Semester-III, PGeMBA 2006-08, MET’s AMDC

Prepared by:

1. Krunal Shah 6156 2. Gautam Foria 6045 3. Ishita Kohli 6083 4. Niral Chandarana 6023 5. Pratik Parekh 6122 6. Sneha Lalwani 6087 7. Vivek Jain 6064 8. Brinda Jogani 6069

We the members of Group No. 3 students of Mumbai Educational Trust, PGeMBA – Finance, Sem-3 hereby declare that we have completed the project on VENTURE CAPITAL in academic year 2007-08. The information submitted is free from any errors to the best of our knowledge.

We the members of Group No. 3 students of Mumbai Educational Trust, PGeMBA – Finance, Sem-3 hereby declare that with respect to the subject on

Financial Management - II, we have completed the project on Venture Capital in academic year 06-07.under the control and guidance of our college Prof. Vijay Paradkar.


During the perseverance of this project we were supported by different people, whose names if not mentioned would be inconsiderate on our part. We would like to thank with affection and appreciation and acknowledge our indebt ness to Prof. Vijay Paradkar, visiting faculty of Mumbai Educational Trust, Bandra who initiated us in the preparation of a Project on Venture Capital. The learning and knowledge that we have gained in the process of preparation of this

project has been tremendous and we would like to thank Prof. Vijay Paradkar for providing us with the opportunity to work on this project. We owe sincere gratitude towards each and everyone who have given a helping hand in the completion of this project.

Sr. No. I. II. III. IV. V. VI. VII. VIII. IX. X. TOPICS Executive Summary Indian Financial Sector Concept Of VC Venture Capital Flow Features of A VC VC – The History Private Equity Types of VCs SEBI Regulations For VCs SEBI Regulations For Foreign VCs


Valuation Methods Used By VCs Financial Instruments Used By VCs Stages Of VC Investment Documentation Difference Between A VC & A Banker/Money Manager An Exercise: Launching & Managing A VCF Bibliography

A number of technocrats are seeking to set up shop on their own and capitalize on opportunities. In the highly dynamic economic climate that surrounds us today, few ‘traditional’ business models may survive. Countries across the globe are realizing that it is not the conglomerates and the gigantic corporations that fuel economic growth any more. The essence of any economy today, is the small and medium enterprises. In the year 2006, venture money invested in India was $3 bn and is expected to reach $6.5 bn by the end of this year. This growing trend can be attributed to rapid advances in technology in the last decade. Knowledge driven industries like InfoTech, health-care, manufacturing, entertainment and services have become the cynosure of bourses worldwide. In these sectors, it is innovation and technical capability that are big businessdrivers. This is a paradigm shift from the earlier physical production and ‘economies of scale’ model. However, starting an enterprise is never easy. There are a number of parameters that contribute to its success or downfall. Experience, integrity, prudence and a clear understanding of the market are among the sought after qualities of a promoter. However, there are other factors, which lie beyond the control of the entrepreneur. Prominent among these is the timely infusion of funds. This is where the venture capitalist comes in, with money, business sense and a lot more.

The financial sector in India is characterized by liberal and progressive policies, vibrant equity and debt markets and prudent banking norms. India’s financial sector has been one of the fastest growing sectors in the economy. India has a financial system that is regulated by independent regulators in the sectors of banking, insurance, capital markets etc.

2.1. Size
• • • • Total banking assets stood at around $ 600 billion Assets owned by India’s mutual funds crossed the Rs 4 trillion-mark India’s entire stock of financial assets--equity, corporate and government debt and bank deposits--is valued at US$ 1.1 trillion More than 80 venture capital and private equity funds operate in India.

2.2. Structure
• • • Public Sector (Government owned) banks account for 75% of the banking assets; however, Indian private banks and foreign banks are growing at a rapid pace. Standard Chartered Bank, Citibank and HSBC are the top three foreign banks in India accounting for more than 65% of the total assets of foreign banks Most of the global players in banking & financial services – Morgan Stanley, Merrill Lynch, JP Morgan, Deutsche Bank, UBS, ABN Amro, Barclays, Calyon etc. - have presence in India

The Mutual Funds industry has both domestic and foreign players like - UTI Mutual Fund, Prudential ICICI, HDFC, Franklin Templeton, Birla and Tata Funds.

2.3. Banking System
The Indian Banking sector has greatly benefited from the structural reforms over the last decade. This coupled with recent treasury gains & improved quality of credit portfolios has made balance sheets of majority of banks appear to be in a far healthier state than they have historically been. Apart from the improvement in underlying business fundamentals, the sector’s prospects have been boosted by an upturn in the economy and increased demand from both the corporate and the retail clientele. In today’s scenario banking has assumed a technology intensive and customer-friendly face with focus on the ease and speed of operations. An array of services is provided today from retail banking to corporate banking and industrial lending to investment banking. The Reserve Bank of India (RBI) controls and supervises the banking industry. It also prescribes broad parameters of banking operations within which the country’s banking and financial system functions.

2.4. Insurance Sector
The Insurance sector in India has been traditionally dominated by state owned Life Insurance Corporation and General Insurance Corporation and its four subsidiaries. Government of India has now allowed FDI in insurance sector up to 26%, which has seen a number of new joint venture private companies entering the life and general insurance sectors, and their market share is rising at a rapid pace. Insurance Development and Regulatory Authority (IRDA) is the regulatory authority in the insurance sector developed under the provisions of the Insurance Development and Regulatory Authority Act, 1999.

2.5. Capital Market
India has a transparent; highly technology – enabled and well regulated stock / capital market. A vibrant, well-developed capital market facilitates investment and economic growth. The capital market transactions today involve lots of checks and balances with efficient electronic trading and settlement systems. Today the stock markets are buoyant and have a range of players including mutual funds, FIIs, hedge funds, corporate and other institutions. Securities and Exchange Board of India regulate the Indian capital markets. India’s capital market comprises of 23 stock exchanges with over 9000 listed companies. Bombay Stock Exchange (BSE) is one of the oldest exchanges in Asia. National Stock Exchange (NSE) is third largest exchange in the world in terms of number of trades. These exchanges constitute an organized market for securities issued by the Central and State Governments, public sector companies and public limited

companies. The average daily turnover of BSE is around 4,000 crores and that of NSE is 9,000 crores. The stock exchanges provide an efficient and transparent market for trading in equity, debt instruments and derivatives. The stock exchanges are demutualised, and have been converted into companies now, in which brokers only hold minority share holding. In addition to the SEBI Act, the Securities Contracts (Regulation) Act, 1956 regulates the stock markets.

2.6. Mutual Funds
The Indian mutual fund industry is one of the fastest growing sectors in the Indian capital and financial markets. The mutual fund industry in India has seen dramatic improvements in quantity as well as quality of product and service offerings in recent years. The industry has grown in size and the total assets under management (AUM) stood at Rs 4, 02,035.88 crores in May 2007(equivalent to US$ 100 billion). Almost all varieties of schemes are offered today. The Mutual fund industry operates in a strict regulatory environment and conforms to the best international standards. Association of Mutual Funds in India (AMFI) is a trade body of all the mutual funds in India. It is a non-profit organisation set-up to promote and protect the interests of mutual funds and their unit holders. SEBI is the regulator of the mutual fund industry in India.

2.7. Non Banking Finance Companies
Non Banking Financial Companies (NBFCs) have played a crucial role in broadening the access to financial services, enhancing competition and in the diversification of the financial sector. NBFCs are increasingly being recognized complementary to the banking system, capable of spreading risks at times of financial distress. NBFCs are recognized as an integral part of the financial system with an impetus to improve the credibility of the entire sector. Today, NBFCs are present in the competing fields of vehicle financing, hire purchase, lease, personal loans, working capital loans, consumer loans, housing loans, loans against shares, investments, distribution of financial products, etc. The total number of NBFCs registered with the RBI in India in 2006 stood at 13,014.

2.8. Credit Rating Agencies
India’s credit rating agencies are world reckoned. The credit rating agencies rate corporate debt and equity securities such as debentures, shares and commercial paper. Today, credit ratings have become necessary because it has become mandatory for companies to obtain a credit rating before issuing convertible and non-convertible debentures. The four important credit rating agencies in India are Credit Rating Information Services of India Limited (CRISIL) Investment Information and Credit Rating Agency of India (ICRA), Credit Analysis and Research Ltd. (CARE) Today the rating agencies have diversified and forayed into a variety of services such as risk management, strategy, corporate advisory, IT, across various sectors. The credit rating agencies are regulated by SEBI through separate regulations.

2.9. Venture Funds
Venture capital can be used as a financial tool for development, within the range of SME finance, by playing a key role in business start-ups, existing small and medium enterprises (SME) and overall growth in developing economies. Venture capital acts most directly by being a source of job creation, facilitating access to finance for small and growing companies which otherwise would not qualify for receiving loans in a bank, and improving the corporate governance and accounting standards of the companies. India is a prime target for venture capital and private equity today, owing to various factors such as fast growing knowledge based industries, favorable investment opportunities, cost competitive workforce, booming stock markets and supportive regulatory environment among others. The sunrise sectors that attract venture funds are healthcare, education, financial services, hospitality, media & entertainment, ITES and InfoTech. Indian venture Capital Association is the apex association of VC funds in the country. India has more than 80 venture Funds registered with SEBI.

Venture capital is a growing business of recent origin in the area of industrial financing in India. The various financial institutions set-up in India to promote industries have done commendable work. However, these institutions do not come up to the benefit of risky ventures when new or relatively unknown entrepreneurs undertake them. They contend to give debt finance, mostly in the form of term loan to the promoters and their functioning has been more akin to that of commercial banks. The financial institutions have devised schemes such as seed capital scheme, Risk capital Fund etc., to help new entrepreneurs. However, to evaluate the projects and extend financial assistance they follow the criteria such as safety, security, liquidity and profitability and not potentially. The capital market with its conventional financial instruments/ schemes does not come much to the benefit or risky venture. New institutions such as mutual funds, leasing and hire purchase Company’s have been established as another leasing and hire purchase Company’s have been established as another source of finance to industries. These institutions also do not mitigate the problems of new entrepreneurs who undertake risky and innovative ventures. The term Venture Capital comprises of two words that is “Venture” and “Capital”. Venture is defined as a course of processing, the outcome of which is uncertain but to which is attended the risk or danger of LOSS. Capital means resources to start an enterprise. To connote the risk and adventure of such a fund, the generic name Venture Capital was coined.

Venture capital is long-term risk capital to finance high technology projects, which involve risk, but at the same time has strong potential for growth. Venture capitalists pool their resources including managerial abilities to assist new entrepreneur in the early years of the project. Once the project reaches the stage of profitability, they sell their equity holdings at high premium. Venture capital refers to organize private or institutional financing that can provide substantial amounts of capital mostly through equity purchases and occasionally through debts offerings to help growth oriented firms to develop and succeed. The term venture capital denotes institutional investors that provide equity financing to young businesses and play an active role advising their managements. Broadly the Venture Capital finance includes a variety of investment vehicles. A much wider range of activities than purely start up situations are undertaken by Venture capital.

What is Venture Capital?
Venture capital is a type of private equity capital typically provided by professional, outside investors to new, growth businesses. Generally made as cash in exchange for shares in the investee company, venture capital investments are usually high risk, but offer the potential for above-average returns. The term ‘Venture Capital’ is understood in many ways. In a narrow sense, it refers to, investment in new and tried enterprises that are lacking a stable record of growth. In a broader sense, venture capital refers to the commitment of capital as shareholding, for the formulation and setting up of small firms specializing in new ideas or new technologies. It is not merely an injection of funds into a new firm, it is a simultaneous input of skill needed to set up the firm, design its marketing strategy and organize and manage it. It is an association with successive stages of firm’s development with distinctive types of financing appropriate to each stage of development. It is the investment of long term risk finance in new and untried enterprises that are “lacking in a stable record of growth.” It means an investment in those business ventures where uncertainties are yet to be reduced to the risk that is subject to rational criteria of security analysis. Venture capital can also include managerial and technical expertise. Most venture capital comes from a group of wealthy investors, investment banks and other financial institutions that pool such investments or partnerships. This form

of raising capital is popular among new companies, or ventures, with limited operating history, which cannot raise funds through a debt issue. The downside for entrepreneurs is that venture capitalists usually get a say in company decisions, in addition to a portion of the equity. Contrary to popular perception, venture capital plays only a minor role in funding basic innovation. Where venture money plays an important role is the next stage of innovation life cycle-the period in a company’s life when it begins to commercialize its innovation. It is estimated that more than 80% of the money invested by VC goes into building the infrastructure required to grow the business in expense investments (manufacturing, sales, and manufacturing) and the balance sheet (providing fixed asset and working capital). Venture money is not long term money. The idea is to invest in a company’s balance sheet and infrastructure until it reaches a sufficient size and credibility so that it can be sold to a corporation or so that an institutional public equity markets can step in and provide liquidity. In essence VC buys a stake in an entrepreneur’s idea, nurtures it for a short period of time, and then exits with a help of Investment Banker. Venture capitals niche exists because of the structure and rule of capital markets. Someone with a new idea or technology often has no other institution to turn to. Usury law, limits the interest banks can charge on loans-and the risk inherent in start ups justify the higher rates so charged by the banks. This limits a bank to invest in those projects that secure the debt with hard assets. And in today’s information based economy, many start ups have few hard assets. Public Equity and Investment Bank are both constrained by regulations and operating practices to protect the public investor. Venture Capital fills the gap between innovation and traditional lower cost sources of capital available for ongoing concerns. Filling that void successfully requires the venture capital industry to provide a sufficient return on capital to attract private equity funds, attractive returns for its own participants, and sufficient upside potential entrepreneurs to attract high quality ideas that will generate high returns.


4.1. Venture Capitalist
A venture capitalist (VC) is a person who makes investments in potentially stable growing companies. VC is a fund manger who gets a fee to invest in companies that has growth potential and provides expected returns to its investors. With venture capital, the venture capitalist acquires an agreed proportion of the equity of the company in return for the requisite funding. Investors in venture capital funds are typically very large institutions such as pension funds, financial firms, insurance companies, and university endowmentsall of which put a small percentage of their total funds into high risk investments. In return for financing one or two year of financing company’s start ups, VC expect a ten times return of capital over five years. Usually VC expects a return of between 25% and 35% per year over the lifetime of the investment. Because these investments represent such a tiny part of the institutional investors’ portfolios, venture capitalists have a lot of latitude. What leads to invest in these funds is not the specific investment but firms overall track record. While investing a VC looks into the following:  A strong committed management team, established performance record and a high degree on integrity  Sustainable competitive advantage  Scalability of operations  Potential for above average profitability leading to attractive returns on investment  Subscription to equity/ equity type instruments  Unlisted companies preferably in small scale/ small scale graduating to medium scale  Availability of exit route for Venture Capital investment A typical VC allocates its time in the following fashion:  Deal flow and solicitation…10%  Screening and evaluation…10%  Terms and negotiation…5%  Board meetings and monitoring…25%  Consulting, recruiting and assisting…45%  Exiting…5%

One myth is that VC invests in good people and good ideas. The reality is that they invest in good industries that are competitively forgoing the market.
In effect VC focuses on the middle part of classic industry S-Curve. They avoid both the early stages, when technologies are uncertain and market stages are unknown and the later stage when competitive shakeouts and consolidations are inevitable and growth rates slow dramatically. Growing within high growth segments is a lot easier than doing so in low, no or negative growth ones as every businessman knows. In other words regardless of the talent or charisma an individual entrepreneur may posses they rarely receive backing from VC if they are in low growth industry. During this adolescent period of high and accelerating growth, it can be extremely hard to distinguish the final winners from the losers because their financial performance and growth rate looks strikingly similar. At this stage, all companies are struggling to deliver products to this product-starved market. Thus the critical challenge for the VC is to identify competent management that can execute-that is, supply the growing demand. This need for high returns makes venture funding an expensive capital source for companies, and most suitable for businesses having large up-front capital requirements which cannot be financed by cheaper alternatives such as debt. That is most commonly the case for intangible assets such as software, and other intellectual property, whose value is unproven. In turn this explains why venture capital is most prevalent in the fast-growing technology and life sciences or biotechnology fields. Picking the wrong industry or betting on a technology risk is an unproven market segment is something VC’s avoid. By investing in areas with high growth rates, VC primarily consign their risk to the ability of the company’s management to execute. Because of the strict requirements venture capitalists have for potential investments, many entrepreneurs seek initial funding from angel investors, who may be more willing to invest in highly speculative opportunities, or may have a prior relationship with the entrepreneur. Furthermore, many venture capital firms will only seriously evaluate an investment in a start-up otherwise unknown to them if the company can prove at least some of its claims about the technology and/or market potential for its product or services. To achieve this, or even just to avoid the dilutive effects of receiving funding before such claims are proven, many start-ups seek to self-finance until they reach a point where they can credibly approach outside capital providers such as VCs or angels. This practice is called "bootstrapping". VC investing in high growth segments is likely to have exit opportunities because investment bankers are to 8% money raised through an IPO.

