a mutually acceptable price without the prior approval of RBI. As per SEBI this has been done to motivate the overseas venture capital funds to register with SEBI.

5.5 SEBI-Foreign Venture Capital Investor- Regulations, 2000
In order to regulate the activities of the overseas venture capital investors and to provide a level playing field to the domestic venture capitalists, SEBI notified Foreign Venture Capital InvestorsRegulations, 2000 on September 15, 2000. Overseas investors desiring to make venture capital 32

investment in India are required to get the necessary approval by the Reserve Bank of India for making investments in India without going through an Indian fund. Alternately they have to apply and register themselves with SEBI for making venture capital investment in India. Bodies incorporated outside India that are authorized to invest in venture capital funds or carry on activity of a venture capital fund and regulated by an appropriate foreign regulatory authority are eligible to be registered under this regulations. As per these regulations a ―foreign venture capital investor‖ means an investor incorporated and established outside India, which proposes to make investment in venture capital fund(s) or venture capital undertakings in India and is registered with SEBI. Overseas venture capitalists can invest in India either by setting up their own venture funds here or through a domestic fund. That fund would get the tax pass through benefit. They are required to appoint domestic custodian for the custody of the securities, enter into an arrangement with a bank to operate a non-resident or foreign currency account. The registered foreign venture capital investors have to abide by these regulations. The minimum corpus of the fund would have to be Rs. Five crores. The registered foreign venture capital investors would get the benefit of being able to automatically bring in their investments, without going through the FIPB provided the investments are within the overall ceiling fixed for the sector. Venture capital funds would also be permitted to invest through automatic approval route even when their investments result in transferring the shares of an Indian company to a foreign / NRI / OBC investor. Such transfers are subject to case by case approvals. The registered overseas venture capital funds have no limitations in investing in competing technologies and trademarks through the automatic route. This is to encourage foreign venture capital funds to participate in knowledge based and high risk industries. They would also be exempt from the RBI‘s exit pricing norms for foreign investors. Those who prefer to continue investing as private equity funds can continue to do so but they would not enjoy the benefits being accorded through these regulations. The provision is made especially for the foreign angle investors to be able to operate in India. However the body corporate whose application is rejected is not allowed to carry on any activity of venture capitalist.

Investment Criteria for a Foreign Venture Capital Investor: All investments to be made by foreign venture capital investors shall be subject to the following conditions: a. It shall disclose to the Board its investment strategy. b. It can invest its total funds committed in one venture capital fund, however it cannot invest more than 25% of the funds committed for investments to India in one Venture Capital Undertaking. 33

c. At least 75% of the investible funds are to be invested in unlisted equity shares or equity linked instruments in the Venture Capital Undertaking and 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 and debt or debt instrument of a venture capital undertaking in which the venture capital fund has already made an investment by way of equity. d. Investment in the associated companies of the fund is not allowed. e. Investment in the activities specified in the negative list as given in the third schedule, that is real estate, none banking financial services, gold financing and activities not permitted under the Government‘s Industrial Policy, is not permitted. f. Other investment norms are same as for domestic venture capital funds.

5.6 Self Regulation by IVCA
In a responsible society all professional organizations collectively form a body to regulate themselves by developing a voluntary code of conduct and making the code binding their members. Indian Venture Capital Companies / Funds have formed a voluntary association which acts as their representative and self regulatory body. It is named Indian Venture Capital Association and is modeled on the lines of American Venture Capital-Association. The association was formed to co-ordinate the activities of its members. Its main objective is to set up professional standards and practices in venture Capital industry, to bring about better coordination among Venture Capital companies and funds, to represent the interest of Venture Capital companies and funds to the government and other regulatory bodies.5 It had made suggestions to government and SEBI regarding changes sought in the venture capital guidelines and regulations. WCA also organizes and conducts programs for training of personal for the venture capital industry. Presently IVCA is compiling a database on the venture capital industry in India so as to be able to provide authentic information to government agencies, international venture capital organizations / companies, angle investors and others having interest in the venture capital investment in India. IVCA is meant to promote the venture capital industry in India, lobby with the government and the regulators i.e. SEBI, CBDT. It plans to bring in self-regulation in the industry through its members and thus reduce the scope of outside regulation. IVCA has been bringing out an Annual Report from the calendar year 1993. This report highlights the general trends in the Indian venture industry and includes member profiles. The membership policy and code of conduct also form a part of this report. IVCA members fall into different categories. Some function as investment and fund management companies, others set up funds and function as asset management companies. Some companies manage domestic funds, some manage offshore funds and some manage both domestic and offshore funds. Financial organizations investing in venture capital as a minor activity and offshore fund management companies engaged in venture capital business are taken as non-voting associate members of 1VCA. At present the association has 28 members, which include leading domestic as well as offshore venture capital funds. 34

5.7 Structuring of Venture Capital in India
1. Venture capital company 2. Trust fund 3. A scheme of unit trust of India 4. Off- shore entity 5. A statutory body

Venture capital Company
Some of the venture capital organizations are structured in the form of a company. Here shareholders are investors in the fund. RCTC Ltd and TDICI Ltd. were the oldest VC companies in India. Presently venture capital companies have to register themselves with SEBI and take a certificate before commencing their operations. Structuring the venture investments through this route had some shortcomings; a) A company is promoted on the concept of a going concern where as venture capital investors like to lock in their investment for a limited period. Thus the company needs to be dissolved after a certain period and the winding up procedures for a company are cumbersome with a lot of procedural formalities. b) Venture capital investors seek returns in the form of capital gains as such returns are more tax efficient. When structured as a company venture capitalist can be provided their returns by way of dividends, which attracted a dividend tax. All venture capital companies or funds were required to pay an income tax of 20 percent on income distributed as dividend. This has presently been exempted. c) As yet there are problems in redeeming the share capital of a company to provide return to the investors. APIDC Venture Capital Limited and IFB Venture capital finance are venture capital companies promoted by state and private sector respectively and are registered with SEBI.

Trust Funds
Structuring the venture instruments as Trust funds overcomes some of the shortcomings encountered in a company. A trust normally has a limited life and is wound up on a pre-determined time or even earlier if the trustees so desire and there is an enabling provision in the Trust deed. The units can be redeemed during the interim period of operation of the Trust fund. The venture capital funds in India are registered under Indian Trust Act 1882 and also registered as Venture capital trust with SEBI. Here, pools of funds available for investment from investors are entrusted to Trustees of the fund. Individuals as well as companies can become Trustees. When the trustee themselves manage the funds it is a two layer structure consisting of investors and trustees. Gujarat Venture Capital Fund and Canbank Venture Capital Funds are two layer trust funds, which are managed by their trustee that is Gujarat Venture Capital Ltd. and Canbank Financial Services Ltd. In a three-layer structure trustee entrust the fund to an asset management company for management. Normally an AMC is specially created for this purpose. The board of directors of AMC is subordinate to the directors of 35

Trustee Company and report to the Trustee Company. The Trustee Company specifies contribution / disbursement procedure, induction of new contributors and issue related to investment objectives, policies and guidelines etc. The responsibility of Trustee Company and AMC is delineated to ensure that there is no overlapping. AMC is normally paid under two heads - a fixed fee linked to the corpus of the fund and a variable fee linked to the performance of the fund. After providing a normal (agreed) rate of interest to the investors the net capital appreciation is shared by AMC with the investors in a pre agreed proportion, say on 80 - 20 basis. For example IFCI venture receives a management fee at the rate of 1.875 percent per annum of the cumulative disbursements and is also entitled to 7.5 percent of surplus generated on termination of Vecaus fund.

Structuring Scheme
In India a few initial funds were structured as schemes of unit trust of India (UTI) wherein the corpus of fund is subscribed by UTI and various domestic and foreign investors like LIC, GIC, and ADB etc. A manager or an Asset Management Company manages the fund. As all the schemes of UTI were exempt from tax under Unit Trust of India Act, the venture capital so floated enjoyed tax exemption. Initial funds of TDICI and RCTC were structured as schemes of UTI and were funded by UTI and multilateral funding agencies like International Finance Corporation, Asian development bank etc. Vecaus I, II and III managed by TDICI and RCTC were such funds. In India some funds have been set up as divisions of banks and financial institutions instead of separate legal entity. The prominent amongst them are venture capital activities of IDBI and SIDBI. IFCI had structured Risk Capital Foundation (RCF) as a venture capital scheme, which in 1975 was converted into an investment company. State Bank of India also set up SBI Venture Fund as a scheme of the bank. Herein the profits of venture capital divisions are taxed along with the profits of the financial institute. Earlier IDBI was exempted from income tax and it made sense in structuring the venture capital as a division of the company.

Structuring of Offshore Funds
ANZ Grindleys 31 Investment Limited structured and managed two off shore NRI funds (India Investment Fund I and II) The venture capital funds promoted and structured in India are required to comply with SEBI and CBDT regulations. The private equity funds caring out venture investment and structured outside India did not fall under the preview of SEBI and CBDT for venture capital investment in India. The offshore funds are structured in Mauritius to avail of benefit of tax avoidance treaties between Mauritius and India. Typically, a fund is constituted as a non- resident offshore fund in Mauritius while trustee of the fund are constituted as resident companies of Mauritius. JF Electra (Mauritius) Ltd. is an offshore fund registered in Mauritius and is managed by JF Electra Advisors (India) Limited a Hong Kong based company with its principal office in Mumbai, India. On the other hand Walden Nikko India Ltd. is a foreign venture capital company operating in venture capital financing as a Foreign Institutional Investor.


Even today when SEBI has formulated registration and regulation for the offshore venture capital funds, a window is still open for private equity funds registered in Mauritius to make venture investments in India.

Statutory Body
The Securities and Exchange Board of India (Venture Capital Funds) (Amendment) Regulations, 1999 in November has made a provision for statutory bodies set up by Parliament and State legislatures to set venture capital funds after applying to SEBI for registration and obtaining the necessary certificate. Venture fund set up for IT industry by SIDBI with the financial participation and support of Central government is the first example of this kind.

5.8 Limitations of Structuring of Venture Capital in India
SEBI rules permit venture capital to be structured as a company or a trust fund with a three tier mechanism; investor, trustee company and AMC. A tax efficient vehicle in the form of ‗Limited Liability Partnership Act‘ which is popular in USA is not made available for structuring venture capital in India. In a Limited Liability Partnership while investor‘s liability towards the fund is limited to the extent of his contribution in the fund the formalities for structuring the fund are simpler. It is now accepted that an efficient structure for venture capital is one that is tuned to the following four characteristics of venture investment;• Different classes of investors. • Limited liability of the investors. • Flexibility in operations. • Transparent and efficient taxation.

5.9 Different Classes of Investors
The persons investing in venture funds vary in their risk profile, tax liability, requirements, and investment timings in terms of entry and exit, investment policies and preference for voting rights. A large majority of them are passive investors and are not inclined to participate in fund‘s operations. Some of them are active and prefer to act as fund manager or be more active in management of the Fund. The venture capital structure should be flexible enough to allow different classes of investors and to differentiate the role of investors and managers with their share in Fund‘s profits and losses. Limited Liability: Most of the investors are passive investors and participate primarily for capital gains. They would do so only if theirs liability is limited to the moneys committed by them upfront. The company structure fulfils this need satisfactorily.

Flexible Operations:


The venture capital structure should provide enough flexibility during investment and disinvestment process so as to be able to serve the investors interest in the fast changing economy. It should be flexible to decide its operation on a case-to-case basis within a uniform regulatory framework. The structure should be such that it is capable of offering a variety of investment instruments with different risk profile. Partnership concerns are more flexible as compared to companies or trusts. Taxation: It is always desirable to have a structure that is transparent and allows the tax to be levied on individual investors at their personal tax rate. Different investors for example individuals, companies, non resident Indians, foreign bodies, off shore institutions including multilateral organizations like Industrial Finance Corporation and Asian Development Bank participate in venture funds. These have different marginal tax rate. Some of these like IFC, ADB and off shore investors registered in different tax heavens enjoy tax exemption under various treaties. Indian structure had been taxing all of these at a flat tax rate by levying tax on the Funds. Presently a large number of investors are getting their funds registered in Mauritius to save on income tax. On one hand this puts the domestic Funds to disadvantage and on the other drives capital to foreign countries. A tax transparent structure that gives a tax pass through status to venture capital is suitable for domestic venture funds as well as the venture capital investors in India and abroad. The same has been established with effect from assessment year 2001-02. United States, where the venture financing has matured and made a major contribution to the economy provides a statuary structure of Limited Partnership (LP), Limited Liability Partnership (LLP), and Limited Liability Company (LLC). A close look at these structures can help us in selecting a suitable structure and modifying the same to suit our conditions.

