Venture Financing in India

A. Sahay*

Abstract
Innovation is stated to be the initiating force for a new venture but venture finance is the life blood for
entrepreneurship. Innovation is the fuel for igniting the Entrepreneurial engine, Venture capital revs
up the engine fast till it attains sustainable speed to change the gears from idea to entity, eventually
reaching IPO stage. The paper starts with Research and Development Cess Act, 1986 and covers the
development in the field till 2003 and presents an analysis of venture investments as well as future
prospects . The history of Venture capital (VC), its advent in India, Characteristics of VC, Government
guidelines on VC, Classification of VC in India, Types of VC and their analysis has been dealt in the
paper.
.

Introduction
Since Independence till early1990s, the Government has been playing the role of an entrepreneur as
well. This was on account of the policy direction which propounded socialistic society and mixed
economy. There was dearth of capital, infrastructure facilities and entrepreneurship in the country.
During this period, the Government developed infrastructural base such as roads, railways, electricity,
ports, banks, financial institutions, insurance etc through the public sector enterprises which were
supposed to attain commanding heights of the economy. The environment thus created resulted in
the people of India becoming job seekers and the Government itself became a dominant entrepreneur
and job provider. Industrialists in general became license seekers rather than wealth creators. Goods
and services of poor quality were produced at higher cost and lower reach, thus India Inc. could never
develop a competitive edge. It is in this context that President Kalam, on the eve of Republic Day,
2004, said that “The combination of entrepreneurship education in schools and colleges, the hassle
free flow of venture capital and evolution of good market will give momentum for the National Growth”.
Entrepreneurship is the king pin for growth and prosperity for which we have to plant idea factory in
every mind through education. Ideas, when pursued, will need innovation. If innovation is the fuel for
igniting the Entrepreneurial engine, Venture capital revs up the engine fast till it attains sustainable
speed to change the gears from idea to IPO stage. With the fuel alone, one can’t drive the car. It
needs fuel injector, accelerator, lubricator and many other accessories. Lubricating oil is needed even
at starting stage otherwise the engine will cease. Entrepreneurship is a key factor in promoting growth
in output and employment. Consequently, to encourage new start-ups, most governments in
developed countries have created public venture capital programmes and encourage promotion of
private venture capital firms. Venture capital is a means of financing growing private companies.
Finance may be required as seed capital, for the startup, development/expansion or purchase of a
company via a mechanism such as in a management buyout. Both establishing a new business as
well as a growing businesses always requires capital. There are a number of different ways to fund
new business and its growth. These include the owner's own capital, arranging debt finance or
seeking an equity partner, as is the case with venture capital. With venture capital, the venture
capitalist acquires an agreed proportion of the equity of the company in return for the requisite
funding. Equity finance offers the significant advantage of having no interest charges. It is patient
capital that seeks a return through long-term capital gain rather than immediate and regular interest
payments. Venture capital investors are, therefore, exposed to the risk of the company failing.

When venture capitalists invest in a business they become part-owners and typically require a seat on
the company's board of directors. They tend to take a minority share in the company and usually do
not take day-to-day control. Rather, professional venture capitalists act as mentors and aim to provide
support and advice on a range of management and technical issues to assist the company to develop
its full potential. Surveys, worldwide, consistently rate the management support as the most important
contribution of a venture capital firm. There are many sources of capital, but only a venture capitalist
can provide experienced management input gained by helping many other companies successfully
conquer the inevitable problems and growing pains.
*A. Sahay, Professor of Strategic Management & Entrepreneurship, Management Development
Institute, Gurgaon
Venture capital has a number of advantages over other forms of finance, such as:

• Finance - The venture capitalist injects long-term equity finance, which provides a solid capital
base for future growth. The ven ture capitalist may also be capable of providing additional
rounds of funding should it be required to finance growth.
• Business Partner - The venture capitalist is a business partner, sharing the risks and rewards.
Venture capitalists are rewarded by business success and the capital gain.
• Mentoring - The venture capitalist is able to provide strategic, operational and financial advice
to the company based on past experience with other companies in similar situations.
• Alliances - The venture capitalist also has a network of contacts in many areas that can add
value to the company, such as in recruiting key personnel, providing contacts in international
markets, introductions to strategic partners and, if needed, co-investments with other venture
capital firms when additional rounds of financing are required.
• Facilitation of Exit - The venture capitalist is experienced in the process of preparing a
company for an initial public offering (IPO) and facilitating in trade sales.