As long as VC are able to exit the company and industry before it tops out, they can reap extra ordinary returns at relatively low risk.

4.2. Venture Capital Fund
A venture capital fund (VCF) is a pooled investment vehicle (often a limited partnership) that primarily invests the financial capital of third-party investors in enterprises that are too risky for the standard capital markets or bank loans. Venture Capital Fund shall make investment in the venture capital undertaking as enumerated below: • At least 75% of the investible funds shall be invested in unlisted equity shares or equity linked instruments. • Not more than 25% of the investible funds may be invested by way of:  Subscription to initial public offer of a venture capital undertaking whose shares are proposed to be listed subject to lock-in period of one year.  Debt or debt instrument of a venture capital undertaking in which the venture capital fund has already made an investment by way of equity. The venture capital fund shall issue a placement memorandum, which shall contain details of the terms, and conditions subject to which monies are proposed to be raised from investors. The Venture Capital Fund shall file with the Board for information, the copy of the placement memorandum or the copy of the contribution or subscription agreement entered with the investors along with a report of money actually collected from the investor. VCF promotes growth in the companies they invest in and managing the associated risk to protect and enhance their investors' capital. VCF typically source most of their funding from large investment institutions. VCF Invest the amount in companies with high growth potential or in companies, which have the ability to quickly, repay. VCF Exit through the company listing on the stock exchange, selling to a trade buyer or through a management buyout.

Most venture capital funds have a fixed life of 10 years, with the possibility of a few years of extensions to allow for private companies still seeking liquidity. The investing cycle for most funds is generally three to five years, after which the focus is managing and making follow-on investments in an existing portfolio. In a typical venture capital fund, the general partners receive an annual management fee equal to 2% of the committed capital to the fund and 20% of the net profits (also known as "carried interest") of the fund; a so-called "two and 20" arrangement, comparable to the compensation arrangements for many hedge funds. Strong Limited Partner interest in top-tier venture firms has led to a general trend toward terms more favorable to the venture partnership, and many groups now have carried interest of 25-30% on their funds. Because a fund may run out of capital prior to the end of its life, larger VCs usually have several overlapping funds at the same time; this lets the larger firm keep specialists in all stages of the development of firms almost constantly engaged. Smaller firms tend to thrive or fail with their initial industry contacts; by the time the fund cashes out, an entirely-new generation of technologies and people is ascending, whom the general partners may not know well, and so it is prudent to reassess and shift industries or personnel rather than attempt to simply invest more in the industry or people the partners already know.

4.3. Venture Capital Company
A venture capital company is defined as a financing institution which joins an entrepreneur as a co-promoter in a project and shares the risks and rewards of the enterprise. Venture capital general partners (also known in this case as "venture capitalists" or "VCs") are the executives in the firm, in other words the investment professionals. Typical career backgrounds vary, but many are former chief executives at firms similar to those which the partnership finances and other senior executives in technology companies. Investors in venture capital funds are known as limited partners. This constituency comprises both high net worth individuals and institutions with large amounts of available capital, such as state and private pension funds, university financial endowments, foundations, insurance companies, and pooled investment vehicles, called fund of funds. Other positions at venture capital firms include venture partners and entrepreneur-in-residence (EIR). Venture partners "bring in deals" and receive income only on deals they work on (as opposed to general partners who receive income on all deals). EIRs are experts in a particular domain and perform due diligence on potential deals. EIRs are engaged by VC firms temporarily (six to 18 months) and are expected to develop and pitch startup ideas to their host firm

(although neither party is bound to work with each other). Some EIRs move on to roles such as Chief Technology Officer (CTO) at a portfolio company.

4.4. Nature and Scope
Merchant bankers can assist venture proposals of technocrats, with high technology that are new and high risk, to seek assistance from venture capital funds for technology based industries which contribute significantly to growth process. Public issues are not available on such Greenfield ventures. Venture capital refers to organize private or institutional financing that can provide substantial amounts of capital mostly through equity purchases and occasionally through debts offerings to help growth oriented firms to develop and succeed. The term venture capital denotes institutional investors that provide equity financing to young businesses and play an active role advising their managements. Venture capital thrives best where it is not restrictively defined. Both in the U.S.A., the cradle of modern venture capital industry and U.K. where it is relatively advance venture capital as n activity has not been defined. Laying down parameters relating to size of investment, nature of technology and promoter’s background do not really help in promoting venture proposals. Venture capital enables entrepreneurs to actualize scientific ideals and enables inventions. It can contribute as well as benefit from securities market development. Venture capital is a potential source for augmenting the supply of good securities with track record of performance to the stock market that faces shortage of good securities to absorb the savings of the investors. Venture capital in turn benefits from the rise in market valuation that results from an active secondary market.

The key terms found in most definition of Venture capital are: high technology and high risk, equity investment and capital gains, value addition through participation in management.

5.1. High Risk
By definition the Venture capital financing is highly risky and chances of failure are high as it provides long term start up capital to high risk-high reward ventures. Venture capital assumes four types of risks: ⇒ ⇒ ⇒ ⇒ Management Risk-inability of the management teams to work together. Market Risk- product may fail in the market. Product Risk- product may not be commercially viable Operation Risk- operations may not be cost effective resulting in increased cost and decreased gross margins.

Normally three out of every ten units financed by Venture capital succeed.

5.2. High Technology
As opportunities in the low technology area tend to be few and of lower order, and hi-tech projects generally offer higher returns than projects in more traditional areas, Venture capital investments are made in high technology areas using new technology. Not just high technology, any high-risk ventures where the entrepreneur has conviction but little capital gets venture finance. Venture capital is available for expansion of existing business or diversification to a high-risk area. Thus technology financing had never been primary objective but incidental to Venture capital.

5.3 Equity Participation and Capital Gains
Investments are generally in equity and quasi equity participation through direct purchase of shares, options, convertible debentures where the debt holder has the option to convert the loan instruments into stock of the borrower or a debt with warrants to equity investment. The funds in the form of equity help to raise term loans that are cheaper source of funds. In the early stages of business, because dividends can be delayed, Equity investment implies that investors bear the risk of venture and would earn a return commensurate with the success in the form of capital gains.

5.4. Participation in Management
Venture capital provides value addition by managerial support, monitoring and follow up assistance. It monitors physical and financial progress as well as market development initiative. It helps by identifying key resource persons. They want one seat on the company’s board of directors and involvement, for better or worse, in the major decisions affecting the direction of the company. This is a unique philosophy of “hands on management” where Venture capitalist acts as complementary to the entrepreneurs. Based upon the experience with other companies, a venture capitalist advises the promoters on project planning, monitoring, financial management, including working capital and public issue. Venture capital investor cannot interfere in day today management of the enterprise but keeps close contact with the promoters or entrepreneurs to protect his investment.

5.5. Length of Investment
Venture capitalists help companies grow, but they eventually seek to exit the investment in three to seven years. An early stage investment may take seven to ten years to mature, while most of the later stage investments take only a few years. The process of having significant returns takes several years and calls on the capacity and talent of venture capitalist and entrepreneurs to reach fruition.

5.6. Illiquid Investment
Venture capital investments are illiquid that is, not subject to repayment on demand or following a repayment schedule. Investors seek return ultimately by means of capital gains when the investment is sold at market place. The investment is realized only on enlistment of security or it is lost if enterprise is liquidated for unsuccessful working. It may take several years before the first investment starts to return proceeds. In some cases the investment may be locked for seven to ten years. VC understands this illiquidity and factors in his investment decisions.

In the 1920’s &30’s the wealthy families of and individuals investors provided the start up money for companies that would later become famous. Eastern Airlines and Xerox are the famous ventures they financed. Among the early VCF set up was the one by Rockefeller Family that started a special called VENROCK in 1950, to finance new technology companies. USA is the birthplace of Venture Capital Industry, as we know it today. During most its historical evolution, the market for arranging such financing was fairly informal, relying primarily on the resource of wealthy families. After the Second World War in 1946 the American Research and Development was formed as first venture organization that financed over 900 companies. Venture capital had been a major contributor in development of the advanced countries like UK, Japan and several European countries.

6.1. Beginning of modern venture capital
Although many other similar investment mechanisms have existed in the past, General Georges Doriot is considered to be the father of the modern venture capital industry. In 1946, Doriot founded American Research and Development Corporation (AR&DC), whose biggest success was Digital Equipment Corporation. When Digital Equipment went public in 1968 it provided AR&D with 101% annualized Return on Investment (ROI). ARD's $70,000 USD investment in Digital Corporation in 1957 grew in value to $355 million. It is commonly accepted that the first venture-backed startup is Fairchild Semiconductor, funded in 1959 by Venrock Associates. Venture capital investments, before World War II, were primarily the sphere of influence of wealthy individuals and families. One of the first steps toward a professionally managed venture capital industry was the passage of the Small Business Investment Act of 1958. The 1958 Act officially allowed the U.S. Small Business Administration (SBA) to license private "Small Business Investment Companies" (SBICs) to help the financing and management of the small entrepreneurial businesses in the United States. Passage of the Act addressed concerns raised in a Federal Reserve Board report to Congress that concluded that a major gap existed in the capital markets for long-term funding for growth-oriented small businesses. Facilitating the flow of capital through the economy up to the pioneering small concerns in order to stimulate the U.S. economy was and still is the main goal of the SBIC program today. Generally, venture capital is closely associated with technologically innovative ventures and mostly in the United States. Due to structural restrictions imposed

on American banks in the 1930s there was no private merchant banking industry in the United States, a situation that was quite unique in developed nations. As late as the 1980s Lester Thurow, a noted economist, decried the inability of the USA's financial regulation framework to support any merchant bank other than one that is run by the United States Congress in the form of federally funded projects. These, he argued, were massive in scale, but also politically motivated, too focused on defense, housing and such specialized technologies as space exploration, agriculture, and aerospace. US investment banks were confined to handling large M&A transactions, the issue of equity and debt securities, and, often, the breakup of industrial concerns to access their pension fund surplus or sell off infrastructural capital for big gains. Not only was the lax regulation of this situation very heavily criticized at the time, this industrial policy differed from that of other industrialized rivals—notably Germany and Japan—which at that time were gaining ground in automotive and consumer electronics markets globally. However, those nations were also becoming somewhat more dependent on central bank and elite academic judgment, rather than the more diffuse way that priorities were set by government and private investors in the United States. Actually venture capitalist developers venture situations in which to invest. For his trouble, venture capitalist receive 20 to 25 percent of the ultimate profits of the partnership know as carried interest. He also collects an annual fee of 2 percent (of capital lent or invested in equity) to cover costs. Apart from individuals, investors include institutions such as pension funds, life insurance companies and even universities. The institutional investors invest about 10 percent of their portfolio in the venture proposals. Specialist venture capital funds in USA have about $30 billions on an annual basis to seek-out promising startups and take in them. In Japan there are about 55 active venture firms with funds amounting to $ 7 billions (1993). Venture capital funds are also extant in U.K., France and Korea.

6.2. Venture Capital In India The developmental financial institutions like IDBI, ICICI and State Financial Corporations possibly did this activity in the past. These institutions promoted entities in the private sector with debt as an instrument of funding. For a long time funds raised from public were used as a source of VC. This source however depended a lot on the market vagaries. And with the minimum paid up capital requirements being raised for listing at the stock exchanges, it became difficult for smaller firms with viable projects to raise funds from public. In India, the need for VC was recognised in the 7th five-year plan and long term fiscal policy of GOI. In 1973 a committee on Development of small and medium enterprises highlighted the need to faster VC as a source of funding new entrepreneurs and technology. VC financing really started in India in 1988 with the formation of Technology Development and Information Company of India Ltd. (TDICI) - promoted by ICICI and UTI. The first private VC fund was sponsored by Credit Capital Finance Corporation (CFC) and promoted by Bank of India, Asian Development Bank and the Commonwealth Development Corporation viz. Credit Capital Venture Fund. At the same time state level financial institutions started Gujarat Venture Finance Ltd. and APIDC VENTURE CAPITAL LTD. Sources of these funds were the financial institutions, foreign institutional investors or pension funds and high networth individuals. Though an attempt was also made to raise funds from the public and fund new ventures, the venture capitalists had hardly any impact on the economic scenario for the next eight years. India is prime target for venture capital and private equity today, owing to various factors such as fast growing knowledge based industries, favorable investment opportunities, cost competitive workforce, booming stock markets and supportive regulatory environment among others. The sectors where the country attracts venture capital are IT and ITES, software products, banking, PSU disinvestments, entertainment and media, biotechnology, pharmaceuticals, contract manufacturing and retail. An offshore venture capital company may contribute up to 100 percent of the capital of a domestic venture capital fund and may also set up a domestic asset management company to manage the fund. Venture capital funds (VCF) and venture capital companies (VCC) are permitted up to 40 percent of the paid up corpus of the domestic unlisted companies. This ceiling would be subject to relevant equity investment limit in force in relation to areas reserved for SSI. Investment in a single company by a VCF/VCC shall not exceed 5 percent of the paid up corpus of a domestic VCF/VCC. The automatic route is not available.

Indian companies received almost no Private Equity (PE) or Venture Capital (VC) funding a decade ago. This scenario began to change in the late 1990s with the growth of India’s Information Technology (IT) companies and with the simultaneous dot-com boom in India. VCs started making large investments in these sectors, however the bust that followed led to huge losses for the PE and VC community, especially for those who had invested heavily in start-ups and early stage companies. After almost three years of downturn in 2001-2003, the PE market began to recover towards the end of 2004. PE investors began investing in India again, except this time they began investing in other sectors as well (although the IT and BPO sectors still continued to receive a significant portion of these investments) and most investments were in late-stage companies. Early-stage investments have been dwindling or have, at best, remained stagnant right through mid-2006.

6.3.The PE and VC Investment Boom in 2000 and Its Aftermath
1996-1997 - Beginning of PE/VC activity in India: The Indian private equity (PE) and venture capital (VC) market roughly started in 1996-1997 and it scaled new heights in 2000 primarily because of the success demonstrated by India in assisting with Y2K related issues as well as the overall boom in the Information Technology (IT), Telecom and the Internet sectors, which allowed global business interactions to become much easier. In fact, the total value of such deals done in India in 2000 was $1.16 billion and the average deal size was approximately US $4.14 million. 2001-2003 - VC/PE becomes risk averse and activity declines: Not surprisingly, the investing in India came “crashing down” when NASDAQ lost 60% of its value during the second quarter of 2000 and other public markets (including those in India) also declined substantially. Consequently, during 20012003, the VCs and PEs started investing less money and in more mature companies in an effort to minimize the risks. For example: (a) The average deal size more than doubled from $4.14 million in 2000 to $8.52 million in 2001 (b) The number of early-stage deals fell sharply from 142 in 2000 to 36 in 2001 (c) Late-stage deals and Private Investments in Public Equity (PIPEs) declined from 138 in 2000 to 74 in 2001, and (d) Investments in Internet-related companies fell from $576 million in 2000 to $49 million in 2001. This decline broadly continued until 2003. 2004 onwards - Renewed investor interest and activity: Since India’s economy has been growing at 7%-8% a year, and since some sectors, including the services sector and the high-end manufacturing sector,

have been growing at 12%-14% a year, investors renewed their interest and started investing again in 2004. As Figure 1 shows, the number of deals and the total dollars invested in India has been increasing substantially. For example, US $1.65 billion in investments were made in 2004 surpassing the $1.16 billion in 2000 by almost 42%. These investments reached US $2.2 billion in 2005, and during the first half of 2006, VCs and PE firms had already invested $3.48 billion (excluding debt financing). The total investments in 2006 are likely to be $6.3 billion, a number that is more than five times the amount invested in 2000.