Limited Partnership: In general partnership the partners have unlimited liability. All partners, jointly and severally, are equally responsible for partnership‘s activities. Each partner is personally liable for the total debts of the partnership. In case of a limited partnership, there are two types of partners, general partners and limited partners. The general partners have unlimited liability as in the case of general partnership. The liability of the limited partners is limited. They may have a right to vote but cannot participate in the control of partnership. A limited partnership is defined as a partnership formed by two or more persons, having as members one or more general partners and one or more limited partners. The general partners are personally liable for the debts of partnership, have a power to act on behalf of the partnership and have control over the partnership, On the other hand, limited partners, do not participate in the control, do not have the power to act for the partnership and are not personally liable for the debts of partnership. The limited partnership agreement defines the partnerships affairs and the manner of conducting the same in such a way to provide maximum flexibility in its operations. The agreement may also provide for different classes of members and managers having separate rights, powers and claims on assets / 38

liabilities, profits / losses of the limited partnership. A limited partnership is for a period specified in the agreement and stands dissolved and its affairs wound up at the specified time or on the occurrence of a given incident. It is taxed like an ordinary partnership, wherein the members are individually taxed for their proportion of profits or losses. Limited Liability Partnership: In a limited liability partnership the partners are protected from personal liability for claims related to other partner‘s negligence, error, omission and incompetence. The partner‘s liability is also limited for the negligence, error, omission and incompetence of the partnership employees or other agents. It is defined as a form of general partnership that provides an individual partner protection against personal liability for certain partnership obligations. While being responsible for partnership‘s debts and obligations it protects the partners only against tort claims and not from the liability due to their negligence or wrongful conduct. The creditors are allowed to pierce the limited liability shield of a partner. In US a limited liability partnership is taxed as partnership. Only the partners are taxed and not the partnership firm. Limited Liability Company: It is a new entity even in U S. It is also called as statutory partnership association. A limited liability company can have the benefits of the limited liability of a company and the flexibility and tax benefits of a partnership. The investors can participate actively in the business, like general partners in a partnership. [In U S Limited Liability Company gets the tax benefits of a partnership where the partners and not the firm are taxed.] The major advantage of structuring a venture fund in any of these structures is the avoidance of taxation at two levels, that is, at the level of the fund and at the hands of the investors (members). Of the three, limited partnership is widely used in U S and is the most appropriate for Indian conditions. Herein the general partners who control the activities of the partnership have unlimited liability towards outsides and creditors. The liability of the passive investors and limited partners is limited to their investment, besides the rewards can be shared between the two type of members as per the pre agreed plan. However this will need a suitable change in the Income Tax Act for taxation of partnership to its status prior to assessment year 1993-94 when partners and not the partnership firm was taxed. To sum up setting up of investment bodies for channelizing funds from investor to investee constitutes structuring of venture capital. Venture capital in India can be structured in the form of a company or a trust. Trust fund offers benefits such as limited life / time span, winding up / dissolution on a pre-specified basis, income distribution etc. over structuring of investment in a company.7 The changes in the statute are required to provide a limited partnership as a more efficient structuring of venture capital in India.


Chapter 6 Alternatives to VC funding


6.0 Alternatives to VC funding

Fund from operations:
Existing operations is first place to look for funds. It may be possible to ―tune‖ the business to reduce cash needs or generate more cash from existing customers. If this is a startup, the first year month-by month operating and cash projections show how well an entrepreneur has thought through his business, optimized elements that generate cash, planned new investment burn rate and identified contingencies. Interested partners: License part of your solution: You may be able to enlist others to exploit parts of the market. For example, biotech companies like Genentech license their new processes and drugs to major pharmaceutical companies and Ballard Power Systems licensed their fuel cell technology to the major automotive companies. Launch Customers: Do you have any customers who are willing to fund your R&D to get the product? Vendor financing: How much can your suppliers of equipment and facilities provide?


Research grants: Small Business Innovation Research (SBIR) grants and other ―gifts‖ that don‘t need to be repaid are available from various sources. Sweat equity: There may be people willing to work for stock options, reducing up-front cash. 6.3 Fund it yourself (a) Its beneficial not to have to answer to creditors; and (b) The return on your investment should be higher than other places where you could invest your money. 6.4 Debt financing: In today‘s low interest world, debt is a low-cost capital source. You can also finance your equipment, facilities, and receivables at rates lower than venture capital. Even with VC funding, the venture capitalists will maximize debt to minimize their investment, so you might as well take this step yourself first. 6.5 Friends, family and angels: Friends and family are more likely to loan risk money and likely to charge less because you are more bound to pay them back than you would someone with whom you only have a business relationship. Friends and family financing can also be a precursor to venture capital. It is often debt convertible to shares at the lender‘s option.
6.6 Comparing the alternatives Operations Varies Partners Varies Self Small (~$100K) Free to 5% Varies Company Owners Debt Varies Friends Small (~$100K 8-12% + option Varies Friends/ Company VC $2-20M

Size of investment Cost of Capital Risk Tolerance Financials Emergency Control

Free Not Applicable Company Owners

Free to 10% Not applicable Not applicable Owners

5-10% Low Bank/ company


High Audited VCs




Chapter 7 Venture Capital Operations in India


7. Venture Capital Operations in India
Over the last few years Indian venture capital has evolved its own set of procedures and practices. The foremost of these practices is the manner in which Indian venture firms choose their investments. Like their counterparts in US and Europe venture capitalists here look for investments with a characteristic of high risk and high return. The choice of investment is the function of the venture capitalists policy with regards to the preferred industries and the stage of the investee company, yet the exact choice of investment vary from one venture capital fund to another.

7.1 Factors Influencing Venture Capitalists Choice of Investment
The venture capitalists usually take into account the following factors while deciding on the investment. 1. Track record of the promoters and the management team is the single most important factor. It is often said that three most important considerations in selecting the venture capital investment are ―Management‖, ―Management‖ and ―Management‖. Venture capitalists look for a track record in terms of the successes of the promoters in their previous vocations, whatever these might have been. They put their bets on successful people and avoid those who have tasted failures earlier. A venture capital fund manager does not take more than ten minutes to decide if the management quality is not okay. The two key points a venture capital manager sees are weather the entrepreneur has a vision and whether the management team is cohesive. Here he looks for various questions like: > How do entrepreneurs work together? > How compatible is the venture capital fund with the team? > How complete is the management expertise in the area of business? This means, do the team have members with expertise in various aspects of business. > How is the chemistry between various members of the team?

They also check on the softer issues like temperament of team members, past record and overall management competence. 2. The nature of the business and the promoters experience in the proposed or related business is an important consideration. Venture capitalists are the firm believer of the Corridor Principal1 that states that the probability of the venture‘s success is high when the business falls in the corridor of the entrepreneur‘s previous vocation or education. 3. The business should meet the investment objectives of the venture capitalist in terms of risk profile, the return and the time horizon of the fund. In case of closed ended funds, if the venture capital has earned a substantial return in the first round of investments, it is more open to investments with comparatively higher risk. In the initial investment rounds of a fund the venture capitalist is normally willing to take a


longer term exposure as compared the later rounds when the fund is nearing maturity. In the later rounds the venture capitalist goes in for balancing investments. 4. The funds normally invest in select industries where they have the knowledge and expertise. This helps then in providing value added services to the investee companies. 5. Project cost, scheme for financing and financial projections over next few years, including details of underlying assumptions are closely studied, The resultant Internal rate of return (IRR) must meet the minimum fixed by the venture capitalist as the hurdle rate. The IRR is adjusted for any protection, the venture might be enjoying in the form of subsidy or any other concession from any government or statutory body. This is to ensure the inherent earning potential of the investment in spite of policy changes by the government. 6. Marketing strategy, including target market, market survey, marketing effort, market size and growth potential also effect the decision. 7. Technology and technology collaboration if any are looked at carefully. 8. Miscellaneous factors looked at include raw material availability, pollution clearances, government policy, rules and regulations — controlling the industry, location, water and electricity needs etc.. Most of the venture capital firms do not want an introduction from any one. A business proposal that is well prepared is the best introduction that one can ha‘ye. Most venture capital firms are interested in good investments and not in social contacts and introductions. A detailed and well-organized business plan is the only way to gain a venture capitalist attention and obtain funding. VCs do not invest in a two page summery. The summary is needed as a start but not as a substitute for a sound plan. A well prepared business plan serves two functions. Firstly it informs the venture capitalists about the entrepreneur‘s ideas, secondly it shows that the entrepreneur has seriously thought about the intended business, knows the industry and has thought through all the potential problems. The summary should contain the name, address and telephone number of the contact persons in a conspicuous location. Briefly the type of business or nature of industry should be discussed. This should be followed by a thumb nail sketch of the company‘s up to date history. The experience of the entrepreneurs and the top management personal should be mentioned. A short description of product or service is required. The amount of funds and the form in which required should also be given. Summary of five years financial projections and five years history of existing group companies should be appended. Besides the exit plan should also be mentioned. The detailed proposal must cover the following issues. I. Business and its Future 1. Nature of Business 2. Business History 3. Future Projections 44

4. Uniqueness 5. Target Customers 6. Competition 7. Production Process 8. Market 9. Labor and Employees 10. Suppliers 11. Sub-contractors 12. Plant and Equipment 13. Property and Facilities 14. Patents and Trademark 15. Research & Development 16. Litigations 17. Government Regulations 18. Conflict of Interest 19. Orders outstanding 20. Insurance 21. Taxes 22. Corporate Structure II. Management 1. Directors and Officers 2. Key Employees 3. Remunerations 4. Conflict of Interest 5. Principal Share Holders 6. Consultants, Lawyers Accountants, & Bankers III. Financing 1. Proposed Financing 2. Collaterals 3. Condition of Financing 4. Proposed Reporting and MIS 5. Investor Involvement 6. Capital Structure 7. Guarantees 8. Use of Proceeds 9. Fees Paid IV. Risk Factors 1. Limited Operating History 2. Limited Resources 3. Limited Management Experience 45

4. Market Uncertainties 5. Production Uncertainties 6. Liquidation 7. Dependence on Key Management Personal 8. What Could Go Wrong? V. Analysis of Operations and Projections 1. Financial Projections 2. Ratio Analysis 3. Contingent Liability VI. Product Literature, Procedure and Articles Venture capital firms in India usually have either a fixed format or guidelines on how to present a proposal and the information they are looking for. IDBI has prescribed a preliminary application format, to include, brief details of performance of industrial concerns if existing, nature and advantages of the proposed process / product, development content in the process, proposal for scheme including nature of up-scaling and appropriate cost of venture. After examining the prima facie eligibility of the proposal a detailed application form is send by IDBI. In case of IDBI the factors taken into account while appraising the project include the technology development content. The commercial aspects such as cost advantage of the proposed technology, market potential, demand supply gap, and the availability of management team well versed in various disciplines. Indus venture capital fund usually accepts the project report prepared as per the format prescribed by the financial institutions as in most cases the project will have been received and appraised by the institution before it comes to Indus Investment Fund. Customer is asked to bear the transaction cost relating to investment by Fund including any professional fee of accountants, solicitors etc. In the proposal or project report, they look for the background and performance record of promoters, nature of promoters business, summary of the project cost and the amount of money sought, information on loan and bank facilities, other equity participants, details of government approvals required for the project and their current status, details of management team and its experience, outline of product, market size, strategy and marketing plan, summary of premises, production and general operations, financial projections covering five years period, cash flow forecasts. Details of financial operations of the existing group companies for last five years particularly audited figures and forecast for the current year are also sought. IFCI Venture also has a detailed Techno Economic evaluation and takes help of outside experts whenever required. The format prescribed by them includes name and address of the organization, write up on promoters and their background, particulars of the company structure, R & D set up, project / feasibility report, market survey report, production process / technology, status / stage of development of technology, advantages of the proposed project over existing products, scope of commercial exploitation, proposed strategy for achieving the objective including specific approach for such tasks, as technology inputs, design, development, prototype development and production, large scale production, testing, evaluation, manufacturing arrangement for up gradation to commercial scald economic scale of 46

production, manpower development, market penetration and also likely constraints and how these are proposed to be overcome; details of government‘s consents, cost of project and proposed means of financing, organization chart for the company and the project, responsibility centers, bio-data of key personals, sales forecasts, profitability projections, cash flow statements and amount and type of assistance required from IFCI Ventures. ICICI venture considers investment on the basis of four important aspects. First is the sound management team whose members have established track records with displayed ability, dedication and integrity. Second is the large and rapidly growing market opportunity. Scope for international marketing of the product or service is considered an added advantage. Third is the long term competitive advantage that would pose entry barriers to competition. This could be in terms of quality, performance or cost over substitute and competitive products. Finally it is the potential for above average profitability leading to attractive return over a longer period. The criterions used by APIDC Venture Capital Fund in selecting the investee company include several factors. The quality, depth, maturity and experience of management or exposure in the industry in which the assisted concern proposes to implement the project are factored in. In case of project by first generation entrepreneur, the experience, qualification and depth of knowledge of the relevant lines and the efforts put in by the entrepreneur are considered. The other factors are innovativeness of the technology / process, its advantage over the existing technology / process, the resultant benefits that may accrue on account of the new technology and process; in case of existing products, the potential size of the market with long term growth prospects, existence of clear demand supply gap over the period of investment or advantage available to the assisted concern for marketing its product over its competitors; in case of innovative product the competitive advantage of such product over existing products, the potential for replacement and estimate of such replacement demand; in case of new products its uniqueness and innovation to give competitive edge over the existing products. IL&FS Venture Corporation considers market growth potential, management skills, technology, quality consciousness, experience in the related field, commitment to the business and business ethics in the order of priority. Their investment in a particular industry is based upon its growth potential, technical innovation and rate of obsolescence. With the maturity of venture capital industry the decision to invest now hinges on four criteria, each of which must be satisfied before the venture capitalist commits his funds. A host of new breed private sector and offshore funds during due diligence follow a four point criteria as under: 1. Fundamental analysis as to the soundness of the business. 2. Financial analysis of the prospect for the value of the business to grow. 3. Portfolio analysis is to determine whether the investment will fit into the venture capitalists ―basket‖ of investments. 4. Disinvestment analysis to determine the mean time and a probable value of the investment upon exit.

