University of East London

Sources of Finance
FEM205 - Information Systems and Financial Modelling

Sources of Finance

Venture Capital in India Sources of finance are generally studied in two classifications, namely long term and short term. The different sources of finance are also studied in two broad classifications: internal and external sources. Table 1 Overview of Sources of Finance provides a general over-view of the sources of finance. (Jones, 2006) This essay will attempt to study the development of venture capital funds as a long term source of finance in India. Typically the term venture capital is used to describe the investments made by large institutions or rich individuals in both public and private firms. Such investors or institutions have also been observed to be more active in the management of the financed firms. The investment or provision of finance may happen either during seed, start-up or during expansion phase of receiving firms. (Jeng & Wells, 2000) Table 1 Overview of Sources of Finance Adapted from (Jones, 2006) Short Term(less than two years) Internal(Within firm) Efficient cash management Efficient debtors management Efficient stock management External(Outside firm) Bank Overdrafts Bank loans Invoice discounting Debt factoring Sale and lease back Leasing Share capital Long-term borrowing Long Term(Over two years) Retained profits

Since its inception in 1940’s to its present day gargantuan status of a multi-billion dollar global financing market the venture capital field has been instrumental in the development of innovative industries and therefore has fuelled economic growth. The managerial experience, industrial knowledge and professional advice offered by venture capital firms gives a start-up firm a comparative edge over others. (King, 2008) Apart from the obvious importance of providing finance a venture capital firm has also been seen an encouraging factor towards early market entry of a product, management maturity and overall direction of a firm. It might be summarised that venture capital adds value to finance by raising the probability of success

due to introduction of professional management practise and advice, and also by encouraging aggressive marketing strategies. (Keuschnigg & Nielsen, 2004) Pandey (1998, p 253) defines venture capital within the Indian context as investment “in the form of equity, quasi-equity and/or a conditional loan made in new, unlisted, high-risk or high-tech firms, started by technically or professionally qualified entrepreneurs.” Pandey (1998) also claims that as a concept venture capital has been in practise in India for a long time in terms of finance provided by family and friends. However it has only been since the late 1980’s that the concept of modern and formal venture capital has taken roots. Venture capital firms in India can be categorized into at least four types. They are venture capital firms that are promoted by the central and state government controlled development finance institutions, firms that are promoted by public sector banks and finally venture capital firms promoted or run by private sector banks, foreign firms and institutions. (Pandey, 1998) As mentioned before venture capital in India took roots in the late 1980’s. Still loyal to socialism the Indian government announced guidelines facilitating venture capital in 1988 – guidelines primarily meant to be allowing venture capital firms controlled by public sector banks. For their part, private players were not greatly interested either. This was followed by a World Bank backed announcement providing for an institutional structure for venture capital in the same year. The structure had emphasised lending rather than providing for equity investment. (Dossani & Kenney, 2002) The World Bank (1989) also observed that capital markets were not being receptive to the needs to young growth enterprises requiring capital to fuel their growth and expansion. Back then the bulk of capital resources available in India resided with the banks, the largest of which had been nationalised by 1969. These public sector banks were quite averse to risk and typically chose to finance large industries or other public sector industries. (World Bank, 1989 cited in Dossani & Kenney, 2002) The World Bank was then involved with a pioneering project wherein it would provide $45 million as a loan to the Indian government which would in turn loan it to four venture capital firms. Despite restrictive regulations on investments and industry operations Dossani and Kenney (2002) have labelled the project as a modest success. It had provided India with trained venture capitalists and also threw light on viable investment opportunities in the country. This has been labelled as Period 1 of venture capital in India.

It might be argued that most of the criticism is directed at government policy often at the risk of ignoring other practical issues faced by the industry. Pandey (1998) throws light on such practical aspects of setting up venture capital firms in India other than the legislative restrictions. For instance, the average Indian entrepreneur was not most welcoming about equity participation by investors because other financial

investors such as banks could offer some assistance without intrusive controls. This lead to venture capital firms evolving new types of investment instruments such as conditional loans that required repayment along with a royalty on sales. It was also difficult for firms to exit investments becomes of the lack of a well developed secondary market. Listing on the markets, however would entail legal and bureaucratic hassles which many firms were not eager to enter.

Dossani and Kenney (2002) further trace the story of regulatory hassles. Only six industries namely software, informational technology, pharmaceuticals, agriculture and allied are eligible to receive investments from venture capital firms. Even within these industries it was discovered that Indian hi-tech firms were not emphasising on research and development, not many innovative ground breaking products were being developed. Technology finance was not to take off in the country for some more time. (Pandey, 1998)

Whilst studying such issues other than direct legislative hurdles it is also important to notice that practise of venture capital in India needs to be different from the model used in the well developed economies. And therefore a direct co-relation with the Western models may not provide the most appropriate perspective. Naqi & Hettihewa(2007) have further expanded on the differences between Asian and traditional venture capital. The emphasis is on recognizing and understanding the peculiar nature of Asian venture capital market and how little it differs from the traditional definition of private equity.

Making a similar case for China Bruton and Ahlstrom (2003) insist that differences need to be studied from an institutional theory perspective. Like in India, venture capital practise in China have been observed to face similar difficulties such as monitoring of firms, cultural resistance to outsiders moving into the firm and others. Given that both India and China have had a similar economic past with socialist set-ups it is necessary that venture capitalists have to alter views and systems to suit their operating environments. The prior lack of adaptation to their operating environment perhaps necessitated the new venture capital firms to undergo a longer than normal learning curve.

The science and technology policy announced in 2003 with its emphasis on private enterprises has also been observed to have given the venture capital firms a much needed impetus. Almost the entire gamut of investments made by venture capital firms have been observed to be in technology oriented industries. Almost half of the capital flowing into the venture capital funds has been contributed by foreign institutional

investors. (Mani, 2004) However despite the decent growth Mani (2004) also observes how regulatory bodies and regulations have failed to make the distinction between venture capital instruments and other forms of investment. It is interesting to note that the lack of sufficient legislative support and restrictive regulations has been found to be a common recurrent theme in Indian venture capital literature. The consensus is that the government could provide better legislative support and adopt a much more investor friendly venture capital policy.

Bruton, G. D., & Ahlstrom, D. (2003). An institutional view of China's venture capital industry. Explaining the difference between China and the West. Journal of Business Venturing , 233-259.

Dossani, R., & Kenney, M. (2002). Creating an Environment for Venture Capital in India. World Development , 227-253. Jeng, L. A., & Wells, P. C. (2000). The determinants of venture capital funding: evidence across countries. Journal of Corporate Finance , 241-289. Jones, M. (2006). Accounting. Chichester: John Wiley & Sons Ltd. Keuschnigg, C., & Nielsen, S. B. (2004). Start-ups, venture capitalists and the capital gains tax. Journal of Public Economics , 1011-1042. King, B. L. (2008). Strategizing at Leading Venture Capital Firms: of Planning, Opportunism and Deliberate Emergence. Long Range Planning , 345-366. Mani, S. (2004). Institutional support for investment in domestic technologies: An analysis of the role of government in India. Technological Forecasting and Social Change , 855-863. Naqi, S. A., & Hettihewa, S. (2007). Venture capital or private equity? The Asian experience. Business Horizons , 335-344. Pandey, I. (1998). The Process of developing venture capital in India. Technovation , 253-261. World Bank. (1989). India Industrial technology development project staff appraisal report. Washington DC: World Bank.