PE investment expands beyond IT and ITES: A very important feature of the resurgence in the PE activity in India since 2004 has been that the PEs are no longer focusing only on the IT and the ITES (IT Enabled Services, commonly known as “Business Process Outsourcing” or BPO) sectors. This is partly because the growth in the Indian economy is no longer limited to the IT sector but is now spreading more evenly to sectors such as biotechnology and pharmaceuticals; healthcare and medical tourism; autocomponents; travel and tourism; retail; textiles; real estate and infrastructure; entertainment and media; and gems and jewellery. Figure 2 shows the division across various sectors with respect to the number of deals in India in 2000, 2003 and the first half of 2006.

Early Stage VC Investments during 2000-2006: Since the Purchase Power Parity (PPP) in India is approximately a factor of 5 (as in, a factor of 5 is used to normalize the GDPs of US & India on a PPP basis), analysis shows that early stage VC investments in India should include those that are $8 million or less. In fact, we can classify early stage investments further into Seed, Series A and Series B investments depending upon their value. Figure below highlights an approximate comparison of the typical range of Seed, Series A, and Series B funding in India versus that in the US (actual dollar amounts; not adjusted in terms of PPP).

Figure given below provides a break-up of the total value of investments into early-stage investments (primarily by VCs) and late-stage investments and PIPEs (primarily by PEs). Even within early-stage investments, seed investments declined the most during 2000-2003 and have essentially remained negligible during 2004-2006.

Figure below shows the break-up of early-stage investments by Seed and Series A and B investments. In a nuance, perhaps unique to India, since the Indian upper middle class has become quite affluent during the last 7-10 years, the entrepreneurs are relying more and more on family and friends for seed funding, and since emerging entrepreneurs come from this upper middle class, the need for seed funding from VCs could remain low for many years to come.

In the year 2006 Venture money invested in India was $3bn and is expected to reach $6.5bn by the end of the year.

Private equity is a broad term that commonly refers to any type of non-public Ownership Equity securities that are not listed on a public exchange. Since they are not listed on a public exchange, any investor wishing to sell private equity securities must find a buyer in the absence of a public marketplace. There are many transfer restrictions on private securities. Investors in private securities generally receive their return through one of three ways: an initial public offering, a sale or merger, or a recapitalization. Private equity firms generally receive a return on their investment through one of three ways: an IPO, a sale or merger of the company they control, or a recapitalization. Unlisted securities may be sold directly to investors by the company (called a private offering) or to a private equity fund, which pools contributions from smaller investors to create a capital pool. Considerations for investing in private equity funds relative to other forms of investment include:  Substantial entry costs, with most private equity funds requiring significant initial investment (usually upwards of $100,000) plus further investment for the first few years of the fund called a 'drawdown'.  Investments in limited partnership interests (which are the dominant legal form of private equity investments) are referred to as "illiquid" investments that should earn a premium over traditional securities, such as stocks and bonds. Once invested, it is very difficult to gain access to your money, as it is locked-up in long-term investments that can last for as long as twelve years. Distributions are made only as investments are converted to cash; limited partners typically have no right to demand that sales be made.  If the private equity firm can't find good investment opportunities, they will not draw on our commitment. Given the risks associated with private equity investments, you can lose all your money if the private-equity fund invests in failing companies. The risk of loss of capital is typically higher in venture capital funds, which back young companies in the earliest phases of their development, and lower, in mezzanine capital funds, which provide interim investments to companies which have already proven their viability but have yet to raise money from public markets.  Consistent with the risks outlined above, private equity can provide high returns, with the best private equity managers significantly outperforming the public markets. For the above-mentioned reasons, private equity fund investment is for those who can afford to have their capital locked in for long periods of time and who are

able to risk losing significant amounts of money. This is balanced by the potential benefits of annual returns, which range up to 30% for successful funds. Most private equity funds are offered only to institutional investors and individuals of substantial net worth. The law often requires this as well, since private equity funds are generally less regulated than ordinary mutual funds.

8.1. Incubators
Incubator is a company or facility designed to foster entrepreneurship and help startup companies usually technology-related, to grow through the use of shared resources, management expertise and intellectual capital. Kanwal Rekhi School of Information Technology (KReSIT) is a business incubators at IIT Mumbai is the best example of business incubators in India.

8.2. Angle Investors
An angel investor (known as a "business angel" in Europe, or simply an "angel") is an affluent individual who provides capital for a business start-up, usually in exchange for ownership equity. Angels typically invest their own funds, unlike venture capitalists, who manage the pooled money of others in a professionallymanaged fund. However, a small but increasing number of angel investors are organizing themselves into angel networks or angel groups to share research and pool their investment capital. Angel investments bear extremely high risk, and thus require a very high return on investment. Because a large percentage of angel investments are lost completely when early stage companies fail, professional angel investors seek investments that have the potential to return at least 10 or more times their original investment within 5 years, through a defined exit strategy, such as plans for an initial public offering or an acquisition. Angel investors are often retired entrepreneurs or executives, who may be interested in angel investing for other reasons in addition to pure monetary return. These include wanting to keep abreast of current developments in a particular business arena, mentoring another generation of entrepreneurs, and making use of their experience and networks on a less-than-full-time basis. Thus, in addition to funds, angel investors can often provide valuable management advice and important contacts.

8.3. Venture Capitalist
Venture capitalists are organizations which pooled in money from various investors in a professionally managed fund. VCs are inclined toward the turnaround ventures that entail some investment risk but offer the potential for above average future profits. Sources of venture capital includes wealthy individual investors; subsidiaries of banks and other corporations organized as small business investment companies (SBICs); groups of investment banks and other financing sources who pool investments in venture capital funds or Venture Capital Limited Partnerships.

8.4. Private Equity players
Equity capital that is made available to companies or investors but not quoted on a stock market. The funds raised through private equity can be used to develop new products and technologies, to expand working capital, to make acquisitions, or to strengthen a company's balance sheet. KKR (Kohlberg Kravis Roberts), Blackstone and Vestar Capital Venture and ICICI venture are examples of private equity players. Private equity funds typically control management of the companies in which they invest, and often bring in new management teams that focus on making the company more valuable.

8.5. Types of Venture Capital firms
There is quite a variety of types of venture capital firms. They include: 1. Traditional partnerships: which are often established by wealthy families to aggressively manage a portion of their funds by investing in small companies. These funds are typically established as partnerships that invest the money of their institutional limited partners. The partners typically include corporate pension funds, government pension funds, private individuals, foreign investors, corporations and insurance companies. These include venture capital funds that are focused on investing in minority businesses or minority markets. 2. Investment banking firms: which usually trade in more established securities, but occasionally form investor syndicates for venture proposals. 3. Manufacturing companies: which have sometimes looked upon investing in smaller companies as a means of supplementing their R & D programs (Some "Fortune 500" corporations have venture capital operations to help keep them abreast of technological innovations). 4. Small Business Investment Corporations (SBICs): which are licensed by the Small Business Administration (SBA) and which may provide management assistance as well as venture capital. In addition to these venture capital firms there are individual private investors and finders. Finders, which can be firms or individuals, often know the capital industry and may be able to help the small company seeking capital to locate it, though they are generally not sources of capital themselves. Care should be exercised so that a small business owner deals with reputable, professional finders whose fees are in line with industry practice. Further, it should be noted that venture

capitalists generally prefer working directly with principals in making investments, though finders may provide useful introductions.

8.6. Parties involved
1. Entrepreneurs The word entrepreneur derived from the French verb enterprendre, which means “to undertake”. It is very difficult to define entrepreneur but Peter Drucker and Francies Walker explain their views on entrepreneur. It is the qualities of the entrepreneur that define entrepreneur. Innovative, risk taking ability, passionate, visionary, change agent and many more qualities that makes entrepreneur apart from others and define what he is. Entrepreneurs has various types but broadly classified according to: the type of business, the use of technology, the motivation, the growth, the stages of development, area, gender and age, the sale of operation and others. In the flow entrepreneur creates an idea which creates the entire flow. Entrepreneur has to sell its idea to the Venture Capitalist. In turn entrepreneur receives the fund (money) to implement his idea into reality. 2. Venture Capitalists He is the one who supports the idea of the entrepreneur and in turn makes fund available to the entrepreneur. Venture capitalist posses a good experience of his area and provide expertise to the entrepreneur. Venture capitalist makes money for themselves by making market for entrepreneurs, investors and bankers Venture capitalist will raise money from the investors who expect high returns. Venture capitalist takes the help of bankers to issues IPOs and in turn received the initial outflow. 3. Investors These are the private investors who expect high return as they invest in the business which is full of risk. They invest in from of money and received return in form of money as well. Venture capitalists raise money from these investors to invest in entrepreneur’s idea. 4. Bankers An investment banker helps the venture capitalist to float the IPOs in the market. They are the one who help the venture capitalist to exit from the VC.

8.7. How funds flow between the parties

“Venture capital fund” means a fund established in the form of a trust or a company including a body corporate and registered under these regulations which— (i) Has a dedicated pool of capital; (ii) Raised in a manner specified in the regulations; and (iii) Invests in accordance with the regulations; “Venture capital undertaking” means a domestic company— (i) Whose shares are not listed on a recognized stock exchange in India. (ii) Which is engaged in the business for providing services, production or manufacture of article or things or does not include such activities or sectors which are specified in the negative list by the Board with the approval of the Central Government by notification in the Official Gazette in this behalf.

Application for Grant of Certificate: (a) Any company or trust or a body corporate proposing to carry on any activity as a venture capital fund on or after the commencement of these regulations shall make an application to the Board for grant of a certificate. (b)Any company or trust or a body corporate, which on the date of commencement is carrying any activity as a venture capital fund without a certificate shall make an application to the Board for grant of a certificate within a period of three months (maximum of six months in special cases) from the date of such commencement. (c) An application for grant of certificate shall be accompanied by a nonrefundable application fee. (d) Any company or trust or a body corporate who fails to make an application for grant of a certificate within the period specified therein shall cease to carry on any activity as a venture capital fund. (e) The Board may in order to protect the interests of investors appoint any person to take charge of records, documents, securities and for this purpose also determine the terms and conditions of such an appointment. Eligibility Criteria: For the purpose of the grant of a certificate by the Board the applicant shall have to fulfill in particular the following conditions, namely:— (a) if the application is made by a company :— (i) Memorandum of association as has its main objective, the carrying on of the activity of a venture capital fund; (ii)It is prohibited by its memorandum and articles of association from making an invitation to the public to subscribe to its securities;

(iii) Its director or principal officer or employee is not involved in any litigation connected with the securities market which may have an adverse bearing on the business of the applicant; (iv) Its director, principal officer or employee has not at any time been convicted of any offence involving moral turpitude or any economic offence; (v) It is a fit and proper person (b) If the application is made by a trust— (i) The instrument of trust is in the form of a deed and has been duly registered under the provisions of the Indian Registration Act, 1908 (16 of 1908); (ii) The main object of the trust is to carry on the activity of a venture capital fund; (iii) The directors of its trustee company, if any or any trustee is not involved in any litigation connected with the securities market which may have an adverse bearing on the business of the applicant; (iv) The directors of its trustee company, if any, or a trustee has not at any time, been convicted of any offence involving moral turpitude or of any economic offence; (v) The applicant is a fit and proper person; (c) If the application is made by a body corporate— (i) It is set up or established under the laws of the Central or State Legislature, (ii) The applicant is permitted to carry on the activities of a venture capital fund, (iii) The applicant is a fit and proper person, (iv) The directors or the trustees, as the case may be, of such body corporate have not been convicted of any offence involving moral turpitude or of any economic offence, (v) The directors or the trustees, as the case may be, of such body corporate, if any, are not involved in any litigation connected with the securities market which may have an adverse bearing on the business of the applicant; (d) The applicant has not been refused a certificate by the Board or its certificate has not been suspended or cancelled under regulation. Furnishing of information, clarification: The Board may require the applicant to furnish such further information as it may consider necessary. Consideration of application: An application which is not complete in all respects shall be rejected by the Board: Provided that, before rejecting any such application, the applicant shall be given an opportunity to remove, within thirty days further on being satisfied that it is necessary to extend the period by such further time not exceeding ninety days. Procedure for grant of certificate: (a) If the Board is satisfied that the applicant is eligible for the grant of certificate, it shall send intimation to the applicant.

(b) On receipt of intimation, the applicant shall pay to the Board; the registration fee. (c) The Board shall on receipt of the registration fee grant a certificate of registration. Procedure where certificate is not granted: (a) After considering an application made under regulation , if the Board is of the opinion that a certificate should not be granted, it may reject the application after giving the applicant a reasonable opportunity of being heard. (b) The decision of the Board to reject the application shall be communicated to the applicant within thirty days.

Minimum investment in a Venture Capital Fund: (a) A venture capital fund may raise monies from any investor whether Indian, Foreign or non-resident Indian by way of issue of units. (b) No venture capital fund set up as a company or any scheme of a venture capital fund set up as a trust shall accept any investment from any investor which is less than five lakh rupees: Provided that nothing contained in sub-regulation (2) shall apply to investors who are,— (i) Employees or the principal officer or directors of the venture capital fund, or directors of the trustee company or trustees where the venture capital fund has been established as a trust; (ii) The employees of the fund manager or asset Management Company; (c) Each scheme launched or fund set up by a venture capital fund shall have firm commitment from the investors for contribution of an amount of at least rupees five crores before the start of operations by the venture capital fund. Investment conditions and restrictions: All investment made or to be made by a venture capital fund shall be subject to the following conditions, namely:— (a) Venture capital fund shall disclose the investment strategy at the time of application for registration; (b) Venture capital fund shall not invest more than 25% corpus of the fund in one venture capital undertaking; (i) Venture capital fund may invest in securities of foreign companies subject to such conditions or guidelines that may be stipulated or issued by the Reserve Bank of India and the Board from time to time. (c) Shall not invest in the associated companies; and (d) Venture capital fund shall make investment as enumerated below: (i) At least 66.67% of the investible funds shall be invested in unlisted equity shares or equity linked instruments of venture capital undertaking. (ii) Not more than 33.33% of the investible funds may be invested by way of: (ii.a) Subscription to initial public offer of a venture capital undertaking whose shares are proposed to be listed

(ii.b) Debt or debt instrument of a venture capital undertaking in which the venture capital fund has already made an investment by way of equity. (ii.c) Preferential allotment of equity shares of a listed company subject to lock in period of one year; (ii.d) The equity shares or equity linked instruments of a financially weak company or a sick industrial company (a company, which has at the end of the previous financial year accumulated losses, which has resulted in erosion of more than 50% but less than 100% of its net-worth as at the beginning of the previous financial year) whose shares are listed. (ii.e) Special Purpose Vehicles which are created by a venture capital fund for the purpose of facilitating or promoting investment in accordance with these Regulations. (e) Venture capital fund shall disclose the duration of life cycle of the fund. Prohibition on listing: No venture capital fund shall be entitled to get its units listed on any recognized stock exchange till the expiry of three years from the date of the issuance of units by the venture capital fund.