1. Fundamental Analysis 47

A detailed fundamental analysis of the enterprise and the industry is considered essential. The fundamental analysis at the minimum should consider the following: >A brief history of the company including date of incorporation and summery of progress to date. > The quality, experience, strategy and motivation of the management, directors and existing shareholders. > A complete description of company‘s products or services. This considers the distinctive advantage or unique selling points which is likely to lead to the company‘s success. > The market which the company services, including size and nature of the industry, the size, location and characteristics of customer base, potential competition and distinctive or any unique selling point. >Manufacturing and operational aspects of business, including a description of technology employed, access to sources of supply, manufacturing capacity and the premises owned or occupied. >An objective analysis of the fundamental risk and the management‘s plan to cope with these. 2. Financial Analysis Indian venture capital firms use financial analysis to look at the financial implications of the company‘s strategy and to measure its performance. Venture capitalists use this to determine: > The earning growth potential of the company. > The sensitivity of these earnings to fluctuations in sales & margins and thus the risk associated with the returns. > The likely time lag between investments (e.g. Capital equipments, marketing etc,) and returns. > The likely impact on cash flows, and possibility of having to make second or third round financing into the Investee Company, which do not live up to their projections. > The expected value of the company at the time of disinvestment. > An objective analysis of the financial risk and management‘s plans to cope with them. 3. Portfolio Analysis The initial investment decision also depends upon the venture capitalist‘s portfolio balance at the time the investment proposal is being considered. That is the proposed investment must be an acceptable addition to venture capitalist‘s portfolio in terms of its size, its stage of development, its geographic location and its industry sector. Many venture capital firms avoid seed startup or early stage propositions for fundamental reasons, while a growing number of venture capitalists are wary of irrational and depressed IPO markets in India and hence avoid Buyout / Buyins. 4. Disinvestment Analysis It is vital that the venture capitalist keeps his mind on exit at all times; clear idea as to the method, the timing and the valuation of the company upon disinvestment. Indian venture capital funds have faced maximum problem in this respect. Presently the exit plan is finalized and agreed upon before the venture capital fund commits investment


Till 1998 foreign venture capital funds were not convinced that money could be made in India and concerns existed on the exit options, The successful exit of ICICI ventures and some other domestic funds have acted as a trigger in attracting a number of foreign venture capital funds to India. The other important practices relate to use of financing instrument and the process of monitoring and value addition.

7.2 Structuring A Deal
During structuring a deal venture capital in India has faced two specific problems, namely: Promoter share: As venture capital is to finance growth, venture capital investment should ideally be used for financing expansion of the ventures (eg. New plant, capital equipment, additional working capital etc.). On the other hand, entrepreneurs may want to sell away a part of their own interests in order to book-in a profit for their work in building up the company. In such case, the structuring often includes some vendor shares, with the bulk of financing going to buying new shares to finance growth. Handling director’s and shareholder’s loans: In India a company often has an existing director‘s and shareholder‘s loans prior to inviting a venture capitalist to invest. As the money from venture capital is put into the company to finance growth, it is preferable to secure the deal to require these loans to be repaid back to the shareholders / directors only upon IPOs / exits or at some mutually agreed period (say 1 Or 2 years after investment) This increases the financial commitment of the entrepreneurs and the shareholders of the enterprise.

7.3 Financing Instruments
The type of financing available from the Indian venture capitalists was mainly equity or debt or a combination of both. Due to the rigid rules in India, the Indian venture capital firms do not have the flexibility that UK or US venture capitalists have in innovating new investment instruments. PACT and TDICI (earlier versions of ICICI Ventures) were first to use ―royalty on sales‖ in Indian venture capital. Herein the investee company is provided conditional loan that is serviced through a percentage of sales as royalty if the venture succeeds and the amount is written off if it fails. Of late with the relaxation of the regulation and the maturity of the venture capital industry innovative financing instruments are now available. ICICI venture has introduced optionally and partially convertible debentures. Share warrants have been used to bring down prices. ICICI and some other funds have provided bridge finance to the assisted companies. Over the last five years Indian venture capitalists have become more flexible. In the five year period 1993-98 venture capital investment in the form of non convertible debt has reduced from 36 percent to 7 percent. Some funds invest using only one or two instruments; others use a variety of instruments In India only 20 percent venture capital firms use just one type of instrument, while 30 percent use two types of instruments. A few funds use even five types of investment instruments.


7.4 Monitoring
All venture capitalists in India practice hands on active monitoring. 17 venture capital firms provided information about their monitoring practice. 15 respondents claimed active monitoring while one called its monitoring approach as proactive. Only one fund is believed to be following a passive / hands off approach. ICICI Ventures follows a mid way approach. Almost all the domestic funds nominate their representatives on the Board of Directors of the investee companies. Offshore funds are not that particular about their nominee on the Board of the investee company, however they are very particular on regular monitoring. In terms of value added services most of the Indian venture capital funds provide only financial advice and a few of them provide management inputs. According to the views of the assisted entrepreneurs the contribution of the nominee directors particularly from the public sector funds is lacklustre except in the area of financial management. Very few funds are able to provide a real value addition through networking. However some of the state sector venture funds do provide good support in interfacing with state agencies and are helpful in arranging additional funds from state industrial development and financial institutions. Gujarat Venture Finance Ltd. supported Saraf Foods, an investee company in many ways — by arranging for finance when the company was in need of it, getting technical problems sorted out when the pilot project had teething problems. It stood behind Suresh Saraf, the promoter of Saraf Foods even while the company was not making profits in the first couple of years. It also encouraged the company to expand.3 DHL decided to go in for venture capital funding, its aim was not only to correct the debt equity structure of the company but also find a partner who could help them introduce the best practices in financial management. It wanted to hive off its international travel business and wanted to choose a partner to do due diligence for it. It chose Bankers Trust as its venture capitalist which also helped DHL, in Y2K compliance and in its financial management.

7.5 SOME OF VENTURE CAPITAL ORGANISATIONS ICICI Venture Funds Management Company Limited ICICI Venture (formerly TDICI Limited) was founded in 1988 as a joint venture with the Unit Trust of India. Subsequently, ICICI bought out UTI's stake in 1998 and ICICI Venture became a fully owned subsidiary of ICICI. ICICI Venture also has an affiliation with the Trust Company of the West (TCW), which provides it a platform for networking Indian companies with global markets and technology. Strong parentage and affiliates for ICICI Venture also translates into access to a broad spectrum of financial and analytical resources thus enabling a keen understanding of the Indian financial markets and entrepreneurial ethos. IFCI VENTURE CAPITAL FUNDS LTD. (IVCF) IFCI Venture Capital Funds Ltd. (IVCF) was originally set up by IFCI as a Society by the name of Risk Capital Foundation (RCF) in 1975 to provide institutional support to first generation professionals and technocrats setting up their own ventures in the medium scale sector, under the Risk Capital Scheme. In 50

1988, RCF was converted into a company, Risk Capital and Technology Finance Corporation Ltd. (RCTC), when it also introduced the Technology Finance and Development Scheme for financing development and commercialization of indigenous technology. To reflect the shift in the company's activities, the name of RCTC was changed to IFCI Venture Capital Funds Ltd (IVCF) in February 2000.  SIDBI Venture Capital Limited (SVCL) SIDBI Venture Capital Limited (SVCL) is a wholly owned subsidiary of SIDBI, incorporated in July 1999 to act as an umbrella organization to oversee the Venture Capital operation of SIDBI. SVCL mission is to catalyze entrepreneurship by providing capital and other strategic inputs for building businesses around growth opportunities and maximize returns on investment. SVCL will manage the various Venture Capital Funds launched/ being launched by SIDBI.  IL & FS Group Businesses IL&FS was incorporated in 1987, and commenced operations in May 1988 as a subsidiary of Central Bank of India (CBI), one of the largest nationalized banks in the country. The initial shareholders were the Unit Trust of India (UTI) and the Housing Development Finance Corporation Limited (HDFC). Thus, from its inception, IL&FS inherited the experience and expertise of these institutions.  Gujarat Venture Finance Limited (GVFL) Started in July 1990, at the initiative of the World Bank, GVFL Ltd. is regarded as a pioneer of Venture Capital in India. Over the past ten years, GVFL Ltd. has provided financial and managerial support to over 57 companies with a high growth potential. GVFL Ltd invests all over India and across industries. It has created a niche for itself in small and medium scale companies. Investment and monitoring such companies require considerable effort and involvement as compared to large projects. Over the last ten years GVFL Ltd. has been developing an edge, dealing in such investments. 7.6 Where are VC’s Investing In India? • IT and IT-enabled services • Software Products (Mainly Enterprise-focused) • Wireless/Telecom/Semiconductor • Banking • PSU Disinvestments • Media/Entertainment • Bio Technology/Bio Informatics • Pharmaceuticals • Electronic Manufacturing • Retail


Chapter 8 Current Trends in India


8 CURRENT TRENDS IN INDIA 8.1 Growth of VC in India Venture capitals in India invest in the companies that fit into their criteria of investment stage, potential yield and exit period. The actual choice varied with the venture capitalists depending upon their investment strategies. The numbers of venture capital funds which are active in India are growing at a rapid rate. Also the average investments which are made by capitalists are growing. VC investment in India jumped 120% to $238 million in 2nd Quarter 08, driven by various deals Bangalore, Mumbai and New Delhi (21 August 2008) — Venture capitalists invested some $928 million in 80 deals for entrepreneurial companies in India during 2007, according to the Quarterly India Venture Capital Report. This was a whopping 166% increase over the $349 million invested in 36 deals in 2006 and easily the highest total on record for the region. The report found nearly 48% of all venture financing deals in India were for Information Technology (IT) companies. The most popular recipients of venture capital in the IT industry were companies in the Webheavy ―information services‖ sector, which accounted for 22 deals and nearly $141 million in investment. Among the deals in this area was the $10 million second round for Bangalore-based Four Interactive, an online provider of local information on food, events, lifestyle, shopping and more. According to the data, the overall business/consumer/retail industry saw 30 deals completed in 2007 and more than $346 million invested, a 92% jump over the $180 million invested in 16 deals in the industry in 2006. As said, the business/consumer service area accounted for the bulk of the interest in this industry, with 22 deals and $254 million invested. India's health care industry, while still in its infancy, also saw increased investor interest in 2007 with seven completed deals and nearly $100 million invested, more than double the $41 million invested in the prior year. 79% of all deals in India were for seed and first rounds and a lot of these companies will continue raising venture capital as they progress toward profitability and liquidity. And because the majority of investment is going to early-stage companies, we aren't seeing ballooning deal sizes like those in the U.S and Europe where investors are focused more on later-stage companies.‖ In fact, the median size of a venture capital round for companies India was $9 million in 2007, up slightly from $8.7 million in 2006 but well below the $18.8 million median seen in 2005. Of all the companies in India that received venture funding in 2007, nearly 73% were already generating revenues or profitable. Issues and Challenges Indian VC yet to be established as a sustainable asset class among institutional investors. Moreover a limited amount of true ―risk-capital‖ impacts entrepreneurial activity. Exit challenges exist mainly due to shallow capital markets and dull M&A environment for small companies. Most importantly, India is yet to create a brand-name for IP-led companies, like Israel has successfully done