Prohibition on inviting subscription from the public: No venture capital fund shall issue any document or advertisement inviting offers from the public for the subscription or purchase of any of its units. Private placement: A venture capital fund may receive monies for investment in the venture capital fund only through private placement of its units. Placement memorandum or subscription agreement: (a) The venture capital fund shall— (i) Issue a placement memorandum which shall contain details of the terms and conditions subject to which monies are proposed to be raised from investors; or (ii) Enter into contribution or subscription agreement with the investors which shall specify the terms and conditions subject to which monies are proposed to be raised. (b) The Venture Capital Fund shall file with the Board for information, the copy of the placement memorandum or the copy of the contribution or subscription agreement entered with the investors along with a report of money actually collected from the investor. Contents of placement memorandum: The placement memorandum or the subscription agreement with investors shall contain the following, namely:(a) Details of the trustees or Trustee Company and the directors or chief executives of the venture capital fund;

(b) (i) The proposed corpus of the fund and the minimum amount to be raised for the fund to be operational; (ii) The minimum amount to be raised for each scheme and the provision for refund of monies to investor in the event of non-receipt of minimum amount; (c) Details of entitlements on the units of venture capital fund for which subscription is being sought; (d) Tax implications that are likely to apply to investors; (e) Manner of subscription to the units of the venture capital fund; (f) The period of maturity, if any, of the fund; (g) The manner, if any, in which the fund shall be wound up; (h) The manner in which the benefits accruing to investors in the units of the trust are to be distributed; (i) Details of the fund manager or asset Management Company if any, and the fees to be paid to such manager; (j) The details about performance of the fund, if any, managed by the Fund Manager; (k) Investment strategy of the fund; (l) Any other information specified by the Board. Maintenance of books and records: (a) Every venture capital fund shall maintain for a period of eight years books of account, records and documents which shall give a true and fair picture of the state of affairs of the venture capital fund. (b) Every venture capital fund shall intimate the Board, in writing, the place where the books, records and documents are being maintained. Power to call for information: (a) The Board may at any time call for any information from a venture capital fund with respect to any matter relating to its activity as a venture capital fund. (b) Where any information is called for shall be furnished within the time specified by the Board. Submission of reports to the Board: The Board may at any time call upon the venture capital fund to file such reports as the Board may desire with regard to the activities carried on by the venture capital fund. Winding-up: (a) A scheme of a venture capital fund set up as a trust shall be wound up, (i) When the period of the scheme, if any, mentioned in the placement memorandum is over; (ii) If it is the opinion of the trustees or the trustee company, as the case may be, that the scheme shall be wound up in the interests of investors in the units; (iii) If seventy-five per cent of the investors in the scheme pass a resolution at a meeting of unit-holders that the scheme be wound up; or (iv) If the Board so directs in the interests of investors.

(b) A venture capital fund set up as a company shall be wound up in accordance with the provisions of the Companies Act, 1956. (c) The trustees or trustee company of the venture capital fund set up as a trust or the Board of Directors in the case of the venture capital fund is set up as a company (including body corporate) shall intimate the Board and investors of the circumstances leading to the winding up of the Fund or Scheme. Effect of winding-up: (a) On and from the date of intimation, no further investments shall be made on behalf of the scheme so wound up. (b) Within three months from the date of intimation, the assets of the scheme shall be liquidated, and the proceeds accruing to investors in the scheme distributed to them after satisfying all liabilities. (c) Notwithstanding anything as asset and subject to the conditions, if any, contained in the placement memorandum or contribution agreement or subscription agreement, as the case may be, in specie distribution of assets of the scheme, shall be made by the venture capital fund at any time, including on winding up of the scheme, as per the preference of investors, after obtaining approval of at least 75% of the investors of the scheme.

Board’s right to inspect or investigate. The Board may suo motu or upon receipt of information or complaint appoints one or more persons as inspecting or investigating officer to undertake inspection or investigation of the books of account, records and documents relating to a venture capital fund. Notice before inspection or investigation. Before ordering an inspection or investigation, the Board shall give not less than ten days notice to the venture capital fund.

Liability for action in case of default: Without prejudice to the issue of directions or measure under regulation 29, a venture capital fund which— (a) contravenes any of the provisions of the Act or these regulations; (b) Fails to furnish any information relating to its activity as a venture capital fund as required by the Board; (c) Furnishes to the Board information which is false or misleading in any material particular; (d) Does not submit periodic returns or reports as required by the Board; (e) Does not co-operate in any enquiry, inspection or investigation conducted by the Board; (f) Fails to resolve the complaints of investors or fails to give a satisfactory reply to the Board in this behalf;

Shall be dealt with in the manner provided in the Securities and Exchange Board of India (Procedure for Holding Enquiry by Enquiry Officer and Imposing Penalty) Regulations, 2002.

Application fee Rs. 1, 00,000 Registration fee Rs. 10, 00,000

(a) Non-banking financial services excluding that NBFC which are registered with RBI and have been categorized as Equipment Leasing or Hire Purchase Companies. (b) Gold financing excluding those Companies which are engaged in gold financing for jewellery. (c) Activities not permitted under industrial policy of Government of India. (d) Any other activity which may be specified by the Board in consultation with Government of India from time to time.

“Designated bank" means any bank in India which has been permitted by the Reserve Bank of India to act as banker to the Foreign Venture Capital Investor. "Domestic custodian" means a person registered under the Securities and Exchange Board of India (Custodian of Securities) Regulations, 1996. “Equity linked instruments" includes instruments convertible into equity share or share warrants, preference shares, debentures compulsorily; or optionally convertible into equity. "Foreign venture capital investor" means an investor incorporated and established outside India, is registered under these Regulations and proposes to make investment in accordance with these Regulations. "Investible funds" means the fund committed for investments in India net of expenditure for administration and management of the fund. "Venture Capital Fund" means a Fund established in the form of a Trust, a company including a body corporate and registered under Securities and Exchange Board of India (Venture Capital Fund) Regulations, 1996, which (i) Has a dedicated pool of capital; (ii) Raised in the manner specified under the Regulations; and (iii) Invests; in accordance with the Regulations. "Venture capital undertaking" means a domestic company:(i) Whose shares are not listed in a recognized stock exchange in India; (ii) Which is engaged in the business of providing services, production or manufacture of articles or things, but does not include such activities or sectors which are specified in the negative list by the Board, with approval of Central Government, by notification in the Official Gazette in this behalf."

Application for grant of certificate: For the purposes of seeking registration under these regulations, the applicant shall make an application to the Board with the application fee as specified

Eligibility Criteria: For the purpose of the grant of a certificate to an applicant as a Foreign Venture Capital Investor, the Board shall consider the following conditions for eligibility, namely: (a) The applicants track record, professional competence, financial soundness, experience, general reputation of fairness and integrity. (b) Whether the applicant has been granted necessary approval by the Reserve Bank of India for making investments in India; (c) Whether the applicant is an investment company, investment trust, investment partnership, pension fund, mutual fund, endowment fund, university fund, charitable institution or any other entity incorporated outside India; or (d) Whether the applicant is an asset management company, investment manager or investment Management Company or any other investment vehicle incorporated outside India; (e) Whether the applicant is authorized to invest in venture capital fund or carry on activity as foreign venture capital investors; (f) Whether the applicant is regulated by an appropriate foreign regulatory authority or is an income tax payer; or submits a certificate from its banker of its or its promoter’s track record where the applicant is neither a regulated entity nor an income tax payer. (g) The applicant has not been refused a certificate by the Board. (h) Whether the applicant is a fit and proper person. Furnishing of information, clarification The Board may require the applicant to furnish such further information as it may consider necessary. Consideration of application An application which is not complete in all respects shall be rejected by the Board: Provided that, before rejecting any such application, the applicant shall be given an opportunity to remove, within thirty days of the date of receipt of communication, the objections indicated by the Board. Provided further that the Board may, on being satisfied that it is necessary to extend the period specified above may extend such period not beyond ninety days. Procedure for grant of certificate (a) If the Board is satisfied that the applicant is eligible for the grant of certificate, it shall send intimation to the applicant. (b) On receipt of intimation, the applicant shall pay to the Board; the registration fee. (c) The Board shall on receipt of the registration fee grant a certificate of registration.

Procedure where certificate is not granted (a) On considering an application made if the Board is of the opinion that a certificate should not be granted, it may reject the application after giving the applicant a reasonable opportunity of being heard. (b) The decision of the Board to reject the application shall be communicated to the applicant.

Investment Criteria for a Foreign Venture Capital Investor All investments to be made by a 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. (c) It shall make investments as enumerated below: (i) At least 66.67% of the investible funds shall be invested in unlisted equity shares or equity linked instruments of Venture Capital Undertaking. (ii) Not more than 33.33% of the investible funds may be invested by way of: (ii.a) Subscription to initial public offer of a venture capital undertaking whose shares are proposed to be listed. (ii.b) Debt or debt instrument of a venture capital undertaking in which the foreign venture capital investor has already made an investment by way of equity. (ii.c) Preferential allotment of equity shares of a listed company subject to lock in period of one year. (ii.d) The equity shares or equity linked instruments of a financially weak company or a sick industrial company (a company, which has at the end of the previous financial year accumulated losses, which has resulted in erosion or more than 50% but less than 100% of its net worth as at the beginning of the previous financial year) whose shares are listed. (ii.e) Special Purpose Vehicles which are created for the purpose of facilitating or promoting investment in accordance with these Regulations. (d) It shall disclose the duration of life cycle of the fund.

Maintenance of books and records (a) Every Foreign Venture Capital Investor shall maintain for a period of eight years, books of accounts, records and documents which shall give a true and fair picture of the state of affairs of the Foreign Venture Capital Investor. (b) Every Foreign Venture Capital Investor shall intimate to the Board, in writing, the place where the books, records and documents are being maintained. Power to call for information (a) The Board may at any time call for any information from a Foreign Venture Capital Investor with respect to any matter relating to its activity as a Foreign Venture Capital Investor.

(b) Where any information is called for it shall be furnished within the time specified by the Board. General Obligations and Responsibilities (a) Foreign Venture Capital Investor or a global custodian acting on behalf of the foreign venture capital investor shall enter into an agreement with the domestic custodian to act as a custodian of securities for Foreign Venture Capital Investor. (b) Foreign Venture Capital Investor shall ensure that domestic custodian takes steps for,(i) Monitoring of investment of Foreign Venture Capital Investors in India (ii) Furnishing of periodic reports to the Board (iii) Furnishing such information as may be called for by the Board. Appointment of designated bank Foreign Venture Capital Investor shall appoint a branch of a bank approved by Reserve Bank of India as designated bank for opening of foreign currency denominated accounts or special non-resident rupee account.

Board's right to inspect or investigate The Board may, suo-moto or upon receipt of information or complaint, cause an inspection or investigation to be made in respect of conduct and affairs of any foreign venture capital investor by an Officer whom the Board considers fit for. Notice before inspection or investigation Before ordering an inspection or investigation, the Board shall give not less than ten days notice to the venture capital fund.

Board's right to suspend or cancel certificate of registration Without prejudice to the appropriate directions or measures board may after consideration of the investigation report, initiate action for suspension or cancellation of the registration of such Foreign Venture Capital Investor: Provided that no such certificate of registration shall be suspended or cancelled unless the procedure specified is complied with. Suspension of certificate The Board may suspend the certificate where the Foreign Venture Capital Investor: (a) Contravenes any of the provisions of the Act or these regulations; (b) Fails to furnish any information relating to its activity as a Foreign Venture Capital Investor as required by the Board; (c) Furnishes to the Board information which is false or misleading in any material particular; (d) Does not submit periodic returns or reports as required by the Board; (e) Does not co-operate in any enquiry or inspection conducted by the Board;

Cancellation of certificate The Board may cancel the certificate granted to a Foreign Venture Capital Investor: (a) When the Foreign Venture Capital Investor is guilty of fraud or has been convicted of an offence involving moral turpitude; Explanation: The expression "fraud" has the same meaning as is assigned to it in section 17 of the Indian Contract Act, 1872. (9 of 1872) (b) The Foreign Venture Capital Investor has been guilty of repeated defaults. or (c) Foreign Venture Capital Investor does not continue to meet the eligibility criteria laid down in these regulations; (d) Contravenes any of the provisions of the Act or these regulations. Action against intermediary The Board may initiate action for suspension or cancellation of registration of an intermediary holding a certificate of registration under section 12 of the Act who fails to exercise due diligence in the performance of its functions or fails to comply with its obligations under these regulations. Provided that no such certificate of registration shall be suspended or cancelled unless the procedure specified in the regulations applicable to such intermediary is complied with. Appeal to Securities Appellate Tribunal Any person aggrieved by an order of the Board under these regulations may prefer an appeal to the Securities Appellate Tribunal in accordance with section 15T of the Act. Amount to be paid Application fee (US$) Registration fee shall be payable at for grant of certificate (US $) as the time of fees 5, 000 registration 20, 000

(a) Non-banking financial services excluding those Non – Banking Financial companies which are registered with Reserve Bank of India and have been categorized as Equipment Leasing or Hire Purchase companies. (b) Gold financing excluding those companies which are engaged in gold financing for jewellery. (c) Activities not permitted under the Industrial Policy of Government of India (d) Any other activity wshich may be specified by the Board in consultation with the Government of India from time to time.

In 2002, Under new rules in India, the entire income of registered VC funds, whether foreign or domestic, is exempt from Indian income tax, subject to certain conditions. But to take advantage of this tax-exempt status, funds must register with the regulator, the Securities and Exchange Board of India. In late 2000, Sebi issued the Foreign Venture Capital Investor Regulations, 2000. They apply to foreign venture capital investors (FVCI) incorporated and established outside India and which propose to invest in India. Until recently, FVCIs avoided registering themselves with Sebi due to the extremely confusing regulatory and tax position. FVCIs preferred to operate from overseas, usually through a liaison office in India. However, this was no longer the case following the enactment of the Regulations, and also amendment to the Indian Income Tax Act, 1961 (IT Act). The clear advantages of registration notwithstanding, there were an argument that it is mandatory anyway. This view was based on Section 12(1B) of the Sebi Act, 1992, which provides that no person may sponsor or carry on any venture capital fund without a certificate of registration from Sebi, in accordance with the Regulations. Failure to register may amount to a contravention of the provisions of Section 12(1B) of the Sebi Act, 1992, which can lead to heavy fines. This view proceeds on the assumption that a distinction must be made between a non-resident making a foreign direct investment (FDI) and an FVCI. This distinction is established from the nature of the agreements entered into by a foreign investor with the Indian investee companies and its promoters, and also whether the foreign investor otherwise carries on the business of being a venture capital fund outside India. This contention was reinforced when India's central bank, the Reserve Bank of India (RBI), amended the Foreign Exchange Management (Transfer or Issue of Security by a Person Resident outside India) Regulations, 2000, to specifically bring within its fold investments by a Sebi-registered FVCI in a domestic, Sebiregistered venture capital fund or an unlisted Indian company. The effect of the amendment is that such an investment will no longer be regarded as FDI, but as a separate category of investment. The advantage of such treatment is that shares issued by unlisted Indian companies to an FVCI will not be subject to compliance with the usual price guidelines and the FVCI may acquire or purchase the shares issued by unlisted Indian companies at a price that is mutually agreed between the buyer and the seller or issuer.

Advantages of Regisration
The obvious advantage of registration is that, under the IT Act, its income is tax free. But another advantage is that under the normal FDI rules, all FDI investors require the central government's prior permission to invest in a similar field to any of its previous investments or tie ups. In other words, automatic approval is not allowed and a no-objection certificate of the Indian investee company (with whom there is an existing tie up) is required. However, Sebi-registered FVCIs are exempted from this requirement. There is no minimum capitalization requirement for being registered as an FVCI. It can invest either in a domestic fund or in a domestic company whose shares are not listed on a recognized stock exchange in India (it does not matter if its shares are listed on a stock exchange outside India, such as the NASDAQ or NYSE) and is not engaged in any activity except real estate, non-banking financial services or gold financing (a venture capital undertaking). While granting registration, Sebi will take into account the FVCI's track record, reputation of the group and financial soundness. While it can invest its total funds even in one domestic fund, it cannot invest more than 25 per cent of its committed funds in any one venture capital undertaking (and at least 75 per cent of such investments must be in equity). The Regulations require an FVCI to appoint a domestic custodian as well as open a non-resident rupee or foreign currency account with a designated bank. Banks are allowed to offer forward cover (for hedging against forex risk) to FVCIs to the extent of their inward remittance. Registration fees payable to Sebi are about $11,000.