8.2 No. of venture Firms in India
Here the venture capital industry is highly fragmented no one is market leader. The market for industry‘s product or service is becoming more global, putting companies in more and more countries in the same competitive arena. The industry is young and crowded with aspiring contenders. As in the year 2006 and 2007 the stock market of India was booming like anything thus more venture capital investors and players were attracted towards industry, which can be seen from the chart given below. But in the year 2008 because of sub-prime crisis the stock market has crashed and it affect adversely the venture capital industry because the IPO is the main exit route for the venture capital industry and because of current crash no one is coming with IPO. As there was high growth of stock market in the year 2006 and 2007 most of the VCs have entered in the market so now in crashed market every one is eager to sell their services in small market of buyers. So the competition is very high at current stage., strategic review 2008 published by (National Association of Software and Service Companies) Strategic review 2008


8.3 Top Venture Capital Investments


8.4 Investment Pattern:
In venture capital industry, firms are investing on some basic criteria which they have decided by their own requirement. Here some companies are investing in some particular industries and some of them have also decided the stage of financing the company. So venture capital firm investing in early seed stage does not directly compete with the firm investing in the later stage, one investing in LBO, MBO and MBI deals. So the competition between stages is moderate while it is high within the stages. So the overall competition is moderate to high


Company IDBI venture fund ICICI venture funds SIDBI RCTC venture capital fund scheme CANBANK VC fund LTD Gujarat venture capital funds 1995 Industrial venture capital Ltd.

Seed stage 50

Start up stage 63

Early stage 1

Later stage 2





5 6

19 43

2 3

3 7













( Source : Venture capital in India by “Satish Tanej”, “Galgotia publishing company”, Pg. No.245-288) 8.5 EFFECT OF GLOBALISATION: Formerly whenever money was invested in a company, many factors were considered – the kind of market available for the product, the economic viability, and its place in the stock market. Today however globalization is a factor to contend with. The investors want to be the 1 st in the market to be associated with something that is really ―hot‖ and are prepared to take the ―high risk‖ factor in their stride because they know that it is likely to produce tremendously ― high returns‖. So because of less concerned about other factors investors are looking only for the returns thus the competition among players is moderate to high



Source :

We can see from the chart that the market is growing at 43% CAGR. As we know market will grow only if the demand for services is increasing which will attract new entrants to the market and will also led the existing players think on the matter how to handle new entrants and how to compete with other existing players. So the growth rate increases the competition among rivalry.

8.6 Emerging sectors:
In today‘s world new entrepreneurs are entering in businesses which lead to increase in competition and also give arise to new emerging business which will need finance which can increase the scope of venture capital. From the below given chart we can see that there is a huge investment opportunities for the money suppliers. This can raise funds in market and will also increase the competition among existing players.


From the above we can say that competition among rivalry is moderate to high 8.7 Threat from substitutes:

Stages Substitute

Early stage Angel investors Friends & family IPO Private Placements

Start up stage IPO Preference shares Debentures Bank loan

Expansion stage Bank IPO Parent firms FDI

Substitute at early stage financing : Here the substitute are angle investors, friends, family and here the level of investment is very low, so no one is ready to take the money from venture capital firm. Threat from substitute is high. 58




Angel investors Friends & Family IPO Private placement Venture capital



Here the venture capital is the only option providing management support to the business while the financial burden is very low. It also have the control over the business. Thus, the mind set of Indian entrepreneur can not accept the entry of venture capital funds in his business. So at early stage threats from substitute is so high Substitute at start up stage: Here the require huge capital for starting the business and that time there is lot of risk. So the company collects the company through IPO rather than through Venture capital. Threat from substitute is moderate.







Here also the venture capital only is providing management support while the other options (IPO, Debenture, Bank loan, Preference shares) can provide more management safety than VCs. Moreover it also handover some management control to venture capitalist while other options except IPO provide full freedom. Thus, venture capital doesn‘t fit according to Indian entrepreneur mindset. So threat from substitute is moderate to high. 59

Substitute at Expansion Stage: Here the company wants to expand geographically and make merger and acquisition with another company, and also make LBO, MBO/MBI deals so the requirement of investment is very high and there is less risk and this stage company has good bargaining power because the company is already developed and they can collect the money from any where. Nobody is ready to give money to the company at this stage rather than venture capital. Threat from substitute is low.









At this stage the biggest substitute for the venture capital is FDI. Because at this stage firm requires a huge capital for expansion and here the venture capital having only one competitive advantage over FDI is management support provided by them. In all other sectors Venture capital firm and FDI are mostly similar like control, financial burden and risk associated with them.


8.8 Indian scenario 2007 Contribution of funds to VENTURE CAPITAL

CONTRIBUTORS Foreign institutional investors All India financial institutions Multilateral development agencies Other banks Foreign investors Private sector

Rs. MILLION 13,426.47






1,541.00 570 412.53

6.02 2.23 1.61

Public sector



Nationalized banks



Non resident Indians State financial institutions Other public Insurance companies Mutual funds Total

235.5 215 115.52 85 4.5 25,595.17

0.92 0.84 0.45 0.33 0.02 100.00

Chapter 9 Exit Routes


9. Exit Routes
The voluntary exit can have four alternative routes for disinvestments:  Buy back of shares by promoters or company  Sale of stock (shares)  Selling to a new investor  Strategic / Trade sale The ultimate objective of a venture capitalist is to realize his investment by selling off the same at a substantial capital gain. Thus a venture capital firm converts the value of appreciation into cash. The funds released are redeployed in supporting new ventures. After the assisted unit has settled down to a profitable working and the enterprise is in a position to raise funds through conventional resources like capital market, financial institution or commercial banks, the venture capitalist liquidate their investment and make an exit from the investee company. In fact at the time of making their investment, the venture capitalist plans their potential exit. This is usually done in consultation with the promoters. In spite of the same, venture capitalists and entrepreneurs sometime differ on the timings of the exit. As per a survey of the venture capitalists, when the assisted units are not performing well and the venture capitalist wants to quit in order minimizing his losses, the entrepreneur considers the venture capitalist's action as inappropriate and often tries to oppose the same. It is important that at the time of investment venture capitalist makes it clear to the investee company that he not only intends to sell his investment at a higher price with in a fixed period but also about his realization horizon. A disparity in the expected realization horizons of the venture capitalist and the entrepreneurs may lead to problems. Divorce in venture capital is much more difficult and costly than in the domestic equivalent. Expectation: Venture firms vary in terms of their expectation; some prefer a shorter term prospective than others. Even in one venture capital firm the exit period has been found to differ from venture to venture. It depends upon a number of factors like type of industry, the stage of the investee company, extent of investment by a venture capitalist, besides environmental factors like perceived competition, particularly future level bf competition, technological obsolesce etc play an important role. Venture capital realization requires patience as industry tends to be Cyclical and its fortunes fluctuate with the stock market, precisely IPO market. Projects in some areas like Biotechnology take longer while Information Technology projects particularly those related to internet have a shorter prospective for the venture capitalists. Early stage financing normally takes a long term view of five to seven years for realization by the venture capitalist. Obviously the Startup projects require a longer period to stabilize to a level where a trade sale or a public issue of shares can be contemplated. Later stage financing has a shorter exit period of three to five years. The time horizons and exact time of exit depends upon the style of the venture capital firm and its perception of the market variables.


Preparations: The investee company has to prepare and make suitable adjustments in its capital structure at the time of realization by the venture capitalist. The convertible preference shares and convertible loans must be converted to ordinary equity before the exit by the venture capitalist. In case of non-convertible preference shares and loans by the venture capitalist these are to be redeemed. The special debt instruments are normally payable at the time of sale or change of control. At exit the special rights granted to the venture capitalist cease to operate and venture capital firms normally withdraw their nominees from the board of the Investee Company. The venture capital firms have a motto 'exit at the maximum possible profit or minimum possible loss - in case of a failed investment'. The exits 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

9.1 BUY BACK I SHARES REPURCHASE Buy back or Shares repurchase has following distinct forms: i) The investee company is to buyback its own shares for cash from its venture capitalist using its internal accruals. ii.) The promoters and their group buys back the equity stake of the venture capitalist. iii.)The employees' stock option trusts are formed which, in turn, buy the share holding of the venture capitalist in the company. When the venture has settled down to a profitable state and the company or the promoters have amassed sufficient capital through their venture and are constrained to grow through market barrowing this option is preferred. The route is suited to 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/ the company and only on their refusal the other disinvestments routes are looked into. The 64

option price of the shares is set at a level above the hurdle rate of the venture capitalist. The exact price is mutually negotiated between the entrepreneur and the venture capitalist. The price is determined considering - the book value of the shares, future earning potential of the venture, Price / Earning ratio of similar listed companies. Till recently Indian companies were not allowed to buy back their shares, as a result one of the popular exit routes was not available to venture capitalists in India. Recent Companies (Amendment) Act,] 1999 enabled the companies to buy back their own shares and has opened this route. A few deals have been struck by GVFC, ICICI venture and other venture capitalists. Even in UK the companies were permitted buy back of their shares only in 1981. Buy back by the promoters had been the most popular exit route. The problem however is the high rate of income tax, which makes it difficult for Indian entrepreneurs to martial the necessary funds even in case of a highly successful venture. As a result this option is less effective than the company buy back. Most venture capital rums include the buy back as a part of the agreement at the time of investment. IFCI Ventures (RCTC) always had - a buy back by the promoters - clause in its agreement with the assisted units. Canbank Venture Capital Fund has been offering the entrepreneurs an opportunity to buy back the shares within the stipulated period at a predetermined price. GVFL and IDBI also give an option to the promoters for buying their investment at commercially determined rates before disinvesting. Even when venture capitalists have no intension of exiting using this route, they consider it when the venture fails to achieve high growth and the return from the investment is likely to be low /average. The third option is buyback through employee's trust. Here in the trust can obtain funds through contributions made by the employees and / or the company. It can also borrow from banks and other institutions. Though it is popular in UK and US the same has not yet been tried in India. In the developed economies of UK and US buy back route is used when the businesses have not performed well to attract adequate valuation and sponsors for listing.

9.2 SALE ON SHARES ON THE STOCK EXCHANGE The venture capitalist can exit by getting the company listed on the stock exchange and selling his equity in the primary or secondary market using any of the three methods. i.) Sale of shares on stock exchange after listing shares. ii.) Initial Public Offer (IPO) / Offer for sale. iii.)Disinvestment on OTC Sale of Shares on Stock Exchange after Listing Shares Venture capitalist generally invests at the start up stage and proposes to disinvest their holding after company brings out an IPO for raising funds for expansion. This listing on stock exchange provides an exit route from investment.

9.3 Initial Public Offer (IPO) Offer for Sale 65

When the existing entrepreneurs opt out of buy back, the venture capitalists opt for disinvesting their stocks through public offering. More often this happens to be the first public offering by the investee company. The world over it is the preferred exit option as it is beneficial to the promoters as well as the venture capitalists. The major advantages are; 1. The public issue provides liquidity to the business, which is useful for the company. 2. 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. 3. 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 companies 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. 4. 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. 5. The company may get a tax break as listed compa.'1ies usually pay tax at a lower rate. 6. Public listed companies normally. have a higher credit rating, the growing companies will not have to depend on internal accruals for financing expansion. Several promoters have reservations to going public. These include: 1. High cost of raising money through stock market. The cost includes underwriter‘s commission, the expenses of merchant bankers, attorneys, auditors, printing and publicity besides listing fee of the stock exchange. These costs have increased over the years. 2. Going public results in dilution of ownership. The original entrepreneurs have the additional task of informing the new shareholders about the company's activities and answering their quarries. 3. The disclosure requirements as per the listing agreement of the stock exchange and SEBI dissuade some promoters. Those who feel uncomfortable giving information about the director's remunerations, details of company's ownership or information about sales, borrowings profits etc. may like to avoid public issue. 4. The listed companies are required to disclose sufficient information about their operations. The competitor can abuse this information. The knowledge about the company's profitability sometimes leads to labour problems with workers demanding higher wages. 5. Listed companies cannot keep their dealings with interconnected companies where promote have a confidential interest undercover. This harms the promoter's interest. 66

It is preferred where venture is successful and its internal generations are adequate to meet immediate fund for expension. Therefore no IPO is envisaged and instead a part of existing equity is offered for sale.Disinvestment by a public issue is dependent on the ~tock market conditions particularly the primary market. The stock markets are cyclic in nature. The state of the stock market, and its volatility acts as a considerable deterrent to this option. During boom period when the stock market is raising it is easier to disinvest by this route and the venture capitalist gets a higher price for its investment. When the market is in recession floating the public issue is an undesirable exit route. However if the decision to go public has been made, the venture capitalist would like to exit if he can get a good return on his investment. In case he expects a much higher return by delaying the exit, he will wait longer. During US stock market boom of 1991-96 the number of venture backed IPOs increased to 290 raising $12.2 billion in 1996 and came back down to earth in 1997 with 138 companies raising almost $5 billion and 78 companies raising $3.8 billion in 1998. Venture backed IPOs as a percent age of overall IPOs dropped from 27 percent in 1997 to 22 percent in 1998. In Europe the growth in the number of stock exchanges has contributed by providing more exit routes for early and later stage investors. Stephen Schweich, Managing Director of BancBoston Roberston Stephens International, which has completed 15 European equity offerings in technology sector during1999 feels that IPOs are not best exit route for all investments. Initial public offering is the most glamorous and visible type of exit for the venture capitalist in US, In the recent years technology IPOs have been in the limelight during the IPO boom of last seven years. At public offering in US, the venture firm is considered an. insider and will receive stock in the company, but the firm is regulated and restricted how that stock can be sold or liquidated for several years. Once this stock is freely tradable, usually after two years, the venture fund distributes this stock or cash to its investors who may then manage the public stock as a regular stock holding or may liquidate it upon receipt. Over the last twenty-five3 years, almost 3000 companies financed by venture funds have gone public. The listing requirements of Indian stock exchanges have posed a major hurdle for this exit route. Earlier listing guidelines. required atleast 60 percent of the capital to be issued to public, and acted as a blockade for effective retention of control in venture. The revised guidelines have reduced this to 25 percent for general companies and 10 percent for Information Technology related companies. As a result IPOs are becoming more popular with the entrepreneurs. The guidelines relating to minimum size of the paid up capital is another barrier as most of the start up ventures particularly those re ated to software or IT fail to meet the paid-up capital threshold of Rs. five crore at NSE and Rs ten crore at BSE. Venture capitalist in such case hardly has an exit option from investment. Presently there is no organized system facilitating the trading in the securities of private limited companies in the stock market. In India the share price movements are generally driven by sentiments and have low level of fundamental support for the company. Here the stock markets have not been rational. As a result investors either fail to realise the fair value of their investment or get a bounty not supported by the intrinsic worth of investment. Under this. Scenario, venture capital firms fail to realise true worth of their investment.


Disinvestments on OTC An active capital market supports the venture capital activities. It enables the venture capitalists to get a suitable valuation for their investment. Besides the regular stock exchange a well-developed OTC market where dealers can trade in shares on a computer terminal imparts liquidity and breadth to the market. The OTC market enables 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. In US the National Association of Securities Dealers Automated Quotation System (NA~DAQ) is an important OTC market. Presently over eight thousand stocks are being provided liquidity by listing on NASDAQ. Today NASDAQ has a concentration of technology stocks and is considered the hub of venture capital activity in US. As per the recommendations of a number of committees, e.g. G S Patel committee on stock exchange reforms, Abid Hussain committee on capital markets and Dave committee a Second Tier Stock Market, an OTC exchange was required in India. As a result Over The Counter Exchange of India (OTCEI) was established as a non-profit making company under section 25 of the Companies Act 1956. The companies listed on the OTC Exchange enjoy the same status as companies listed on any other stock exchange. OTCEI is owned by public sector financial institutions like UTI, IDBI, ICICI, IFCI, LIC, GIC, Canbank, and SBI Caps. It brings .together investors and the companies seeking to raise funds. It appoints dealers and members for this purpose. The OTCEI was expected to boost the venture capital activity by motivating the closely held companies to go public by shedding their fear of takeover. The flexibility of OTC trading system allowed trading of different types of financial instruments. This provided greater flexibility to the venture capital firms in form of innovative financing.

9.4 CORPORATE I TRADE SALE The venture capital firm and the entrepreneur together sell the enterprise to a third party mostly a corporate entity. Herein the promoters also exit from the venture along with the venture capitalist. This is called a corporate, strategic or trade sale. When the venture has reaches a stable level of operations and the entrepreneurs feel that they have proved their idea, many a times they may prefer to sell off their ventures. The reasons for this sale can be varied, difficulty in running the venture profitably or a perceived competition from more established big business houses having huge resources. In such circumstances the venture is sold to a corporate having business synergy. Trade sales are very popular in UK and US. This is in spite of the fact that stock markets for an lPO as well as OTC are well developed in developed economies. Entrepreneurs with a solid ideas and revenue models have been able to get much higher valuations through this route. This is so as the venture has developed to a stage that the buyer has a clear prospective of the acquired venture's contribution to his 68

business. The sale of hotmail by Sabeer Bhatia to Microsoft for $ 400 million as against the. Valuation of $ 200 million by the venture capitalist Dough Carlisle is a fine example. 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 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. Cerent, a venture capital funded company was sold to Ciaso Systems for an impressive $ 6.9 billion and Siara Systems, a company producing fibre optic network equipment was purchased by Redback Network for a cool $ 4.3 billion. Modalities: The modalities of the trade sale differ from case to case depending upon the nature and level of operations, its size and the requirements of the buyer etc. The sale can be in cash, against the shares of the acquiring company or a combination of the two. The equity owners get the shares of 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 the exchange of the shares. Tax liability is deferred till the sale of shares acquired in exchange. Hotmail was exchanged for 2,769.148 shares of Microsoft. There are occasions when the equity is sold by the owners against notes to be received from the buyer. A part of the cost is paid in cash and for the balance the notes are issued. These notes are often secured by the assets of the company and are redeemed at predetermined intervals. The deferred payment through notes is popular as it helps in tax planning by the seller. The appropriate disinvestments modalities of a corporate / trade sale depend on the needs of the seller and the strengths of the buyer company besides keeping in view the tax considerations. At times this is through a management buyout or buy in, which in turn may be financed partially by another venture capital. Formalities involved in sale / transfer of enterprises have restricted smooth exit for venture capitalist. Entrepreneurs and venture capitalist together find it difficult to sell / transfer the venture pending completion of numerous procedural formalities. It is important to note that in India if the investee company is a listed company at the time of trade sale, those the provisions of listing agreement are attracted besides the provisions of SEBI regulations of merger and acquisitions are also applicable. All corporate sales amount to merger, amalgamation and takeover and have to abide by the relevant provisions of the Companies

Management Buy-outs are important in venture capital market for various reasons. ~ MBOs provide an opportunity to managers to become entrepreneurs. ~ Venture capital investment in buyout has a lower investment risk than early stage investments. ~ MBOs help smaller enterprises to adapt to technological changes. Venture capital buy-outs differ from business buyouts as venture capitalists lay greater stress on active aftercare and due diligence than on financial engineering or capability. Venture capitalist considers high risk and high reward with lower price considerations and are more concerned about product or process development, which remains the focus of their investment. J C Verma7 classifies buyout into two types: 69

~ Corporate disposals or 'hire-downs': This form of buy-out envisages 100 percent sale of the business. Such sale may be of business entity or the product alone or assets alone. The existing management initiates the buy-out and retains a minor stake, but starts an independent enterprise. Such buyouts are common in UK. Venture capital buy-outs are both a successful investment strategy for venture capital investment as well as an efficient exit route. Buy-out financed by another venture capitalist primarily by providing debt is known as leveraged buy-out. Buy-out without participation by another investor is called management buy-out. Here in the current management group purchases the stake of the venture capitalist. The stock options and sweat equity have made management buy-out possible in India. 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 of 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. Bhatia remained his company's top executive after it became a subdivision of Microsoft's Web basics.8 Buy-ins differ from takeovers, as the acquirer in a buying is an individual or a group of individuals with the experience of the same industry. He may be unfamiliar with the acquired business but has knowledge of that type of business.

Merger and acquisitions in India are not very popular yet and market for mergers and acquisitions in India is underdeveloped. This is primarily due to the mindset of Indian promoters to retain control on their enterprises and lack of intent to maximize shareholders wealth. Hence merger and acquisitions do not find favour and venture capital firms find it difficult to exit and more so through this route. Because of lackluster IPO market in US, the number of privately owned venture backed companies being acquired increased to 184 in 1998 with a total value of $7.9 billion as opposed to 162 companies in 1997 totalling $7.6 billion. Merger and acquisitions has been the most successful exit route for venture instruments in US9.

9.5 SELLING TO A NEW INVESTOR Many a times for their exit venture capitalist and / or the promoters locate a new investor, a corporate body or another venture capital firm. The new investors are normally those who find some sort of synergy between the investee company and their existing operations such that the relationship is useful to both the companies. When ever the new investor is a large or a well-known business entity, it provides credibility to the investee company. This raises the valuation of the investment and the share prior of the company. This increased valuation helps the investee company to raise further funds from the capital market at a premium. Often the new investor purchases the additional shares from the secondary market, offering better prices to the existing promoters and stakeholders and may acquire the control of the company. The route is also used when the promoters want to get rid of the venture capitalist. 70

New venture capital funds that have just begun their operations are often interested in buying the ownership positions of the venture capitalist. Some venture capital funds, as a policy, concentrate their activities to startups and early stage investments. Such venture capital funds exit paving way for the venture capital funds specializing in latter stage investments or buyout deals. Often a growing venture needs second stage financing, if the existing venture capitalist as a policy does not commit funds for the second stage it normally locates another venture capital firm that finds this investment attractive enough to enter. Here in besides buying in the stake of the original venture capitalist the new venture capital firm also provides funds for the the major problem faced by the venture capital firms in India is a weak legal framework that hardly discourages entrepreneurs from committing willful contravention of terms agreed with venture capital firms. In such cases, venture capitalists find it difficult to seek legal remedy for disinvestments of their investment. Due to the "reasons discussed above venture capitalists in India have generally failed to envisage and implement a successful exit from their investment. Failure to get a proper exit from investment has often been seen as a major hurdle to the growth of venture capital industry. Transparency, disclosures and strong system of expediting transactions / deals. The prices of the stocks should be driven by their performances and not by the sentiments.

9.6 PRE-REQUITE FOR THE EFFICIENT EXIT MECHANISM A discussion with the executives of venture capital firms regarding the available exit routes and the problems faced in disinvestments using these routes leads to the need for following pre-requisites for efficient disinvestments by the venture capitalists. L) Legal framework: A dedicated legal mechanism for the settlement of any dispute arising out of investment by venture capitalist is to be provided by law. This is necessary since the legal framework in India is very weak and has failed to resolve the disputes relating to terms of investment as agreed upon between the entrepreneurs and the venture capital firms.

ii.) Smooth procedures for sale / transfer of enterprises: In order to facilitate the disinvestments by means of a trade sale it is required that sale / transfer of an enterprise is facilitated at a price as close to the intrinsic value of the firm as possible. The procedural formalities required for such transfer / sale should be minimum possible so as to encourage the trade sales.

iii.) Efficient stock market: An efficient stock market is an important pre-requisite not only for the exit route of stock market sale by a venture capital firm but also for an efficient determination of the intrinsic value of the investment and the growth potential of the companies.