Taxation of FVCI
Under Section 90(2) of the IT Act, a non-resident assessee based in a country with which India has a double taxation avoidance agreement (DTAA), may opt to be taxed either under the IT Act or the DTAA, whichever is more beneficial? Under Section 10(23FB) of the IT Act, any income of a registered FVCI is exempt from income tax. The FVCI can carry on business in India through a permanent establishment in India, and yet its entire income would be tax free. On the other hand, if the FVCI opts to be taxed under the DTAA and it has a permanent establishment in India, its Indian income will not be tax free. The tax exemption under section 10(23FB) has to be read with section 115U of the IT Act, which confers a pass-through status on Sebi-registered venture funds. Investors in such funds would be liable to tax in respect of the income received by them from the FVCI in the same manner as it would have been, had the

investors invested directly in the venture capital undertaking. In other words, income earned by an FVCI by way of dividend, interest or capital gains, upon distribution, would continue to retain the same character in the hands of its investors. This brings us to a question as to what is the nature of the income derived by an FVCI from its Indian investments. While dividend declared by an Indian company is tax free in the hands of any recipient, including an FVCI, the gains, an FVCI would make upon exit from an Indian investment, was so far regarded as capital gains. However, the Authority for Advance Ruling on March 7 2001 held that profits made by a private equity fund or venture capital fund should be taxed as business profits and not as capital gains. Are non-resident investors in an FVCI, therefore, liable to pay Indian income tax on what they receive from the FVCI as business profits, even though the FVCI itself does not have to pay any tax? Although Section 115 U begins with the words ‘Notwithstanding anything contained in any other provisions of this Act', and it would override the normal provisions relating to taxability of individual items of income, it cannot override Section 90(2) relating to DTAA provisions. India is a signatory to the Vienna Convention on the Law of Treaties and, therefore, tax treaties have a special status as compared to domestic tax legislation and would prevail unless there is an express specific domestic provision to override the treaty. In the present case, it does not appear to be the intention of the legislature that Section 115 U should override Section 90(2). Accordingly, a non-resident investor in an FVCI, who receives dividend from the FVCI, is entitled to characterize the same as dividend under the DTAA, by opting to be taxed under the DTAA and not the IT Act. Due to its very recent enactment, obviously, there is no precedent or case law and, therefore, it is not improbable that the Indian tax authorities may contend that the investor is not entitled to the DTAA benefit in view of Section 115 U and is liable to pay tax on business profits in India. Tax planning structures could be worked out to protect against such an eventuality, however remote it may be.

Taxing The Carry
Under the Sebi regulations relating to mutual funds, it is mandatory that a mutual fund must have a separate asset management company (AMC). However, the Regulations do not make this a mandatory requirement for an FVCI. This difference is critical from the viewpoint of tax because while the income of an FVCI is tax free, the income of a domestic AMC is subject to 35.7 per cent tax in India (48 per cent for a foreign AMC). It is not advisable for an offshore AMC to render services to an FVCI by deploying its personnel to India for carrying out various activities such as validation of business plans, due diligence, etc, as the

Indian tax authorities may contend that such AMC is deemed to have a permanent establishment in India and liable to be taxed in India on such part of the ‘carry' as is attributable to its operations in India.

Structuring FVCI’s
On account of its favorable DTAA with India, Mauritius has become a favorite jurisdiction for investing into India. An obvious question arises. If the FVCI is to avail of the total tax exemption under Section 10(23FB), why does it require to be incorporated in Mauritius or any other country with which India has a favorable DTAA? The answer is, that having regard to the legislative fickleness with which the IT Act is amended annually, even if the tax exemption provisions contained in Section 10(23FB) are withdrawn, the FVCI could then rely upon the provisions of the DTAA, so that its income continues to be tax free. So, there is dual protection. Of course, in such an event, the FVCI cannot have a permanent establishment in India. The FVCI can be incorporated as a Mauritius offshore company and will be a tax resident of Mauritius. This process is quick and user friendly. The second step is to register with Sebi as an FVCI. If the FVCI intends to have a place of business in India, under the Foreign Exchange Management (Establishment in India of Branch or Office or other place of Business) Regulations, 2000, it will require RBI approval. Before investing in a venture capital undertaking, the FVCI will have to apply to RBI, through Sebi, for permission. Given the manner in which these Regulations are drafted, it appears that the FVCI may have to obtain such permission on a case-by-case basis, every time it makes an investment. However, in practice, RBI may grant a general or blanket permission as in the case of foreign institutional investors.

As is evident from the above analysis, there are still a couple of grey areas which require tax planning for FVCI and their investors. While Sebi efficiently handles registration, formal permissions under Exchange Control Laws are still required. However, the entire process of setting up an FVCI is much simpler now and can be completed in as little as 90 days. The total tax exemption makes these investments very attractive indeed.

Investment through a Venture Capital Fund

A venture capital fund, which registers in accordance with the Securities and Exchange Board of India (“SEBI”) guidelines and complies with specified investment restrictions will receive pass through tax benefits on certain types of investments (no capital gains or withholding tax on dividends). The investments that qualify for pass through benefits are: Biotechnology Information technology relating to hardware and software development Nanotechnology Seed research and development Research and development of new chemical entities in the pharmaceutical sector Dairy industry Poultry industry Production of bio fuels Hotels/convention centers of a certain description and size Other than investment, the permitted activities of a fund, however, are limited. No services such as incubation services may be provided. A separate entity would be needed in order to provide such services. There may also be restrictions on where the fund can raise money. There are two additional advantages of investment through a SEBI registered fund. Upon an IPO in India, all shares held pre-IPO are locked up for one year. This lock up requirement does not apply to shares held by SEBI registered VC funds provided such shares have been held for at least one year prior to the IPO. Secondly, there is a proposal to treat nominee directors of SEBI registered funds as independent directors under the corporate governance guidelines for listed companies which could help in complying with the guidelines.

Investment through Mauritius
Presently, in India there is no capital gains tax on sales of shares of an Indian company held over one year and sold through a stock exchange and an 11.33% capital gains tax on such sales if the shares in an Indian company are held for less than a year. Sales of shares in a private company, i.e., a company not listed on a stock exchange, are taxed at a 22.66% rate for shares held for more than a year and at 33.99% for shares held for less than a year. The Mauritius approach to investing in India, detailed below, is therefore most advantageous when the Indian company is the primary exit vehicle for investor liquidity and such exit is a sale when the company is private. The benefit of the capital gains tax exemption would not apply if the Mauritius company is formed with the objective of trading in securities, as opposed to long term investment in operating companies. Thanks to the India-Mauritius tax treaty (the “Treaty”) the India tax on sales of shares of an Indian company can be avoided if the seller is a Mauritius company so long as the Mauritius Company does not have a “permanent establishment” in India. In other words, there is no Indian tax on sales of shares in an Indian company by a Mauritius company that does not have a permanent establishment in India

regardless of whether the shares are of a company listed on a stock exchange or of a private company and regardless of the holding period. Otherwise, the proceeds of a sale of shares in an Indian company are taxed in India unless the shares are sold through a stock exchange and have been held for at least one year. While there is a lower tax rate on dividends for Mauritius tax residents under the Treaty, corporate dividends declared by an Indian company are presently not taxed in the hands of the recipient upon payment in India of a dividend tax (presently 17%) by the Indian company that declares the dividend. Under the Mauritius approach, a Global Business Company Category 1 (formerly known as an Offshore Company), regulated by the Mauritius Financial Services Development Act 2001, is formed to make the investment(s). Certain requirements must be met in order to receive a Mauritius tax residency certificate for purposes of the Treaty including: • • • Two local directors approved by the Mauritius Financial Services Commission Bank account in Mauritius; and Compliance with Mauritius corporate formalities.

The tax residency certificate is sufficient evidence for India tax authorities to accept the status of Mauritius tax residence according to Union of India vs. Azadi Bachao Andolan, 2003 SOL 619. The Indian government is advocating changes in the Treaty which would reduce the tax benefits of using Mauritius. As of February 2007, Mauritius has agreed to have tax residency certificates be effective for only one year at a time and to impose new undertakings as a condition for issuing a certificate • • • • • • Two directors resident in Mauritius at all times; Resident directors of “appropriate caliber” who can exercise independence of mind and judgment; All meetings of the Board held, chaired and minuted in Mauritius All accounting records kept at the company’s registered office in Mauritius at all times fenwick & west 2007 update to structuring venture capital and other investments in India All of a company’s banking transactions channeled through a bank account in Mauritius.

A U.S. investor should not underestimate the legal and operating requirements of the Mauritius structure. For example, funds to be invested in or loaned to the India subsidiary should be wired first to the Mauritius company prior to investment in India as opposed to a wire transfer of funds directly from the U.S. investor to the India company. A wire transfer directly from the U.S. to India is an investment in the India company by the U.S. company not the Mauritius company. The Board of Directors of the Mauritius company should approve the investment and funds should be wired to the Indian company from the Mauritius

company. All such actions take time and documentation in order to comply with corporate governance requirements. Business income of any non-Indian company is taxed in India if such non-Indian company has a “permanent establishment” in India which generates such income. This result obtains regardless of where the non-Indian company is formed, i.e., Mauritius, Cyprus, Singapore or the United States. Having an India subsidiary is a necessary but not sufficient condition for a Mauritius company (as well as any other non-Indian company) to avoid permanent establishment status. If a Mauritius company is deemed to have a permanent establishment in India and its activities are determined to be the business of trading in securities within India ( on the basis of guidelnes put forth in circular 4 of 2007), then the profits arising from the sale of such “stock –in – trade” will be treated as business income in India (not as capital gains). There are several recent tax rulings that need to be considered in avoiding permanent establishment status. Under Rulings 442 and 566 of the India Tax Authority for Advance Rulings (“AAR”), activities such as the Mauritius company engaging an Indian firm for providing custodial services for securities or being an investment adviser that has no decision making authority will not by themselves constitute having a permanent establishment in India. Investment decisions must, however, be made outside of India. In addition, the effective management of the Mauritius company must not be carried out in India. Whether the effective management of a company is in India or Mauritius or elsewhere is a question of fact. If there is no permanent establishment in India, business income on the sale of the securities of India investments by the Mauritius company is not taxable in India. An Indian subsidiary that provides only backend fulfillment services for the U.S. parent usually will not cause the U.S. parent to be deemed to have a permanent establishment in India. The Indian subsidiary’s activities may, however, sometimes cause the parent to have a permanent establishment in India. For example, if the India subsidiary exercises authority to conclude contracts, secure orders or deliver goods on behalf of the parent. The implication of the India subsidiary being treated as a permanent establishment of the parent is that it causes the global income of the parent derived from the activity in India to be taxed in India, and not merely the amount billed by the subsidiary for services rendered to parent. In the case of Morgan Stanley & Co v. DIT, the AAR examined whether a U.S. company had a permanent establishment in India under the Treaty based on (1) outsourcing certain services to its subsidiary in India and (2) deputation of personnel to the subsidiary. The personnel deputed to India were engaged either for providing stewardship services to the Indian company or to work under the control of the Indian company. The AAR held that the outsourcing activity by the

U.S. company to its subsidiary did not result in the parent having a permanent establishment in India. The AAR, however, held that the deputation arrangement in India would result in a permanent establishment of the parent. Therefore, the income deemed to have been derived by the U.S. company from the deputation activity in India would be taxable in India. Until March 31, 2009, income arising from export revenues from software and BPO activities rendered from a “Software Technology Park Unit,” is liable to be taxed only at the minimum alternative tax rate of 11.33% instead of the normal corporate tax rate of 33.99% provided the transactions between parent and subsidiary are at arms length prices. It is not clear whether this benefit will be extended beyond March 31, 2009.

Investment through cyprus
Another alternative would be to route investment into India through Cyprus rather than through Mauritius. India and Cyprus are also parties to a tax treaty. The tax treatment for capital gains from the sale of shares in an Indian company held by a Cyprus holding company is the same as through Mauritius so long as the Cyprus company does not have a “permanent establishment” in India. There is no capital gains tax in either India or Cyprus on the sale of the shares. Cyprus has a slight economic advantage over Mauritius when an investment is by way of a mix of equity and debt. The interest payable to the Cyprus company is subject to a withholding tax of 10% instead of the normal rate of 20% for interest paid out of India. The withholding tax in India on interest payable to a Mauritius company is 15% so there is a slight economic advantage to using Cyprus if there is a major debt component of the investment. The disadvantage of using a Cyprus holding company is there is less precedent on the requirements for tax residency. A Cyprus company will be deemed to be a tax resident only if its management and control is in Cyprus. Companies managed and controlled from outside of Cyprus do not receive any benefits under the Cyprus-India tax treaty. Whether the effective management of a company is in India or Cyprus or elsewhere is a question of fact.

Investment through singapore
As with Mauritius and Cyprus, the primary benefit under the India-Singapore Double Taxation Agreement (the “Agreement”); which became effective on August 1, 2005, is no capital gains tax in either India or Singapore on the sale of

the shares of the Indian company by a Singapore company so long as the Singapore company does not have a “permanent establishment” in India. The requirements for Singapore tax residency are much greater than in Mauritius or Cyprus. The Singapore company must satisfy expenditure requirements and likely have sustainable and continuous business operations in Singapore. Annual expenditures on operations in Singapore must be at least $200,000 (SGD) in the 24 months immediately prior to when the gains are realized.

Impact of new budget on VC funds
First on the pass through benefits: The Finance Bill, 2007 proposes to restrict the pass through status for Venture Capital Funds ("VCFs")/Venture Capital Companies ("VCCs") to only income from investment in domestic unlisted company engaged in certain specified businesses such as IT, bio-tech etc ("VCU"). Currently, VCFs/ VCCs enjoy complete pass-through status under Section 10(23FB), irrespective of nature of income. Instead, the income is taxed in the hands of its investors at the time of distribution under Section 115U, on a passthrough basis. The proposed amendment raises several issues in respect of income of VCF from non-VCUs. Firstly, being in the nature of a Trust vehicle, the taxation of VCFs would now be guided by the complex principles relating to trust taxation. Whilst this taxation regime for Trusts also aims at one-level taxation, the implications could be manifold ranging from complex trust taxation provisions, issues relating to characterization as business income or capital gains, taxation on accrual basis rather than on distribution to investors, tax implications for foreign investor in VCF (availability of treaty benefit), etc.

Further, in case of VCCs, the proposed amendment would result in two levels of taxation - i.e. tax in the hands of VCC and on distribution of income to the investors. It is also doubtful as to whether the DDT provisions would apply to VCCs having mixed investments. Also, the existing non-VCU investments that have already been made by VCFs would be governed by the proposed provisions. It would be unjust to subject these investments to the proposed regime considering that the investments were made based on the complete pass-through status which was made available to VCFs. To conclude, with the proposed amendment, the Government has discouraged venture capital from making long term investments in India in key sectors such as Infrastructure/ real estate development.

11.1. What Does A Venture Capiltalist Look In For A Business?
Venture capitalists are high-risk investors and, in accepting these risks, they desire a higher return on their investment. The venture capitalist manages the risk -return ratio by only investing in businesses that fit their investment criteria and after having completed extensive due diligence. Venture capitalists have differing operating approaches. These differences may relate to the location of the business, the size of the investment, the stage of the company, industry specialization, structure of the investment and involvement of the venture capitalists in the company's activities. The entrepreneur should not be discouraged if one venture capitalist does not wish to proceed with an investment in the company. The rejection may not be a reflection of the quality of the business, but rather a matter of the business not fitting with the venture capitalist's particular investment criteria. Venture capital is not suitable for all businesses, as a venture . capitalist typically seeks:  Superior businesses Venture capitalists look for companies with superior products or services targeted at fast-growing or untapped markets with a defensible strategic position. Alternatively, for leveraged management buyouts, they are seeking companies with high borrowing capacity, stability of earnings and an ability to generate surplus cash to quickly repay debt.  Quality and depth of management Venture capitalists must be confident that the firm has the quality and depth in the management team to achieve .its aspirations. Venture capitalists seldom seek managerial control; rather, they want to add value to the investment where they have particular skills including fundraising, mergers and acquisitions. international marketing and networks.  Corporate governance and structure In many ways the introduction of a venture capitalist is preparatory to a public listing. The venture capitalist will want to ensure that the investee company has the willingness to adopt modem corporate governance standards, such as non-executive directors, including a representative of the venture capitalist. Venture capitalists are put off by complex corporate structures without a clear ownership and where personal and business assets are merged.  Appropriate investment structure As well as the requirement of being an attractive business opportunity, the venture capitalist will also be seeking to

structure a satisfactory deal ___ to_produce the anticipated [mancial returns to ~vestors.  Exit plan Lastly, venture capitalists look for clear exit routes for their investment such as public listing or a third¬party acquisition of the investee company.