An efficient stock market should have adequate transparency, disclosures and strong system of expediting transactions/deals. The prices of the stocks should be driven by their performances and not by the sentiments. iv.) Mechanism for listing and trading of equity of smaller companies: As discussed earlier most of the investments by the venture capitalist are with the first generation technocrat entrepreneurs. The companies assisted are smaller and fail to meet the minimum net worth criteria of stock exchange. OTC exchange of India was set up for such companies with low equity base. However due to various reasons activities of OTCEI did not pick up and it failed to meet its objectives. Necessary steps are required to rejuvenate the working of OTCEI. A fully functioning OTCEI is a pre-requisite to provide an exit route for investors (including venture capitalists) in small equity base companies. The fact remains that the objective behind the venture capital investment is to help the assisted company establish itself, after that the venture capital fund exits the investee company so as to reinvest the released capital in other challenging and profit making opportunities. The scheduling of time and route for the exit determines their disinvestments or exit strategy. The exit strategy aims at maximizing the post tax return of the venture capital fund and depends on the tax laws. RECENT DEVELOPMENTS Ministry of Finance, Government of India has imposed two exit restrictions on venture capital funds in India. 1. A venture fund incorporated in India would have to exit with in one year from a venture capital undertaking (VCU) Le. an investee company going public and getting listed on a stock exchange, but it could stay invested even after a year if it agrees to forgo its tax pass-through benefit. This decision of the government sent a wrong signal to the nascent but growing venture capital industry in India. Compulsory disinvestments within 12 months can be very harmful for the venture capitalist if the stock market goes into a tailspin during this period. VCUs have a varying incubation period even after the initial public offering. A venture capitalist normally makes an exit only after the results of post IPO expansion, consolidation and the growth of the investee company are reflected in its stock prices in the capital market. 2. A venture capital fund cannot exit before completion of one year in an unlisted company. Government of India has removed these restrictions with effect from November 2000. Further SEBI has allowed the OTCEI to develop a trading window for unlisted securities where qualified institutional buyers (QIBs} would be permitted to participate. This would enable the venture funds ~ to exit from unlisted companies in which they have invested. As per norms of RBI foreign venture capital funds could exit from an Indian company only at a price worked out on the basis of a formula that came into effect during the time of the Controller of Capital and was still valid. With effect from January 2001, foreign venture capital funds registered with SEBI are no longer bound by a fixed exit price.


PRESENT STATUS The problem relating to disinvestments and exit in India has been that as compared to the nearly 400 odd companies which have been invested in by Bank of America Equity the total number of exits have been less than 40. Most of these exits have been possible during the boom year of 1999, which means that if one excludes the exits in the boom years, almost no venture capitalist have had a cash return to show its investors. TDICI (now ICICI Venture) had the similar problems.

Chapter 10 Advantages of VC over other forms of finance


10 Advantages of VC over other forms of finance:
It injects long term equity finance which provides a solid capital base for future growth. The venture capitalist is a business partner, sharing both the risks and rewards. Venture capitalists are rewarded by business success and the capital gain. The venture capitalist is able to provide practical advice and assistance to the company based on past experience with other companies which were in similar situations. The venture capitalist also has a network of contacts in many areas that can add value to the company, such as in recruiting key personnel, providing contacts in international markets, introductions to strategic partners, and if needed co-investments with other venture capital firms when additional rounds of financing are required. The venture capitalist may be capable of providing additional rounds of funding should it be required to finance growth.

Most venture capitalists seek to realize their investment in a company in three to five years. If an entrepreneur‘s business plan contemplates a longer timetable before providing liquidity, venture capital may not be appropriate. Entrepreneurs should also consider this.


Chapter 11 Threats


 Venture Capital Market in India getting overheated

The Venture Capital market in India seems to be getting as hot as the country‘s famous summers. However, this potential over exuberance may lead to some stormy days ahead, based on sobering research compiled by global research and analysis services firm, Evalueserve. Evalueserve research shows in interesting phenomenon is beginning to emerge: Over 33 US-Based Venture capital firms are now seeking to invest heavily in start-ups and early stage companies in India. These firms have raised, or are in the process of raising, an average of US $100 million each. Indeed, if these 40-plus firms are successful in raising money, they would garner approximately $4.4 billion to be invested during the next 4 to 5 years.Taking India Purchasing Power parity (PPP) into consideration, this would be equivalent to $22 billion worth of investment in the US. Since about $1.75 billion (or approximately 40% of $ 4.4 billion) has been already raised, even if only $2.2 billion is raised by December 2006, Evalueserve cautions that there will be a glut of venture capital money for early stage investments in India. This will be especially true if the VCs continue to invest only in currently favorite sectors such as IT, BPO, software and hardware products, telecom and consumer Internet. Given that a typical start-up in India would require $9 million during the first three years, investing $2.2 billion during 20072010 would imply investing in 150 to 180 start-ups every year during this period, which simply does not seem practical if the VCs continue to focus only on their current favorite sectors.  Unproductive workforce : A global survey by Mckinsey & Company revealed that Indian business leaders are much more optimistic about the future than their international peers. So Indian employees are tardy in their job so it will effect reversely on the economic condition of the country. Because they are unproductive to the economy of the country.  Exit route barriers : Due to crash down of market by 51% from January to November 2008. It creates a problem for venture capital firms. Because Nobody is trying to come up with IPO and IPO is the exit route door venture capital.  Taxes on emerging sector: As per Union Budget 2007 and broad guidelines, Government proposed to limit pass-through status to venture capital funds (VCFs) making investment in nine areas. These nine areas are biotechnology, information technology, nanotechnology, seed research and development, R & D for pharma sectors, dairy industry, poultry industry and production of bio-fuels. Pass through status means that the incomes earned by funds are taxable now.


Chapter 12 Case Studies on VC


12. Case Studies on VC
12.1 Successful External Venture Investment by Nortel Summary: From 1998 to 2001, Nortel invested in approximately 100 external start-ups through it's partner venture capital firms, acquiring usually from 5 to 20% of each venture. Nortel has grown to become a world market leader in telecommunications, voice, and data transmission. By the turn of the century, Nortel owned up to 90% of the world market for its selected competence areas such as tengigabit systems. From 1998 to 2001, Nortel invested in approximately 100 external start-ups through it's partner venture capital firms, acquiring usually from 5 to 20% of each venture Value-added activities in the area of relationship management, screening and selecting strategic investment opportunities, and the capacity for entrepreneur-friendly acquisitions allow Nortel's business model to work effectively and with speed Nortel maintains close ties with and invests through 7 to 8 carefully selected venture capital (VC) firms that are at the forefront of creating new telecommunications service providers. These firms make a network of relationships that makes visible 90-95% of what Nortel needs to know on an ongoing basis. Nortel uses its side-by-side collaboration with VC firms to gain access to entrepreneurs and ventures and to learn the skills of venture screening, valuating, investing and monitoring Occasionally, investments lead to acquisitions. However, usually Nortel has no intention of acquiring the service providers; rather, it's aim is to learn and understand new business dynamics, to cement relationships, to get access to new-generation technologies, to cut out its own comparable research effort, to support OEMs, to share in the value created by its investments, or to get some preferential rights. Major acquisition made by Nortel in order to integrate critical disruptive technologies include acquisition of Qtera, the leader in ten-gigabit fiber-optic technology, for $ 3.25 billion, and acquisition of Bay Networks, manufacturer of LAN switches and other networking equipment, for $ 9.1 billion. The analysis of some firms studied are reported below: 12.2 TEJAS NETWORKS INDIA PVT. LTD. The vision of Tejas Networks is to create state of the art products and solutions in the telecommunications and optical networking arena. Tejas Networks was founded in 2000. Tejas Networks developed software differentiated optical networking products that provide high price / performance in their class, enabling carriers to maximize revenue generating services while optimizing their overall network costs. Tejas Networks also partners with leading third party equipment vendors to build intelligent optical networks for its customers.


Founders and their experience: Sanjay Nayak is the Cofounder and Chief Executive Officer. He worked as the Managing Director of Synopsis India. Synopsis, Viewlogic Systems and Cadence Design Systems, in US. Dr. K.N.Sivarajan is the cofounder and Chief Technology Officer of He had experience in working with

Tejas. He was a professor at Indian Institute of Science. He worked prior to this in IBM Watson Research centre. He received his Ph.D from California Institute of Technology. Arnob Roy is the third co-founder and earlier he worked with Synopsis India. The Tejas team consists of

outstanding professionals with a wealth of experience in deploying carrier class optical networks in India and USA. Origin of the idea: Mr. Nayak and Dr. Sivarajan decided to create something new for self-actualization. The wanted to create a world class product company, as they wanted India to develop innovative telecom products. Mostly, Indian firms were in software services. They wanted to create products from India. This urge made them seek venture capital as they had innovative ideas. Venture Investors: There were three venture investors for Tejas Networks in the first round, and they are · Mr. Gururaj Deshpande, Chairman of Sycamore · Sycamore Networks, a publicly held corporation and · ASG Omni LLC, a financial agency. In the first round the three investors funded US$ 5 million. In the second round Mr. Deshpande, Intel Capital and ILFS invested US$ 6.7 million. Intel Capital is the strategic investment arm of Intel. Products: The main products of Tejas are cost effective SDH Multiplexer equipments designed to manage bandwidth and derive services from the optical core to access. Innovation in optical networking requires high levels of software and hardware integration capabilities. Tejas has undertaken the design and deployment of optical networks. Through innovation and learning Tejas is able to compete with global firms like CISCO, Nortel and Lucent. Tejas combines the cost advantage of India and the innovative strength of its founders. The optical products are based on the dense wave diversion multiplexing and optical amplification to transmit data optically at 79

aggregate rates exceeding one terabit per second over distances of a few thousand kms on a single strand of fibre. Tejas Networks India Ltd, an optical networking start-up launched its intelligent optical access product in India in less than year after its start. Intel Capital announced funding after the product was announced. The nine month company got immediately its first customer, Tata Power to deploy the TJ-100 access product. This is the first intelligent optical network in India. The system leverages the capacity creation of DWDM technology and innovative networking software. With the Internet infrastructure market growing at about 20 percent per annum Tejas Networks hopes to market its TJ 100 family of products in the global market. Venture funding and value addition: Tejas Network is a knowledge integrator. The firm essential y develops network software and markets Sycamore‘s optical networking products in India and the Asia Pacific. It also develops some regionally specific networking products: The venture capital firms supported Tejas in a number of ways: · The name of Deshpande added reputation and acted as a non-traded externality to attracted VCFs · Intel capital helped in wetting the business plans · ILFS helped in co-funding through its private equity arm and · ASG-Omni helped in developing business contacts. 12.3 STRAND GENOMICS Strand Genomics is a bioinformatics company, that develop innovative algorithms and solutions in the field of bioinformatics. Stand‘s vision is to accelerate the drug discovery process by developing a suite of products for genomics, proteomics and in silico-biology. Use of the state of the art knowledge management solutions allow nuggets of knowledge to be extracted from a large pool of data generated by high throughput technology. Though it is a new firm, it has been able to get contract research from many global firms. It is likely to get its second stage funding. The exact amount has not been announced. Founders: A group of scientists and engineers from US and in India came together to

become a world leader in bioinformatics. The founders were computer scientists with complementary skills in 80

· clustering techniques · Graphics and visualizations and · stringology. All the Board members have a Ph.D degrees and rich domain experience Dr. Vijay Chandru who is a Professor of Biochemistry at Indian Institute of Science, came from MIT. The objective of setting up Strand was to develop tools that leverage unique high-end computational skills. Venture Funding: UTI Venture Funds picked up a 17.5 percent stake for an undisclosed sum. UTI Venture funds picked up a 17.15 percent stake in strand after a thorough assessment. The second stage funding is by Westbridge, an off- shore fund. Product: Strand Genomics had launched two products ‗Soochika‘ is a micro-array knowledge management tool and ‗sphatika‘ is an image classification software. The objective is to provide a tool box that addresses the most common problems faced by drug discovery scientists. The company has a total solutions approach to drug discovery. The tools cover modules for · visualization · High dimensional data analysis · Micro array analysis · Intelligent drug prediction tools · Protein modeling and · sequence modeling and analysis tools. Strategy: Within an year of its establishment it introduced a series of products.

Strand‘s business model is a combination of providing high-end services and building out a suite of products called ‗Oyster‘ to improve the productivity of the drug discovery process. Strand uses a service model that provides revenue on a continuous basis. For example, Strand entered into a partnership with Gladstone Institutes to analyze complex micro array data. Strand will use its 81

proprietary data analysis techniques to analyze micro array data sets generated at Gladstone Institute from experiments using Alzheimers disease related mouse models to identify certain genes and associated regulatory networks. Strand also entered into partnership with Automated Cel which is a disease phenotype driven drug discovery company. Strand provides advanced algorithmic skill sets and software engineering skills to develop products and solutions for Automated Cell‘s drug discovery platform which quantifies in vitro disease phenotypes for target prioritization and validation and lead optimization in oncology and immune disease. Strand is a unique company with skill sets normally not available. The senior team consists of a group of scientists and problem solvers encompassing the areas of computer science and biology with the requisite skills for drug discovery. Strand focuses on solutions that have resulted in huge improvements in both productivity and interpreting knowledge from genomic data. The solutions that strand provides are cost effective and scalable and hence an unbeatable combination. Strand Genomics Cofounder Dr.R.Hariharan is in the Technology Review TR100 list in 2002. The service oriented and long term partnership relationships make Strands‘ model a fast growth and low risk model. The second stage funding was announced recently. 12.4 AVESTHAGEN Avesthagen is a fully integrated biotechnology and bioinformatics company setup primarily to promote research and development services world wide making use of proven latest highthroughput technologies and supported by a well trained research team. The vision of the company is to improve the productivity in agriculture and develop agro-technologies that would lead to value addition in food and pharma products. Avesthagen focuses on contract research for global firms and it is a cost effective research firm in genomics. Research as a business concept it has developed research competence. Founder: The company was founded by Dr.Viloo Morawala Patel. He was awarded a

Ph.D in 1993 in plant molecular biology from the University Louis Pasteur, France and work experience at University of Ghent, Belgium. She founded Avestha Gengzaine Technologies in April 1998. Origin of Idea: Dr Patell returned to India with high hopes and spun off Avesthagen in April 1998 with four employers using the technology developed by per at TIFR through the funding 82

from Rockefeller Foundation. Avesthagen raised US$ 2 million as venture funding from ICICI Ventures, Global Trust Bank and Tata Industries Ltd. The dream of Dr. Patel was to invent edible vaccines and new plants using genomics. Venture Capitalists: The three institutions that funded the first round (US$ 1.5million) are: · ICICI Venture Funds · Global Trust Bank and · Tate Industries Ltd ICICI is one of the foremost investor and stakeholder in Avesthagen. GTB has offered a loan, which was later, converted into Avesthagen equity. Tata Industries picked up a stake in Avesthagen. Avesthagen has engaged Kotak Mahindra and KPMG as investment bankers to facilitate the process of raising the second round funding. Avesthagen is looking for a funding of $10 million in the second round. In 2001-2002, Avesthagen has an income of US$ 1.5 million and it hopes to breakeven this year and reach a revenue of US$ 10 million in five years. Products and services: Avesthagen focuses on both products and services. This business model is basically more robust, as services provide for a regular base revenue. Avesthagen essential y provides four services: · providing user friendly database application and management for life science companies · providing new tools that allow the prediction of complex sequence at the gene and protein level using customized algorithms and annotation tools. · providing 3D fold structural insights to protein modeling · providing clean vital data from a given bulk sequence. Avesthagen has developed complimentary DNA libraries in 3 modules, namely standard cDNA libraries, normalized and subtractive cDNA libraries Avesthagen was recently awarded a US patent on a segment of rice DNA sequence. This well help them in enhancing the rice 83

productivity. The second, thrust area is ‗edible vaccines‘. The vaccines will be made part of the gene in a plant food product so that it can administered easily and in a cost effective manner. This firm is one of the VC assisted firms that is focusing on creation of intellectual property. In this case, venture firms helped in assessing the business model for its robustness. 12.5 ITTIAM SYSTEMS Ittiam is positioned in the fastest growing segment of the core technology space: Digital Signal Processing Systems: DSP Systems. The DSP chip market is about US$5 Billion in the year 2000, growing at 30%. The market for DSP software and system design is about US$9 Billion growing at more than 50% per annum. Founders and their dreams: Mr. Srini Rajam who was the head of Texas

Instruments India Ltd and six colleagues decided to create a world class technology company in India. The drive to come together was the passion to create a world class technology company seven people with 15 to 25 years of experience came together. The challenge was to create ―the world‘s best DSP Systems Company‖. Mr. Srini Rajam was the head of TI India Ltd. TI India was one of the most innovative companies in India as it topped the best companies operating in India that were granted US patents in the year 2000. Venture capital: Ittiam started in 2001 with a seed capital of US$ 5 million from Global Technology Ventures. GTV is an investment arm of Sivam Securities and has an investment from Bank of America. After that in the second round the Bank of America Fund offered US$ 5 million for another 6.6%, a price which value this start-up at a staggering $75 million. Products: Within a year of their start, Ittiam has developed multiple products in all their target domains. This includes video imaging and audio speech products in multimedia in addition to wireless and wireline products in communication. Ittiam also announced its wireless products, which are IEEE 802.11 based wireless LAN. Ittiam has developed solutions for both 802.11b standard which has a bandwidth of 11MBPS and orthogonal frequency division multiplexing. Ittiam will lead the new wave of global product companies from India. The company represents the collective aspiration of the team to lead the new wave of Indian technology products thriving in the global arena. Ittiam is singularly focused on Digital Signal Processor based systems in wireline, wireless, audio speech and video-imaging products. 84

Consistent with its bold vision, Ittiam is pushing the frontiers in all the key areas- business, technology and people. In business, Ittiam has chosen to go beyond the traditional service model and has committed itself to products, both customized and off the shelf technology. In technology, Ittiam selected integration as its strategy-algorithm, software to the actual reference board that resides in the end equipment. On the people front, Ittiam works with the fundamental belief that the company is co-owned by all who work and share the dream-irrespective of the function. The company gave shares to all its employees. Ittiam is one of the most innovative firms operating in India with high quality intellectual property. DSP solution is implemented on a generic platform. Ittiam has system focus and not chip focus. The platform integrates all the interrelated domains. The company has a full fledged marketing group and it has entered into a strategic partnership for overall solutions. In other words, Ittiam is a unique niche player with the ability to innovate. There were no technologies companies in India and Ittiam positioned itself as a technology company. The core competence of Ittiam is its capability to identify good windows of opportunity. The five aspects that distinguishes Ittiam are · experienced team · Market focus · World class orientation · High level platform as the mode of integration, and · Vision to a global leader in DSP design. 12.6 MINDTREE CONSULTING PVT. LTD Mindtree is one of the fastest growing software companies operating in India. Mindtree was selected as one of the best places to work in Information Technology. Mindtree was one of the top 100 IT employers in the US within the third year of its establishment, according to the Computerworld survey in 2002. It focuses on state of the art technologies and high level reusable intellectual property. Founders: A number of highly experienced persons from some of the best companies got

together and worked out a plan to start a new firm. The mission was charted out as: deliver


business enabling solutions and technologies by creating partnerships with our customers in a joyous environment for our people. The logic of their getting together was that many of today‘s software services companies will not be able to be leaders in the emerging future. Because, knowledge enabled software requires six things to remain in the leadership position, namely: · Domain capability · Extensive use of tools · Methodology · Quality · Innovation and · brand positioning Mr. Krishna Kumar was the chief Executive of Electronic Commerce Division, Wipro. Mr. Anjan Lahiri, who was working with Cambridge Technology Partners is the Second Partner. Mr. N.S. Parthasarathy General Manager, Wipro‘s Technology Solutions is the third partner. Rostow Ravanan worked with Lucent Technologies and prior to that in KPMG. Mr Ashok Sootha who was the chief Executive of Wipro is the Chairman of Mindtree. Kamran Ozair who worked with Cambridge Technology Partners was another founder. Scott Staples was also with Cambridge Technology Partners. Mr. Kalyan Banerjee who worked as the head of Wipro Technology Solutions Division also joined the founding team. Vision of 2005 The company set up a very ambitious and aggressive target: · To achieve a revenue of $231 million · To be among the top 10% in our business, in terms of profit & ROI · To be one of the top 20 globally admired companies · To give a significant portion of our PAT to support primary education.


Venture Capitalists:

The first round funding was by the Founders, Global

Technology Ventures and Walden International. The first round funding was US$ 9.5million. In 2001 August Mindtree secured the second round funding. This was US$ 14.1million and this was by: · Global Technology Ventures · The founders · Walden International · Capital International and · Franklin Templeton Fund. Products and Services: Mindtree is essential y a services company. It operates in six thrust areas namely, · Internet Technologies · Enterprise Integration and B2B · ERP and supply chain management · Mobile platform and technologies · Application management and · Setting up offshore development centers. The strength of Mindtree is its ability to leverage its vast knowledge base to prescribe tools and architectures which will work for specific business models and industries. The collective experience, coupled with the creation of Mindtree Labs, ensures that the solutions will have high quality and success. The focus of Mindtree unlike the other software firms have been to leverage intellectual property. Mindtree helps firms to improve its product design life cycle. Mindtree developed a set of intellectual properties to complement the product realization service offering. These technology building blocks reduce the product design cycles and may be licensed as individual reusable components. It has a multiplatform, multivendor approach to application development. Mindtree established its own software engineering methodology namely: 87

Distributed Rapid Architecture Development with quality. This methodology encompasses clear processes and measurement criteria and captures organizational learning at all the stages of product development, from concept to life cycle ownership. In three years time Mindtree evolved into a multicultural and multinational organization. The word Mindtree appears in ancient Indian literature, written in 4000BC meaning a source of eternal intellect and wisdom for all who came in contact with it, because it springs from the mind. In the interview with one of the founders he indicated that companies fail not because of market, but lack of experienced teams. Mindtree has one of the best teams with strong business leadership. The focus of the company has been on intensive learning. It works global firms and mostly on difficult projects and newer state of the art areas. The main contribution of venture capitalists has been the refinement and sharpening of the business plan. 12.7 NETWORK SOLUTIONS Network Solutions was a Venture funded company. It focuses on convergence solutions to network problems. It has become the preferred vendor for many firms for integrated data networks. Mr.S.Sharma who started this was nominated for the outstanding Entrepreneur of the year 2000 Award. It had an income of US$ 3 million in 1994 and it reached US$ 19 million in 2001.

Founder: Mr. Sharma is an electronic engineer. He worked with Motorola and HP for sometime. Subsequent to this he implemented a number of independent projects in Asian countries such as China, India, Singapore and Thailand. While working on these projects he started a networking service firm for the multinationals operating in Bangalore. The main focus was designing networks that are cost effective and reliable and identifying network architectures that are reliable, secure, and cost effective and platform independent. Venture capitalists: Intel capital acquired 15% of its stake in the first round funding. This

was for US$ 1.1 million. There was a sharp increase in its revenue after 1997. During the Internet bust the management purchased the stake of Intel. Network Solutions is a private limited company, presently. Products and Services: Network solution provision is the business of the company. This has 800 people working. It is India‘s largest vendor independent network and telecom infrastructure 88

solution provider. CISCO, Nortel, HP Cabletron are its major clients. The growth of revenue of Network solutions is given Network Solution is a unique company as it is the largest vendor independent network infrastructure solution provider. It has become the preferred solution provider for the large banks as well as the stock exchanges in India though it is started by a single entrepreneur. The uniqueness of the firm is that none of its customers have deserted it. The company has a prudent debt planning policy and cost management system. The firm has three domains of expertise and operates at 8 major centers in India. It manages all aspects of the network lifecycle. Recently it has started providing call centre support. It is one of five fastest growing IT companies in India according a survey conducted by Computer Today. It maintains its revenue through services and retaining its client base. One of the value added services it provides is software integration. The essence of learning has been collaborative learning. The venture support by Intel Capital helped Network Solutions in enhancing the reputation. The support provided was mostly financial in nature. 12.8 REVA The electric car company Reva is the India‘s first electric car designed by Reva Electric Car Company (RECC) and is the short form for Revolutionary Electric Vehicle Alternative. The vision of Reva is to establish a tradition of excellence and leadership in environment friendly urban transportation by offering the best value and highest quality electric vehicles in the world. Recently they have been able to get an export order from UK. Founders Reva is the creation of the Maini group headed by Sudershan Maini. Founded in 1973, the Maini Group is today a multi-product, multi-division, enterprise with business interests ranging from manufacture of high precision products for the auto industry to electric "in-plant" material handling equipment, from granites to abrasives and international trading. Sudershan Maini nurtured the idea of a small car for India for 30 years but the idea conceptualized and took a form only after Chetan Maini, his son joined Amerigon an U.S. based company to work as a program manager on an Electric vehicle project. Chetan Maini who has a B.S., (Mechanical Engg) from University of Michigan and M.S., (Mechanical Engg) from Stanford University worked for General Motors (U.S.A.) and Amerigon group of Incorporation (U.S.A.) before taking change as M.D. of Reva Electric Car Company Private Ltd. He was the 89

team leader of the solar car team that won the GM sun race and stood 3 in the world solar challenger in Australia. He was also the project leader for the hybrid electric car project at Stanford University. Before taking charge as Managing Director of REVA Electric Car Company (P) LTD has worked for General Motors (USA) and Amerigon Inc. (USA). Chetan Maini‘s experience with Maini precision products, his core business, which produces high quality parts for OEM‘s in India and overseas came very handy. The group got its first taste of electric powered vehicles at Maini materials movement, which manufactures high tech equipment to transport material people across shop floors. The company is committed to make available facilities, which offer the customer maximum comfort at a minimal cost and make Reva the vehicle of the future generation. Origin of the Idea: Though the first electric vehicle was built in 1834, it was the internal combustion engine that gained popular acceptance. Gasoline driven vehicles were faster and cheaper with a greater range. Ready availability of petroleum products resulted in a further drawback to the growth of electric vehicles. It was only in the 1970‘s when the world was hit with the oil crisis, people realized the increasing need for alternative energy technologies for automobiles. Growing concerns about environmental pollution only enhanced the interest in Electric vehicles. Mr. Maini wanted to eliminate urban air pollution and he looked for new technologies that can be cost effective. His dream was to develop the first electric car in India. The REVA project was started in 1994.The first Reva proto type was ready in mid 1996. It was internally funded. This prototype was displayed in Bangalore in 1996-97 after extensive testing at the ARAI, Pune. Evolution of the idea: RECC is a joint venture between Bangalore based Maini group and Amerigon electronic vehicle technologies (A.E.V.T. Inc.) of U.S.A. Reva has built its reputation on leading rather than following technological change. In line with their motto to introduce technology ahead of the world to consumers in India the company has technical collaboration with world-class companies. The company has collaboration with the following companies