11.2. The Process Of Venture Capital Financing
The venture capital investment process has variances/features that are context specific and vary from industry, timing and region. However, activities in a venture capital fund follow a typical sequence. The typical stages in an investment cycle are as below: 1. Generating a Deal Flow 2. Initial Evaluation: This involves the initial process of assessing the feasibility of the project. 3. Due diligence: In this stage an in-depth study is conducted to analyze the feasibility of the project. 4. Investment valuation 5. Deal structuring and negotiation: Having established the feasibility, the instruments that give the required return are structured. 6. Documentation: This is the process of creating and executing legal documents to protect the interest of the venture. 7. Monitoring and Value addition: In this stage, the project is monitored by executives from the venture fund and undesirable variations from the business plan are dealt with. 8. Exit: This is the final stage where the venture capitalist devises a method to come out of the project profitably. Origination of deal A continuous flow of deal is essential for the venture capital business. Deals may originate in various ways: (i) referral system, (ii) active search and (iii) intermediaries. Referral system is an important source of deals. Deals may be referred to VCFs by their parent organisations, trade partners, industry associations, friends etc. Yet another important source of deal flow is the active search through networks, trade fairs, conferences, seminars, foreign visits etc. A third source, used by venture capitalists in developed countries like USA, is certain intermediaries who match VCFs and the potential 'entrepreneurs. Screening – Analyzing business plans and selecting the opportunities Venture capital is a service industry, and VCFs generally operate with a small staff. In order to save on time and to select the best ventures, before going for an in-dept analysis, VCFs carry out initial screening of all projects on the basis of some broad criteria. For example, the screening process may limit projects to areas in which the venture capitalist is familiar in terms of, technology, or product, or market scope.

Thus, an initial screening is carried out to satisfy the venture capitalist of certain aspects of the project. These include  Competitive aspects of the product or service  Outlook of the target market and their perception of the new product  Abilities of the management team  Availability of other sources of funding  Expected returns  Time and resources required from the venture capital firm  size of investment  geographical location  stage of financing Through this screening the venture firm builds an initial overview about the  Technical skills, experience, business sense, temperament and ethics of the promoters  The stage of the technology being used, the drivers of the technology and the direction in which it is moving  Location and size of market and market development costs, driving forces of the market, competitors and share, distribution channels and other market related issues  Financial facts of the deal  Competitive edge available to the company and factors affecting it significantly  Advantages from the deal for the venture capitalist  Exit options available Due Diligence Once a proposal has passed through initial screening, it is subjected to a detailed evaluation or due diligence process. Most ventures are new and the entrepreneurs may lack operating experience. Hence, a sophisticated, formal evaluation is neither possible nor desirable. The venture capitalists, thus, may rely on a subjective, but comprehensive, evaluation. They evaluate the quality of entrepreneur before appraising the characteristics of the product, market or technology. Most venture capitalists ask for a business plan to make an assessment of the possible risk and return on the venture. Business plan contains detailed information about the proposed venture. Areas of due diligence would include • General Assessment • Business plan analysis • Contract details • Collaborators • Corporate objectives • SWOT analysis

• • •

Time scale of implementation People Managerial abilities, past performance and credibility of promoters • Financial background and feedback about promoters from bankers and previous lenders • Details of Board of Directors and their role in the activities • Availability of skilled labor • Recruitment process • Products/services, technology and process Here the research depends upon the nature of the industry into which the company is planning to enter. Some of the areas generally considered are Technical details, manufacturing process and patent rights Competing technologies and comparisons • Raw materials to be used, their availability and major suppliers, reliability of these suppliers • Machinery to be used and its availability • Details of various tests conducted regarding the new product • Product life cycle • Environment and pollution related issues • Secondary data collection on the product and technology, if so available • Potential entrants and barriers to entry • Supplier and buyer bargaining power • Channels of distribution • Marketing plan to be followeduture sales forecasts • Market Main customers Future demand for the product • Competitors in the market for the same product category and their strategy Pricing strategy Finance  Financial forecasts for the next 3-5 years  Analysis of financial reports and balance sheets of firms already promoted or run by the promoters of the new venture  Cost of production  Wage structure details  Accounting process to be used

   

Financial report of critical suppliers Returns for the next 3-5 years and thereby the returns to the venture fund Budgeting methods to be adopted and budgetary control systems External financial audit if required

Sometimes, companies may have experienced operational problems during their early stages of growth or due to bad management. These could result in losses or cash flow drains on the company. Sometimes financing from venture capital may end up being used to finance these losses. They avoid this through due diligence and scrutiny of the business plan. A venture capitalist tries to maximize the upside potential of any project. He tries to structure his investment in such a manner that he can get the benefit of the upside potential ie he would like to exit at a time when he can get maximum return on his investment in the project. Hence his due diligence appraisal has to keep this fact in mind. The evaluation of ventures by VCFs in India includes the following steps: • Preliminary evaluation The applicant is required to provide a brief profile of the proposed venture to establish prima facie eligibility. Promoters are also encouraged to have a face-to-face discussion to clarify issues. Detailed evaluation Once the project has crossed the qualifying hurdle through initial evaluation, the proposal is evaluated in greater detail. A lot of stress is placed on techno-economic evaluation. Most of the VCFs involve experts for the technical appraisal, whenever necessary. The venture evaluation in India, after receipt of the business plan, starts with a detailed evaluation of the entrepreneur's background. VCFs in India expect the entrepreneur to have:  integrity  long-term vision  urge to grow  managerial skills  commercial orientation.

How do VC’S value businesses: The investment valuation process is an exercise aimed at arriving at ‘an acceptable price’ for the deal Some of the methods used by VC’S to value a business are: • Discounted cash flow method ( DCF)

• •

Price/ earnings method ( PE ) Price/ book value method ( PBV )

It basically includes the following: Net Present Value Method The net present value (NPV) method is the classic economic method of evaluating the investment proposals. It is a DCF technique that explicitly recognises the time value of money. It correctly postulates that cash flows arising at different time periods differ in value and are comparable only when their equivalents--present values--are found out. The following steps are involved in the calculation of NPV: • Cash flows of the investment project should be forecasted based on realistic assumptions. • Appropriate discount rate should be identified to discount the forecasted cash flows. The appropriate discount rate is the project's opportunity cost of capital, which is equal to the required rate of return expected by investors on investments of equivalent risk. • Present value of cash flows should be calculated using the opportunity cost of capital as the discount rate. • Net present value should be found out by subtracting present value of cash outflows from present value of cash inflows. The project should be accepted if NPV is positive (i.e., NPV > 0). Evaluation of the NPV Method NPV is the true measure of an investment's profitability. It provides the most acceptable investment rule for the following reasons: • Time value It recognizes the time value of money-a rupee received today is worth more than a rupee received tomorrow. • Measure of true profitability It uses all cash flows occurring over the entire life of the project in calculating its worth. Hence, it is a measure of the project's true profitability. The NPV method relies on estimated cash flows and the discount rate rather than any arbitrary assumptions, or subjective considerations. • Value-additivity The discounting process facilitates measuring cash flows in terms of present values; that is, in terms of equivalent, current rupees. Therefore, the NPV s of projects can be added. For example, NPV (A + B) =NPV (A) + NPV (B). This is called the value-additivity principle. It implies that if the NPVs of individual projects are known, the value of the firm will increase by the sum of their NPV s. Also if the values of individual assets are known, the firm's value can simply be found by adding their values. The valueadditivity is an important property of an investment criterion because it means that each project can be evaluated, independent of others, on its own merit.

• Shareholder value The NPV method is always consistent with the objective of the shareholder value maximization. This is the greatest virtue of the method. • Cash flow estimation The NPV method is easy to use if forecasted cash flows are known. In practice, it is quite difficult to obtain the estimates of cash flows due to uncertainty. • Discount rate It is also difficult in practice to precisely measure the discount rate. • Mutually exclusive projects When alternative (mutually exclusive) projects with unequal lives, or under funds constraint are evaluated the NPV method need to be used cautiously. The NPV rule may not give unambiguous results in these situations. • Ranking of projects The ranking of investment projects as per the NPV rule is not independent of the discount rates. 1 Let us consider an example. Suppose two projects-A and B-both costing Rs 50 each. Project A returns Rs 100 after one year and Rs 25 after two years. On the other hand, Project B returns Rs 30 after one year and Rs 100 after two years. At discount rates of 5 per cent and 10 per cent, the NPV of projects and their ranking are as follows: Project A Project B NPV at 5 % 67.92 69.27 Rank II I NPV at 10% 61.57 59.91 Rank I II

It can be seen that the project ranking is reversed when the discount rate is changed from 5 per cent to 10 per cent. The reason lies in the cash flow patterns. The impact of the discounting becomes more severe for the cash flow occurring later in the life of the project; the higher is the discount rate, the higher would be the discounting impact. In the case of Project B, the larger cash flows come later in the life. Their present value will decline as the discount rate increases. Internal Rate Of Return Method The internal rate of return (IRR) method is another discounted cash flow technique, which takes account of the magnitude and timing of cash flows. Other terms used to describe the IRR method are yield on an investment, marginal efficiency of capital, rate of return over cost, time-adjusted rate of internal return . Evaluation of IRR Method IRR method is .like the NPV method. It is a popular investment criterion since it measures profitability as a percentage and can be easily compared with the opportunity cost of capital. IRR method has following merits: • Time value The IRR method recognizes the time value of money.

• Profitability measure It considers all cash flows occurring over the entire life of the project to calculate its rate of return. • Acceptance rule It generally gives the same acceptance rule as the NPV method. • Shareholder value It is consistent with the shareholders' wealth maximization objective. Whenever a project's IRR is greater than the opportunity cost of capital, the shareholders' wealth will be enhanced. Like the NPV method, the IRR method is also theoretically a sound investment evaluation criterion. However, IRR rule can give misleading and inconsistent results under certain circumstances.

Some of the problems of the IRR method: • Multiple rates A project may have multiple rates, or it may not have a unique rate of return. These problems arise because of the mathematics of IRR computation. • Mutually exclusive projects It may also fail to indicate a correct choice between mutually exclusive projects under certain situations. • Value additivity unlike in the case of the NPV method, the value additivity principle does not hold when the IRR method is used-IRRs of projects do not add. 1 Thus, for Projects A and B, IRR(A) + IRR(B) need not be equal to IRR (A + B). Consider an example given below. The NPV and IRR of Projects A and B are given below: Co C1 NPV@lO% Project (Rs) (Rs) (Rs) A -100 +120 +9.1 B A+B -150 -250 +168 +288 +2.7 +11.8 IRR (%) 20.0 12.0 15.2

It can be seen from the example that NPVs of projects add: NPV(A) + NPV(B) = NPV(A + B) = 9.1 + 2.7 = 11.8, while IRR(A) + IRR(B) * IRR(A + B) = 20%+ 12%* 15.2% Profitability Index Another time-adjusted method of evaluating the investment proposals is the benefit-cost (B/e) ratio or profitability index (PI). Profitability index is the ratio of the present value of cash inflows, at the required rate of return, to the initial cash outflow of the investment The formula for calculating benefit-cost ratio or profitability index is as follows:



PV of inflows Initial outlay

cash = cash

PV(Cr) =

∑ r =1

Cr +C0 (1+k)


Acceptance Rule The following are the PI acceptance rules: • Accept the project when PI is greater than one • Reject the project when PI is less than one. • May accept the project when PI is equal to one The project with positive NPV will have PI greater than one. PI less than means that the project's NPV is negative.

PI > 1 PI < 1 PI = 1

Evaluation of PI Method Like the NPV and IRR rules, PI is a conceptually sound method of appraising investment, it projects. It is a variation of the NPV method, and requires the same computations as the NPV method. • Time value It recognises the time value of money. • Value maximisation It is consistent with the shareholder value maximisation principle. A project with PI greater than one will have positive NPV and if accepted, it will increase share-holders' wealth. • Relative profitability In the PI method, since the present value of cash inflows is divided by the initial cash outflow, it is a relative measure of a project's profitability. Like NPV method, PI criterion also requires calculation of cash flows and estimate of the discount rate. However, in practice, estimation of cash flows and discount rate pose problems. Price/ Earnings Method The price / earnings (PE) multiple or ratio is the most widely used and misused of all multiples. Its simplicity makes it an attractive choice in applications ranging from pricing initial public offerings to making judgments on relative value, but its relationship to firms, financial fundamentals is often ignored, leading to significant errors and applications. The use and misuse of PE ratios: There are number of reasons PE ratio is used so widely in valuation. • First, it is an initiatively appealing statistic that relates the price paid to current earnings.

• Second, it is simple to compute for more stocks and is widely available making comparisons across stocks simple • Third it can be a proxy for a number of other characteristics of the firm including risk and growth While there are good reasons for using PE ratios, there is wide potential for misuse. • One reason given for using PE ratio is that it eliminates the need to make assumptions about the risk, growth, paid out ratios, all of which have to be estimated for discounted cash flow valuation. This is disingenuous, because PE ratio is ultimately determined by the very same parameters that determine value in discounted cash flow models. Thus, the use of PE ratios is a way, for some analyst, to avoid having to be explicit about their assumptions on their risk, growth, and payout ratios. This maybe convenient, but it is certainly not a legitimate for using PE ratios. • Another reason for using the PR ratios of comparable firm is that there are much more likely to reflect market, moods and perceptions. Thus, investors are upbeat about retail stocks, the PE ratios of these stocks will be higher to reflect this optimism.. Again, this can be a weakness, especially when market makes systematic errors in valuing entire sectors. Determination of the PE ratios: Payout ratio during the high growth and stable periods: PE ratio increases as the payout ratio increases Riskiness; the PE ratio becomes lower as riskiness increases Expected growth rate in earnings in other the high growth and stable periods: the PE ratio increases as the growth rate increase, in either period. Problem with PE ratios There are general problems associated with the estimation of PE ratios that makes its use troublesome. First, PE ratios are not meaningful when the earning per share is negative. While, this can be partially overcome by using normalized or average earnings per share, the problem cannot be eliminated. Second, the volatility of earnings can cause the PE ratio to change dramatically from period to period. For cyclical firms, earnings will follow the economy, whereas the prices reflect expectation about the future. Thus, it is not uncommon for the PE ratio of a cyclical firm to peak at the depths of a recession and bottom out at the peak of an economic boom.

Conclusion: The PE ratio and the other earnings multiples which are widely used in valuations, have the potential to be misused. These multiples are ultimately determined by the same fundamentals that determine discounted cash flow value - expected growth, risk, and payout ratios to the extent that there are differences in fundamentals across countries, across time and across companies, the multiples will also be different. A failure to control for these differences in fundamentals can lead to erroneous conclusions based purely upon a direct comparison of multiples.

Price/ Book Value Multiples General issues in estimating and using pbv ratios: The book value of equity is the difference between the book value of assets and the book value of liabilities. The measurement of the book value of assets is largely determined by accounting convention. Book value versus market value: The market value of an asset reflects its earning power and expected cashflows. Since the book value of an asset reflects it’s original cost, it might deviate significantly from the from the market value if the earning power of the asset has increased or declined significantly since its acquisition. Advantages of using PBV ratios: There are several reasons why investors find the price/ book value ratio useful in investment analysis. The first is that book value provides a relatively stable, intuitive measure of value which can be compared to the market price. For investors who instinctively mistrust discounted cashflow estimates of value, it is a much simpler benchmark for comparison. The second is that, given reasonably consistent accounting standards across firms, PBV ratios can be compared across similar firms for signs of under – or overvaluation. The third is that, even firms with negative earnings, which cannot be valued using price/ earnings ratios, can be evaluated using PBV ratios. Disadvantages of using PBV ratios: There are several disadvantages associated with measuring and using price/ book value ratios.

First, book values are affected by accounting decisions on depreciation and other variables. When accounting standards vary widely across firms, the PBV ratios may not be comparable across firms. Second, book value may not carry much meaning for service firms that do not have significant fixes assets as compared to other firms. Third, the book value of on equity can become negative if a firm has a sustained string of negative earnings reports, leading to negative PBV ratios. Determination of PBV ratios: • Return on equity: earning per share / book value per share. • The PBV ratio is an increasing function on the return on equity. • Payout ratio in both the high growth and stable growth periods: • The PBV ratio increases as the payout ratio increases. • Riskiness ( through the discounting rate r) : • The PBV ratio becomes lower as the riskiness increases. • Growth rate in earnings, in both the high growth and stable growth periods: • The PBV ratio increases as the groth rate increases, in either period. Conclusion: The relationship between price and book value is much more complex. The PBV ratio of a firm is determined by its expected payout ratio, its expected growth rate in earnings, and its riskiness. The most important determinant, however, is the return on equity earned by the firm – higher returns lead to higher PBV ratios and lower returns lead to lower PBV ratios. The mismatch that should draw investor attention is the one between return on equity and PBV ratios – high PBV ratios with low returns on equity are overvalued and low PBV ratios with high returns on equity are undervalued.