Amerigon Electric Vehicle Technologies Inc., specializes in bringing aerospace technology to the automobile industry. Curtis Instruments Inc., USA, is a manufacturer of instrumentation, controls and integrated systems for electric vehicles of all types. 90

This has developed the motor controller for the electric car Tudor India Limited, a subsidiary of the largest and oldest Battery Company in the world (located in the USA), provided the Prestolite batteries specially manufactured for use in the Reva‘s high-tech Power Pack. Modular Power Systems USA, a division of TDI, is a world leader in Charger and Power supplies. The Charger for Reva, which was developed by MPS, is now being made in India through a technical collaboration agreement they have with the Maini Group. The main contribution of RECC is designing, developing and manufacturing electric cars that are cost effective and easy to manufacture. Learning strategies: Maintaining quality had always been an important issue for the Maini

group. Modeled on the zero principle – zero defects, zero time delays and zero inefficiencies - the Group has crafted a unique quality image for itself, both in India and abroad. The Maini group‘s recognition for quality and reliability include the ISO- 9000 Certificate for 3 of its group companies. All the components of Reva are thoroughly inspected and only after due verification are forwarded to the next stage of manufacture. Even though the first prototype of Reva was ready in Mid-1996, it was introduced in to the market only after extensive testing at the Automobiles Research Association of India (A.R.A.I.), Pune for homologation. RECC‘s product quality and reliability have helped it to secure several International collaborations that include General Motors U. S. and Bosch Germany. R & D Strategy: The Maini group has always viewed technology and innovation as the main driver of growth and profitability. The group has always focused on innovation, technology, quality and reliability. The group has 2 in-house R&D Centers, recognized by D.S.I.R. (Dept of Scientific and Industrial Research, Govt of India). Reva has a 25 strong R&D team which is constantly striving to improve the quality of product it is working to come out with a new car by the year-end. The company is also working on an enviable project of drive system for General Motors. Keeping in trend with the international standards REVA spends almost 8% of its turnover on R&D. The R&D efforts have resulted in innovative technologies that are patented. Apart from its design Reva deploys the following 3 key patent protected technologies in its electric car namely: 91

· Running chassis, · Energy management system, and · Climate Control system. Market dynamics: Majority of the capital equipment is indigenously available except for few sophisticated machines. This battery could be charged using a 220-volt, 15-amp power source. 227-kg is the payload. Reva was developed as a completely indigenous car for India. Unlike conventional internal combustion engine car which has more than 7000 component‘s Reva has only 1000 components and more than 95% of these components are indigenously manufactured. Few examples where RECC used their manufacturing philosophy innovatively are use of colorimpregnated panels to eliminate any painting at the assembly stage. This construction method reduced capital costs by 40%. Opting for a thermo-formed (rather than injection-molded) instrument panel, dispensed with curved glass and winding windows it selected conventional lead-acid batteries rather than new-generation lithium types. The car is shown in Institutional support: Reva received commendable support from the Department of Information Technology, IISc. Bangalore. Reva also receives support from Maini Info Solutions, a subsidiary of the Maini Group. On the financial front Reva received financial support from Technology Development Board (India). According to the company Government support for electric vehicle industry is not adequate. It is appropriate that this venture receives the support of the government, since the technological performance of the Electric vehicle largely meets the specifications. Technology Development Board gave RECC a new venture loan of INR 185 million for the development and manufacturing. Organizational strategy: The marketing strategy is aimed at developing a whole new concept in city mobility — non-polluting, noiseless, affordable personal transportation for all ages. The company has targeted to sel 1,500-2,000 cars in 2002-2003. According to Mr. Maini, Electric cars are appropriate in city environments due to increased mobility, zero pollution, less parking space and quiet operation and it is particularly tailor-made for countries like India due to low running and maintenance cost. The feedback shows that for most buyers, Reva is their second car, which they prefer to use in-city, while their regular vehicle is used for long-distance trips. The company is also working on a platform for larger electric cars. 92

The deluxe version is expected to be launched by the end of this year while AC version, with 1520 per cent lower range than present 80 km, is also in the pipeline. The 75 team strong R&D team at RECC is also working on heater version and another one with cooled seats. There are also plans to expand the Reva platform by launching another vehicle by year-end. In the five years since its inception, the Reva project has cost US$20 million, with an additional US$5 million to put the car into production. Features of REVA car are as follows: · running cost of 40 paisa per km. · priced at Rs 254000 · zero pollution car. · Seat two adults and two children vehicle · Easy driving as it has no clutch or gears. · On a single charge, 'Reva' can be driven for 80 km. · Two-door hatchback and · Battery life span of 40,000 km which should last for 3-4 years in city driving conditions. Learning from the case study: The case was aimed at understanding the electric vehicle industry in general and Reva Electric Car Company in particular. This study on Reva gave an understanding as to how a company could leverage technology to indigenously develop world class products. This innovative creation from the Maini group was tremendously helped by Chetan Maini‘s previous experience in electric vehicular technology. This is one of the biggest funded projects that is supported by TDB.

The venture capital industry has started creating innovative firms in India. During the last five years many new entrepreneurial firms have ventured into new product development and contract research for global firms. Till then Indian firms weak in new product development. Firms like 93

Avesthagen, Strand Genomics and Bharat Biotechnics have achieved high revenue levels through revenue from contract research as well. Firms like Tejas Networks, Reva and Ittiam have become product developers for the global market. Mindtree has grown rapidly by focusing on new high technology business segments. Venture Capital assisted firms are still in its infancy. Management buyouts and external corporate venturing have started emerging indicating that offshore funds are started considering India as a potential opportunity. This will reduce the capital gap for entrepreneurial firms. Major observations are given below: 1. Venture Capital is becoming a major mechanism for stimulating innovation and entrepreneurial growth. In India, this is catalyzed by the rapid growth in information technology. There is a strong need to enhance availability of venture capital in developing countries as most of these risk averse but awareness about the role of venture capital has been very limited. There has to be systematic initiatives for simulating entrepreneurship through use of venture funds. The distortions in the capital market due to over regulations and multiple controls are also a problem that is hindering the growth of VCs.

2. Expertise needed for managing new ventures and managing venture funds is yet to evolve in India. Most of the off-shore Funds have a strong experiential base that is absent in local institutions. Off-shore Funds have been able to provide support and business contacts. From the personal interviews it is evident that off-shore funds are able to add more value to the venture assisted firms through the provision of help in preparing reliable and precise business plans. Entrepreneur‘s general y focus on technical aspects and not on business success. Venture capitalists brings the balance between business and technology so that innovation becomes a commercial success. 3. Most of the new ventures have benefited from venture capital, especially those supported by the off-shore funds. Three aspects of support provided by VCF that adds value are: · monitoring the business plans · Support for getting business contacts from other countries and · bringing an external perspective in the business plan.


4. Venture capital growth and industrial clustering have a strong positive correlation. Foreign direct investment, starting of R&D centers, availability of venture capital and growth of entrepreneurial firms are getting concentrated into five clusters. The cost of monitoring and the cost of skill acquisition are lower in clusters, especially for innovation. Entry costs are also lower in clusters. Creating entrepreneurship and stimulating innovation in clusters have to become a major concern of public policy makers. This is essential because only when the cultural context is conducive for risk management venture capital will take-of. Clusters support innovation and facilitates risk bearing. VCs prefer clusters because the information costs are lower. Policies for promoting dispersion of industries are becoming redundant after the economic liberalization. 5. An analysis of venture assisted firms clearly shows that the factors contributing to the success of innovative firms are essentially three fold, namely · Strong experiential base · Vision and urge to achieve something and · A realistic business plan.

6. Bank operated venture capital funds are relatively risk averse and they have a weak experiential base. Local funds are focusing on software services and retail business but not innovative products. The real growth of venture capital in India started after the entry of off-shore venture funds. India has become a preferred destination of venture funds in Asia.

7. The presence of an excellent academic research institutions is a prerequisite for the success of venture firms in a location as it can provide high quality manpower. In the case of Bombay, Madras, Hyderabad, Bangalore and New Delhi the presence of research institutions have facilitated the growth of venture supported firms. 8. One of the untraded externalities that stimulate venture growth is idea entrepreneurship. Idea moves faster and evolves quickly in clusters. Venture capital growth has occurred in clusters in India like in US, Israel,


UK and Taiwan. 9. In developing countries venture funds are not fully evolved and, it may be necessary to start public venture funds. Public venture funds can act as seeds of entrepreneurship. Special attention may be essential for this so that commercial and technical perspectives are integrated. In developing countries public policy should support and evolve institutional systems for stimulating public venture funds. The government supported quasi-venture fund, namely Technology Development Board has been effective in stimulating innovations in India. Good corporate governance of venture funds is one of the critical success factors that has helped Technology Development Board to select and support innovations. To sum up, developing countries have to harmonize the capital market requirements and venture capital needs so that they can stimulate entrepreneurial firms that focus on high-tech innovations. Though most of venture funds state that high technology is their priority only firms started by experienced persons find support by VCFs. Capability for assessing venture projects continues to be a weak area in the case of developing countries such as India because of the lack of prior experience.


Chapter 13 Contemporary Issue in Venture Capital Industry


13. Contemporary Issue in Venture Capital Industry

 IIM-A Eyes venture capital to fund its incubators  Buoyed by the growing tribe of students wanting to go solo with their own entrepreneurial venture, the Indian Institute of Management, Ahmedabad (IIM-A) is looking to attract venture capital funds to the campus. The premier management institute is also in talks with several corporates to provide seed capital to budding entrepreneurs from its incubation lab.  ―The number of students starting up their own venture is increasing in every batch. In a batch of 250 students, at least 10-15 are starting their own ventures. Source: Business Daily from “THE HINDU” group of publications Sunday, 27, 2008

 Angel investors betting big on Indian start-ups  Amid a slowdown in global venture capital investments, Indian start-up firms are emerging as clear favourites for seed capital among global angel investors.  During the first quarter of 2008, US-based venture capitalists invested $350 million in 38 deals in India, a 42 per cent jump from previous quarter, when $246 million was invested in 33 companies. In the case of China, the funding by US-based Venture Capital firms dipped 24 per cent to $250 million invested in 32 firms during the first quarter of 2008, down From the $331 million invested in 39 deals in the previous quarter, according to data from the Money Tree report from price water house coopers and the US-based National Venture Capital Association

Source: Business Daily from “THE HINDU” group of publications Saturday, April 26, 2008.



The study provides that the maturity if the still nascent Indian Venture Capital market is imminent. Venture Capitalists in Indian have notice of newer avenues and regions to expand. VCs have moved beyond IT service but are cautious in exploring the right business model, for finding opportunities that generate better returns for their investors.

In terms of impediments to expansion, few concerning factors to VCs include; unfavorable political and regulatory environment compared to other countries, difficulty in achieving successful exists and administrative delays in documentation and approval.

In spite of few non attracting factors, Indian opportunities are no doubt promising which is evident by the large number of new entrants in past years as well in coming days. Nonetheless the market is challenging for successful investment.

Therefore Venture capitalists responses are upbeat about the attractiveness of the India as a place to do business.




1. Taneja Satish, “ Venture Capital In India”, Galgotia Publishing Company, 2002 2. Pandey I M, “Venture Capital – The Indian Experience”, Prentice Hall of India pvt. Ltd,1999.

1. Trends of Venture Capital in India, survey report by Delloitte,2007. 2. Global Trends of Venture Capital, Survey report by Deloitte,2007. 3. Economic survey 2007-08, Chapter-8



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