11.5. Valuation A Call On Three Factors
• • • Growth Risk Management quality

1. GROWTH: Valuation of any business largely depends on the growth prospects of the company. • How much is the growth of the company • How sustainable is the growth of the company • For long is the growth evaluated 2. RISK Risk is also one of the important factors to value the business of an entrepreneur. The various aspects to be looked for are • The external and the internal risk that is the price risk . • The manageable and non-managable risk. • The mitigatin factors that is the brand and distribution risk. 3. MANAGEMENT QUALITY Management quality is also to be evaluated properly before valuing a business. The important factors to be considered in evaluating management quality are • the reputation of the management • the competence of the management • the vision of the company • the corporate governance of the management

11.6. Reasons Why VC’s Won’t Fund A Business Plan
1. Untested product with insufficient demand - Just b’cos your friends think it is brilliant does not make it so! 2. Faulty or inconsistent ACCESS TO SUPPLY for product creation (People Management Team) 3. Faulty or inconsistent MARKET ACCESS for product (distribution, sales and marketing don’t just happen) 4. Insufficient capital (5-10% should already have been raised) 5. Inexperienced or unskilled management 6. Bad organizational structure 7. Lack of necessary infrastructure

11.7. Deal structuring
Once the venture has been evaluated as viable, the venture capitalist and the venture company negotiate the terms of the deal, viz, the amount, form and the price of the investment. This process is termed as deal structuring. The agreement also includes the protective covenants and earn – out agreements.

Covenants include the venture capitalist’s right to control the venture company and to change its management if needed, buyback arrangements, acquisition, making initial public offerings, etc. Earned out agreements specify the entrepreneur’s equity share and objective to be achieved. Venture capitalists generally negotiate deals to ensure protection of their interests. They would like a deal to provide for a return commensurate with the risk, influence over the firm through broad membership, minimum taxes, investment liquidity, right to replace management in case of poor managerial performance, etc. The venture companies like deal to be structured in such a way that their interest are protected. They would like to earn reasonable returns, minimize taxes, have enough liquidity to operate their businesses and remain in commanding position of their businesses. There are number of common concerns shared by both the venture capitalist and the venture companies. They should be flexible, and have a structure that protects their interest and provides enough incentives to both to co – operate with each other.

Post – investment activities Once the deal has been structured and agreement finalized, the venture capitalist generally assumes the role of a partner and collaborator. He also gets involved in shaping the direction of the venture. This may be done via a formal representation on the board of directors, or informal influence in improving the quality of marketing, finance and other managerial qualities. The degree of the venture capitalist’s involvement depends on this policy. It may not, however, be desirable for a venture capitalist to get involved in the day – to – day operations of the venture. If a financial or managerial crisis occurs, the venture capitalist may intervene, and even install a new management team.

All the Venture Capital firms invest in shares, either Equity or Preference and sometimes both of the Investee Companies. The following methods of financing are being used by Venture Capital Funds 12.1. Equity Shares When Venture Capitalists (VC’s), invest in Equity Shares of Investee Company, they expect that the sustained growth of the venture financed will lead to the growth of the value of the investee companies and its shares Preference Shares  Redeemable Preference Shares These shares are redeemed as Preference shares when the Venture has been established, providing an easy exit  Convertible Preference Shares These are converted to common Equity on a later date enabling the VC to earn Capital Gain

Debt Convertible Debt 1. Debenture This can be in the form of tradable debt that is later converted into Equity 2. Convertible Loan This can be in the form of Non Tradable Debt that is later converted into Equity  Non Convertible Debt 1. Conventional Loan This is a loan that carries a fixed rate of Interest and a pre-determined payment schedule 2. Conditional Loan It is a Quasi Equity Instrument, which does not carry a fixed rate of interest or a pre determined repayment schedule but is liquidated by payment of Royalty on sales. It is akin to Equity in the sense that the returns to the financer are performance based. The Royalty is payable only if the Venture succeeds and the investee company makes Sale 3. Income Notes This is a type of loan that carries a flexible nominal interest. The repayment of the principal is specified over a period besides there is a Royalty on Sales 4. Non Convertible Debentures These are pure Debt instruments with a Fixed Interest Rate and Repayment Schedule but are in the form of tradable security Off late, VC’s have started using a variety of innovative Quasi Equity Instruments. The important ones are as follows: 1. Optionally Convertible Debentures Based on the Performance around third year of operation, the VC can opt for conversion of the Debenture as Equity 2. Partially Convertible Debentures This is a convertible debt wherein a part is converted into Equity to enable the VC to gain from the success of the Venture and the balance remains as a Fixed Interest Debt 3. Bridge Loans These are Short Term Loans provided to a company contemplating a Public Issue to increase its Valuation

4. Shares Warrants This is a Right granted to the investor to purchase Equity Shares at a pre determined price on a later date. This normally provides for the expansion finance required by the investee company and ensures capital gains from successful Ventures In Accordance with the world wide practice the bulk of VC investment in India is in Equity shares. Initially there was a higher proportion of conventional loan but later it was reduced and its place is been taken by various innovative Quasi Equity Instruments. With VC financing getting mature, Preference Shares and Convertible Debts are becoming more popular. Today VC funds use more than one instrument for their investments

There are 5 Investments stages widely used by the industry to invest. These stages are defined as under

13.1.Seed Stage
Financing provided to new companies for use in product development and initial marketing constitutes Seed Stage. Eligible companies may be in the process of being setup or may have been in business for a short time or may not have sold their product commercially. This is the financing provided to companies when the Initial Concept of the business is being formed

Financing provided to new companies, for manufacturing and commercializing the developed products, represent Startup. The companies may be in their initial stages of development and finance may be extended for creation of new infrastructure and meeting the Working Capital Margin

13.3.Other Early Stage
Financing provided to companies that have completed the commercial scale implementation and may require further funds to meet initial cash and further working capital is treated as Other Early Stage. The companies may have

expended their capital and would require additional funds and may not yet be generating profit

13.4.Later Stage Financing
Capital provided for the growth and expansion of established companies. Funds may be used to finance increase in production capacity, market or product development and/ or provide additional working capital. This would include product diversification, forward/backward integration, besides creation of additional capacity. Capital could be provided for companies that are breaking even or profitable or in turnaround situations

13.5.Turnaround Financing
Capital provided for companies that are in operational or financial difficulties where the additional funds would help in Turnaround Situations Earlier VC funds use to invest in Seed and Startup stages and very rarely in Turnaround Stages, but off late the trend is changing and VC funds are a part of every stage and are also actively participating in Turnaround Stages through buyouts and takeovers.

The different legal documents that are to be created and executed by the venture firm are 14.1. Shareholders agreement This agreement is made between the venture capitalist, the company and the promoters. The agreement takes into account a. Capital structure b. Transfer of shares: This lays the condition for transfer of equity between the equity holders. The promoters cannot sell their shares without the prior permission of the venture capitalist. c. Appointment of Board of Directors d. Provisions regarding suspension / cancellation of the investment: The issues under which such cancellation or suspension takes place are default of covenants and conditions, supply of misleading information, inability to pay debts, disposal and removal of assets, refusal of disbursal by other financial institutions, proceedings against the company, and liquidation or dissolution of the company.  Equity subscription agreement - This is the agreement between the venture capitalist and the company on a. Number of shares to be subscribed by the venture capitalist

b. c. d. e.

Purpose of the subscription Pre-disbursement conditions that need to be met Submission of reports to the venture capitalist Currency of the agreement

 Deed of Undertaking - The agreement is signed between the promoters and the venture capitalist wherein the promoter agrees not to withdraw, transfer, assign, pledge, hypothecate etc their investment without prior permission of the venture capitalist. The promoters shall not diversify, expand or change product mix without permission.  Income Note Agreement - It contains details of repayment, interest, royalty, conversion, dividend etc.  Conditional Loan Agreement - It contains details on the terms and conditions of the loan, security of loan, appointment of nominee directors etc.  Deed of Hypothecation, Shortfall Undertaking, Joint and Several Personal Guarantee, Power of Attorney etc.  Whenever there is a modification in any of the agreements, then a Supplementary Agreement is created for the same.

14.2. Monitoring and Follow up
The role of the venture capitalist does not stop after the investment is made in the project. The skills of the venture capitalist are most required once the investment is made. The venture capitalist gives ongoing advice to the promoters and monitors the project continuously. It is to be understood that the providers of venture capital are not just financiers or subscribers to the equity of the project they fund. They function as a dual capacity, as a financial partner and strategic advisor. Venture capitalists monitor and evaluate projects regularly. They are actively involved in the management of the of the investor unit and provide expert business counsel, to ensure its survival and growth. Deviations or causes of worry may alert them to potential problems and they can suggest remedial actions or measures to avoid these problems. As professional in this unique method of financing, they may have innovative solutions to maximize the chances of success of the project. After all, the ultimate aim of the venture capitalist is the same as that of the promoters – the long-term profitability and viability of the investor company. The various styles are:  Hands-on Style - suggests supportive and direct involvement of the venture capitalist in the assisted firm through Board representation and regularly advising the entrepreneur on matters of technology, marketing and general management. Indian venture capitalists do not generally involve themselves on a hands-on basis bit they do have board representations.

 Hands-off Style involves occasional assessment of the assisted firms management and its performance with no direct management assistance being provided. Indian venture funds generally follow this approach.  Intermediate Style venture capital funds are entitled to obtain information about the assisted projects on a regular basis.

14.3. Exit Routes
After the unit has settled down to a profitable working and the enterprise is in a position to raise funds through conventional resources like capital market, financial institution or commercial banks, the venture capitalist liquidate their investment and make and exit from the investee company. The ultimate objective of a Venture Capitalist is to realize from his investment by selling off the same at a substantial capital gain. Thus a venture capital firm converts the value of appreciation into cash. The funds realized are deployed into new ventures. In fact, at the time of making their investment, the venture capitalist plan 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. 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 of competition, technological obsolesce etc. play an important role. The investee company has to prepare and make suitable adjustments in its capital structure at the time of realization by the venture capitalist. The convertible preference shares and convertible loans must be converted to ordinary equity before the exit by the venture capitalist. In case of non-convertible preference shares and loans by the venture capitalist these are to be redeemed. At exit the special rights granted to the venture capitalist cease to operate and venture capital firms normally withdraw their nominees from the board of the investee company. The venture capitalist firms have a motto ‘exit at the maximum possible profit or at a minimum possible loss – in case of a failed investment’. The exit can be voluntary or involuntary. Liquidation or receivership of a failed venture is a case of involuntary exit. The voluntary exit can have four alternative routes for disinvestment: 1. Buy back of shares by promoters or company 2. Sale of stock (shares) 3. Selling to a new investor 4. Strategic / Trade sale

1. BUY BACK / SHARES REPURCHASE Buy back or shares repurchase has the following distinct forms:  The investee company has to buyback its own shares for cash from its venture capitalist using its internal accruals  The promoters and their group buys back the equity stake of venture capitalist.  The employees’ stock trusts are formed which, in turn, buy the share holding of the venture capitalist in the company.  The route is suited to the Indian conditions because it keeps the ownership and control of the promoters intact. Indian entrepreneurs are often very touchy about ownership and control of their business. Hence in India, first a buy back option is normally given to the promoters or to the company and only on their refusal the other disinvestment routes are looked into. The exact price is mutually negotiated between the entrepreneur and the venture capitalist. The price is determined considering the book value of shares, future earning potential of the venture, Price / Earning ratio of similar listed companies. The companies were not allowed to buy back their shares in India; however, with effect from the amendment in the Companies Act (1999) the companies can do so now. Purchase by Employee’s Stock Ownership Trust a method used by some entrepreneurs to buy out the venture capitalist is to set up an employee’s stock ownership trust (ESOT). The ESOT is like a pension and profit-sharing plan, except that it buys stock in your company rather than stock of large traded companies. The ESOT obtains money through contributions by the company and therefore builds up cash. The ESOT can also borrow from the bank on the basis of the projected future contributions by the company. The ESOT uses the money to buy the stock that is owned by the venture capital firm. This is a relatively painless way for the company to buy back the equity ownership held by the venture capital firm. Contributions by the company to the ESOT are tax deductible. Exit by Puts and Calls When the investment was negotiated, the entrepreneur may have set up a formal arrangement that provides for exit for the venture capitalist. This may be in the form of “puts” and “calls.” As we noted earlier, a put is a right given to the venture capitalist to require the company to buy the venture capitalist’s ownership in the company at a predetermined formula. The call provision gives the entrepreneur, or the company, the right to purchase the venture capitalist’s ownership by the same or similar formulas. There are probably as many put-and-call formulas as there are minds thinking about how to structure deals. However, there are seven popular ones that are considered.

a. Price-Earnings Ratio P/E Ratio is probably the most popular formula that treats the company’s stock like the stocks traded on national stock exchanges. The earnings per share are figured for the shares owned by the venture capitalist. A popular price-earnings (PE) ratio is selected from public stocks in the same industry. That PE ratio is multiplied by the earnings per share to come up with a price per share that the entrepreneur or the company will pay to the venture capitalist for the stock he owns. b. Book Value A less common formula is based on book value of the company. It’s simple to compute the book value per share for stock owned by the venture capitalist. That would be the price the entrepreneur or the company would pay for the shares owned by the venture capital company. Book value per share is seldom used because in the early years of a company’s development the company usually has a small book value. It’s only in older companies that have been around long enough to establish a good book value that this becomes the method of valuing the venture capitalist’s equity position. c. Percentage of Sales Sometimes it is inappropriate to use the earnings of the company in a priceearnings formula because in the early years of development, particularly in a start-up company, the earnings may be low owing to heavy depreciation or research and development expenses. It may take several years for the company to become profitable. Using pretax earnings may seem to be more appropriate. However, pretax earnings are held low often because of heavy salaries or heavy expenditures for promotion. In such a case, it may be easier for the entrepreneur to take the normal profit before tax as a percentage of sales typical for the industry. Find statistics on the industry in publications on business statistics. It is found that most companies similar to the entrepreneurs have a pre-tax earnings of 10 percent of sales. It would be simple, then, to take 10 percent of this company’s sales and pretend that number is the profit before taxes. Then the entrepreneur would determine earnings per share by using the hypothetical profit before taxes. Using the industry price-earnings ratio, he could easily determine what the value of the stock owned by the venture capital company would be worth if the hypothetical earnings existed. This can be the method used for buying back the shares owned by the venture capital firm. Using the percentage of sales formula to value and buy back the shares owned by the venture capitalist can be very expensive. d. Multiple of Cash Flow In some industries cash flow is a more accurate barometer of how the business is doing than are profit-and-loss statements based on generally accepted accounting principles. Using an eight-to-ten-times cash flow formula, we might say a company is worth millions of dollars more than a price-earnings ratio of the profit-and-loss statement would indicate. If we assume a company is worth ten

times cash flow, it is simple to compute the value of the percentage of the company owned by the venture capitalist. You can use this as the method for buying back his equity position. The cash flow formula may work quite well for a stable company, but could be extremely expensive in an asset-heavy, leverage buy-out situation. For example, in a leverage buy-out you may have inflated the value of the assets in order to shelter income. However, when these heavily depreciated assets are removed in the calculation of cash flow, the cash flow number will be much higher than the profit before-tax figure. The price the entrepreneur or Co. will have to pay for the equity of the venture capitalist can be high if it is based on cash flow. e. Multiple of Sales The value of some companies in certain industries is based on a multiple of sales. Radio stations traditionally sell at two to three times gross sales. If you determine the value of a company to be two and a half times gross sales, it would be simple then to compute the value of the venture capitalist’s percentage of equity ownership and pay him that amount for his ownership in the company. As in the percentage-of-sales calculation above, the multiple-of-sales valuation also means you will be paying for a company that may or may not have earnings. Many investors in the radio business buy a poorly-run station on a multiple- ofsale calculation knowing full well that the station’s earnings cannot possibly pay back the investment. The investor who is buying the station must put in enough money to carry the station until its sales and earnings can be increased. In fact, the earnings must increase drastically if he is to pay back any debt and get an adequate return on the money invested. f. Appraised Value It is often easy to find an expert individual or a stock brokerage firm to appraise the value of the equity ownership held by the venture capital company. The appraisal will probably be based on a combination of some of the items above. Appraisals are usually computed by two methods. First, the value of the company is determined by its earning power, both past and future. This formula is similar to the price earnings ratio used above. Second, the values of the assets (bricks and mortar) are determined as if they were sold at auction as part of an orderly liquidation. From this liquidation the appraiser subtracts all debts outstanding, and the remaining value is the appraised value. The bricks-and-mortar formula is similar to the book-value calculations, except there it includes an appraisal of the assets and a restated new book value based on their appraised value. When these two figures do not agree, the appraiser usually selects something close to the higher of the two. For example, if the bricks-and-mortar formula was higher than the earnings formula, the appraiser would assume that the highest and best use of the company was to sell all of its assets. g. Prearranged Cash Amount

Of course, a simple formula would be to base a put-and-call option on a single cash amount. That is, at the end of three years the venture capital firm would have the right to require the company to buy its equity ownership position for a certain amount, say, $200,000. Although this method saves a great deal of negotiating and appraising at the end of three years, people find it difficult to agree on a value at the beginning of the investment period. 2. SALE OF SHARES ON THE STOCK EXCHANGE The venture capitalist can exit by getting the company listed on the stock exchange and selling his equity in the primary or secondary market using any of the following three methods:  Sale of shares on stock exchange after listing shares Venture capitalists generally invest at the start up stage and propose to disinvest their holding after the company brings out an IPO for raising funds for expansion. This listing on stock exchange provides an exit route from investment.  Initial Public Offer (IPO) / Offer for sale When the existing entrepreneurs opt out of buy back, the venture capitalist opts for disinvesting their stocks through public offering. The major advantages are: a. The public issue provides liquidity to the business, which is useful for the company. b. The process establishes the fair price of the company’s securities. Venture capitalist can obtain a higher price for his equity and the same is useful for the promoters as it increases the valuation of the company. c. Quite often the new stock is offered for sale rather than the venture capitalist’s equity or sometimes a part of venture capitalist’s equity is clubbed with the new equity. This on one hand improves the company’s net worth and provides funds for growth and expansion, one the other enables the venture capitalists to get a higher price of its equity after listing. d. It paves the way for the company to raise funds for future growth, as it is easier and less costly for the listed companies to raise capital from the market. e. The company may get a tax break as listed companies usually pay tax at a lower rate. f. 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:

a. 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. b. 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 queries. c. 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. d. The listed companies are required to disclose sufficient information about their operations. The competitors can abuse this information. The knowledge about the company’s profitability sometimes leads co labour problems with workers demanding higher wages. e. Listed companies cannot keep their dealings with interconnected companies where promoters have a confidential interest undercover. This harms the promoter’s interest. It is preferred where venture is successful and its internal generations are adequate to meet immediate fund for expansion. 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 stock 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. Disinvestment on OTC An active capital market supports the venture capital activities. It enables the venture capitalists to get a suitable valuation for their investment. Besides the regular stock exchange a well developed OTC market where dealers can trade in shares. This imparts liquidity and breadth to the market. The OTC market enables the new and smaller companies not eligible for listing on a regular stock exchange to be listed at an OTC exchange and thus provides liquidity to the investors. For instance in U.S. the National Association of Securities Dealers Automated Quotation System (NASDAQ) is an important OTC market. Today

NASDAQ has a concentration of technology stocks and is considered the hub of venture capital activity in U.S. As per the recommendations of a number of committees, an OTC exchange was required in India. As a result ‘Over the Counter Exchange of India (OTCEI)’ was set up. 3. CORPORATE / TRADE SALE The venture capital firm and the entrepreneur together sell the enterprise to a third party mostly a corporate entity. Herein the promoters also exit from the venture along with the venture capitalist. This is called a corporate, strategic or trade sale. The reasons for this sale can be varied, difficulty in running the business profitability or a perceived competition from more established big business houses having huge resources and business synergy. Trade sales are very popular in U.S. and U.K. Entrepreneurs with a solid idea and revenue models have been able to get much higher valuations through this route. The sale of Hotmail by Sabeer Bhatia to Microsoft for $400 million as against the valuation of $200 million by the venture capitalist Dough Carlise 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 the market investors are usually swayed by the appeal of the sector in which the venture operates rather than the quality of its specific business operations. Modalities: The modalities of the trade sale differ from case to case depending upon the nature of operations, its size, the requirements of the buyer, etc. The sale can be in cash, against the shares of the acquiring company or the combination of the two. The equity owners get the shares of the buyer-company in lieu of the shares being sold by them. Such sales have the advantage that the seller does not have to pay any tax as the transaction involves only exchange of shares. There are occasions when the equity is sold by the owners against notes to be received from the buyer. These notes are often secured by the assets of the company and are redeemed at the predetermined intervals. The deferred payment through notes is popular as it helps in tax planning by the seller. The appropriate disinvestment modalities of a corporate / trade sale depend on the needs of the seller and the strengths of the buyer company besides keeping in view of the tax considerations. At times, it is through a management buy-out or buy-in, which in turn may be financed partially by another venture capital fund. Formalities involved in sale / transfer of enterprises have restricted smooth exit for venture capitalist. It is important to note that in India if the investee company is a listed company at the time of trade sale, then the provisions of listing agreement are attracted besides the provisions of the SEBI regulations of merger and acquisitions are also applicable.

Management Buy-Outs: Venture capital buy-outs are both a successful investment strategy for venture capital investment as well as an efficient exit route. Buy-out financed by another venture capitalist primarily by providing debt is known as leveraged buy-out. Buy-out without participation by another investor is called management buy-out. Here in the current management group purchases the stake of the venture capitalist. The stock options and sweat equity have made management buy-out possible in India. Management buy-outs are important in venture capital market for various reasons:  MBO’s provide an opportunity to managers to become entrepreneurs.  Venture capital investment in buy-out has a lower investment risk than early stage investment.  MBO’s help smaller enterprises to adapt to technological changes. Buy-in is similar to buy-out but involves new management from outside and improvement in the operations of the venture. Incoming new management is often unfamiliar with the operations of the venture hence the acquiring company may feel that the continuity of the existing entrepreneur will be beneficial for the business; the services of the original entrepreneur are retained. This helps in implementing the remaining parts of the original ideas and also provides continuity to the venture. For instance Bhatia remained his company’s top executive after it became a subdivision of Microsoft’s Web basics. 4. 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. This route is also used when the promoters want to get rid of the venture capitalist. Some venture capitalists, as a policy concentrate their activities to startups and early stage investments. Such venture capital funds exit paving way for the venture capital fund specializing in the later stage investment or buy out deals. Often a growing venture needs second stage financing, if the existing venture capitalist as a policy does not commit funds for the second stage it normally locates another venture capitalist that finds the investment attractive enough to enter. Pre-Requite For The Efficient Exit Mechanism  Legal Framework  Smooth procedures for sale / transfer of enterprises  Efficient stock Market  Mechanism for listing and trading of equity of smaller companies

• • • • Banker is a manager of other people's money while the venture capitalist is basically an investor. Venture capitalist generally invests in new ventures started by technocrats who generally are in need of entrepreneurial aid and funds. Venture capitalists generally invest in companies that are not listed on any stock exchanges. They make profits only after the company obtains listing. The most important difference between a venture capitalist and conventional investors and mutual funds is that he is a specialist and lends management support and also  Financial and strategic planning  Recruitment of key personnel  Obtain bank and other debt financing  Access to international markets and technology  Introduction to strategic partners and acquisition targets in the region  Regional expansion of manufacturing and marketing operations  Obtain a public listing Difference Between Venture Finance and Debt Finance Venture Finance Maximize return Debt Finance Interest payment


Holding period Instruments Pricing Collateral Ownership Control Impact on B/S of financed Exit Mechanism

2-5 years Common shares, convertible bonds, options, warrants Price earnings ratio, net tangible assets Very rare Yes Minority shareholders, rights protection, board members Reduced leverage

Short/long term Loan, factoring, leasing Interest spread Yes No Covenants Increased leverage

Public offering, sale to third party, sale Loan repayment to entrepreneur

XVI. AN EXERCISE: Launching & Managing a Venture Capital Fund
16.1. Launching A Vc Fund
Coming Together: Four friends Aman, Sid, Shivam & Amita who have known each other for many years decide to start a venture capital firm together. They have a vast experience of more than 10 years working in the industry and in varied capacities. Aman holds an engineering degree and has vast experience in operations. Sid is a Chartered Accountant, while Shivam and Amita are MBAs from premiere institutes having specialized knowledge and vast experience in Marketing and Human Resource respectively. The four aspiring Venture Capitalists worked together in a venture capital firm and had an outstanding record working as a team. They thus understand and trust each other’s working style which is of prime importance in any new venture. Investment Focus: They strongly believe in the entrepreneurial skills of young Indians and would like to support new ventures. They believe that they can help budding entrepreneurs and also create decent amount of wealth by leveraging their knowledge and contacts in the industry. They also believe that there is a huge need for early stage financing in the industry today as most of the VCs & PEs are interested mainly in later stage financing due to higher returns in lesser time period. After working through the numbers, they decide to start their firm by raising $100 million to invest. They name their fund as Venture Capital Fund of India (VCFI). They decide to form a Pvt. Ltd. Co. to limit personal liability as this involves huge amount of money. They appoint themselves as the directors of the company with a fixed salary. Gathering Funds: Aman & Shivam who have great convincing power use their contacts in the industry to gather the funds from investors like the corporates, individuals, and banks for their VC fund. Promising returns: From VCFI’s perspective these investors are their customers and Aman & Shivam have promised to invest their money wisely and fetch them higher returns than what they would have got by investing in other avenues like MFs, stock markets, debt markets or even any other venture capital fund. Now as they will be investing in early stage companies the risk will be more and hence the returns expected by their investors would also be higher. Suppose the investors expect an average return of 20% y-o-y from a venture fund which invests in later stage of companies, then they might expect a return of at least 25% from VCFI, excluding the fees paid to them.

Setting up the fund: Once the money is received from the investors the four put it in a ‘fund’ which will invest in young companies. They decide that the fund will be a “closed ended fund” with a 10 year duration, which means that they can not add any more funds to this fund until the end of 10 years when it matures. At the end of 10 years VCFI will have to give the money back to the investors plus what they have earned, minus their fees, their share from profits and any money that they might have lost. VCFI may also decide to return the money back to investors the interim period. Setting the control structure: It’s an act of faith: investors commit their money to a fund, and cede control over the decision making for the life of the fund – usually 10 years. The control, and therefore the pressure, is on Aman, Sid, Shivam & Amita, the promoters in the fund, to make investments that deliver a financial return to their Investors that makes everybody happy.

16.2. Financial Factors
Negotiate: Just as in any deal, the terms of the fund are negotiable: the control, the payback requirements, the share of upside that goes to the Investors or the Promoters of VCFI. VCFI is a new fund, so their negotiating power is fairly neutral – they are happy to play along with the industry norms on the fee structure. Management Fees: Generally, a venture firm is allowed to take a small percentage of the fund every year, usually around 2% or 2.5% of the total fund amount, to pay the firm’s operating expenses. In VCFI’s case that means that they would be allowed to use $2.5 million each year to pay their operating expenses if they set the fees at 2.5%. However, that amount is not paid to VCFI on top of the $100 million fund, but rather is subtracted from the total. This creates a nice tension as VCFI’s performance is measured as if they were investing the entire $100 million. Thus, more money they spend on themselves in the form of management fees, the less they have left to invest. Therefore, the money they do invest has to work that much harder – their deals have to perform that much better to make the returns they have promised. Thus they option to spend less than the permitted amount on management fees, and return the balance to the fund. This allows them to both look prudent to their investors, as well as lower the pressure on their investments. Does VCFI get anything extra? Venture capitalists are supposed to make money at the same time as their Investors. The goal of this compensation arrangement is to align incentives: VCFI and their Investors should be motivated by the same goals. To this end, VCFI, unlike investment bankers, will not get paid a “transaction fee”. Instead, they will share in the “upside” or the gains created by investing their fund. They have negotiated a typical arrangement that will give the venture firm 20% of the gains. The 20% share that goes to VCFI is not based on the amount of money they have invested, but rather on the work they have put into the process. Therefore, this percentage is referred to as a “carried interest”.

If VCFI invests the entire fund of $100 million, and if they make some good investments, at the end of 10 years they might have built a total value of the fund of $800 million. First they pay back to the Investors their original investment of $100 million. Then, in the arrangement they have negotiated, VCFI takes 20% of the remaining $700 million, i.e. $140 million. The Investor Partners receive the balance, or $560 million which is 5.6 times their initial investment.

16.3. Getting Down To Business: Performance Pressure On VCs
High expectations by investors: In the light of recent stock market performance, maybe delivering a minimum of 25% annual returns doesn’t sound like such a challenge. But VCFI has to return a minimum 25% over the life of the fund, net of the rather substantial fee which is a big challenge. Where does VCFI invest? VCFI has primarily decided to go for early stage financing of companies. According to the current market conditions and expertise of its promoters it decides to finance companies in the following sectors: 1. Technology 2. Retail 3. Biotechnology 4. Power (non-conventional) How does it find companies to invest in? VCFI will use the contacts of its promoters with other VCs, investors and companies to create a pipeline of investment opportunities to invest. It also plans to tie up with various educational institutions, R&D institutions, and also hold contests to create a deeper pipeline. How much do they invest? The promoters of VCFI decide to divide the $100 million pie into four investment areas as shown below

Investment Pie


Technology Retail

25% 20%


Biotech Power (nonconvnetional)

Structuring deals: The promoters of VCFI decide to use both debt and equity instruments, to structure their deals which they enter into with young companies. The criteria for choosing the type of instruments it uses to design a deal will depend on factors like perceived risk of the business, current size of the company, financial strength of the promoters, experience, skills and credibility of promoters, standing of the company as compared to its competitors, expected returns from business and so on. In accordance with the general market practice VCFI would like to keep majority of their investments in equity shares. They plan to use equity and quasi equity instruments like Preference Shares and Convertible Debts respectively. Setting the deadlines & targets: VCFI has negotiated its fund’s life with the promoters as 10 years. So if the average time from investment to exit is 5 – 7 years, then it means that VCFI must invest the entire fund during the first 3 – 5 years. So if VCFI promises to give 26% returns on $100 million at the end of 10 years, then the total amount of money it should have at the end of 10 years will be around $1 billion excluding the management fees. That means that on average, the venture capitalists at VCFI have to make 10 times their money on the deals in which they invest. Given that some of their investments do fail, one can see that VCFI promoters can’t afford to invest in companies with limited potential. But once they get going some of the pressure will be taken off the overall value, because they will return some capital in the intervening years. They will not wait until the last minute to give funds back. “You’re only as good as your last exit,” explained a leading venture capitalist to the newcomers at VCFI. The implicit requirement in delivering returns is, of course, that the venture capitalist has to “realize” his return. In other words, it’s not good enough to point to a fast growing company and a fast growing balance sheet. Venture capitalists have to actually hand cash or freely tradable shares back to their Limited Partners during or at the end of the 10 year fund.

Therefore, VCFI must be able to “exit” their investments in order to capture the upside from their deals. You only get into a deal, if you can see several good ways to get out.

16.4. Strategies for Success
Diversify the deals: In order to succeed in their investments as well as mitigate risk VCFI balance the types of deals: sub-segments of industry, and mixing earlier and slightly later stage deals; and by simply having multiple investments. The promoters of VCFI divide responsibility of monitoring and also help in managing the companies whom they finance. They set themselves a target to handle 2-3 new investments each year for the duration of the fund. So if they finance 32 ventures in total, then they assign 8 companies to each promoter, over the life of the fund, to monitor and work closely with. Off course they can take each others help if they feel that the skills or knowledge of the other person can help the company that they have financed as a VC. Thus, by diversifying their portfolio, dividing the work and keeping the number of investments at manageable levels they not only can minimize risk but also make sure that they do not allow things to go out of hands. While doing the math, they also realize that if each partner can only invest in 8 deals, with 4 promoters at VCFI, the average deal size will have to work out to just over $3 million over time. If some deals fail, that means that the companies have to be able put $5 million to effective use, with the investments in each company staged over time. With these assumptions and projections the four promoters at VCFI close their fund and start the process of analyzing and selecting companies in which they would like to invest.

1. 2. 3. 4. 5.

: Principles of Financial Management by I.M. Pandey Investment Valuation by Aswath Damodaran

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