Venture capitalist combines risk capital with entrepreneurial management and advance technology to
create new products, new companies and new wealth. Risk finance and venture capital environment
can bring about innovation, promote technology, and harness knowledge-based ventures. In this
sense, venture capital is different from other types of financing such as

• development finance,
• seed capital, (At times Venture Capitalist provide)
• term loan / conventional financing,
• passive equity investment support, and
• R&D funding sources.

Ventur e capital is a source of investment in the form of seed capital in unproven areas, products or
start-up situations. The concept of venture capital is relatively new to the Indian economy, and is
gaining prominence in the recent years.

In developed countries such as U.S.A. and U.K., venture capital financing, is mainly through private
initiative, with hardly any involvement of the government institutions. It has done great service in
stimulating entrepreneurial growth in unproven and risky ventures which offered high potential for
growth. In developing countries like Taiwan, Singapore, South Korea, and Israel, venture capital has
played an important role in economic growth. Indian venture capital approach is modeled on the
U.S.A./ U.K. pattern. Government not only plays a pro-active role in creating a regulatory environment
to secure benefits to the small and medium enterprises (SMEs) but also provides venture support
through different arms. In India, reliable estimates of VC funding are difficult, mostly beca use not all
that is reported is real and because rules allow many VC transactions to fall outside official statistics
by making them indistinguishable from routine foreign investment. However, there is broad agreement
that in the calendar year 2003, VC funding in India was in the range of $500-600 million, a sharp drop
from $1.1 billion in 2002 and $900 million in 2001. Over 80 per cent new VC investment in India is in
profitable companies rather than start-ups, with Internet companies clearly out of favour and BPO,
media, entertainment and healthcare emerging as the new stars. Indian VC investment is essentially
small, far less than China and Japan, and far less exciting. In Asia, India has now slipped to the 5th
position from the 3rd place in 2002. More than the dotcom bust, this is perhaps due to the belated
realisation that India remains an untested if not shaky market, and that success is often shaped by a
combination of social circumstance and government role.

Characteristics of Venture Capital

Ideas and innovations, which have potential for high growth but has inherent uncertainties, are
financed by Venture capitalists. Further, venture capitalists provide networking, management and
marketing support as well. Therefore, venture capital refers to risk finance as well as managerial
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support. This blend of risk financing and handholding of entrepreneurs by venture capitalists creates
an environment particularly suitable for knowledge and technology based enterprises. Start ups,
where fund is needed most, are seldom funded by Venture capitalist. However, a rare combination of
product opportunity, market opportunity, and proven management may attract venture fund even in
Start ups.

Though the fundamental principle underlying the operations of a venture capital fund is “No return
without risk and greater the risk, greater will be the returns”, the ultimate aim of the venture capitalist
is the same as that of the promoters, i.e., the long-term profitability and viability of the invested
company. Venture capitalists play dual role; that of strategic advisor and financial partner. In the
process, they continuously monitor and evaluate the projects till their exit. As partners, they get
involved in the management of the invested unit where they bring expertise and drive which ensures
the survival and growth of the enterprise. They, generally, have wider horizon and innovative solutions
which maximize the chances of the project success.

In India, Venture capitalists have followed a broad approach in funding the enterprise. They have
supplied funds to new, high risk, not necessarily high tech ventures, and have also extended
management, marketing and financial skills to assisted ventures. In the beginning, they supported
high tech unproven technologies but with the experience of the first few years, it has been broad
based now. They

(a) expect a very high growth rate in the assisted enterprise,

(b) bring management and business skills,
(c) expect medium term gains (5 -10 years), and
(d) do not insist for any collateral to cover the capital provided.

Historical Background
USA is the birth place of Venture Capital Industry. During most its historical evolution, the market for
arranging such financing was informal. Entrepreneurs primarily relied on the resources of wealthy
families. It was in 1946 that American Research and Development Corporation (ARD), a publicly
traded, closed-end investment company was formed. The best known investment of ARD was the
start-up financing it provided in 1958 for computer maker Digital Equipment Corp. ARD provided its
original investors with a 15.8 percent annual rate of return over its twenty-five years as an
independent firm though it had difficult times in the beginning. The number of such specialized
investment firms, which later were called venture capital firms, began to boom in the late 1950s.The
creation of federal Small Business Investment Company (SBIC) program in 1958 aided the growth of
venture capital firms. Hundreds of SBICs were formed in the 1960s, and many remain in operation
today.

During the 1960s and 1970s, venture capital firms focused their investment activity primarily on
starting and expanding companies. More often than not, these companies were exploiting
breakthroughs in electronic, medical or data-processing technology. As a result, venture capital came
to be almost synonymous with technology finance. Venture capital firms suffered a temporary
downturn in 1974, when the stock market crashed and investors were naturally wary of this new kind
of investment fund. 1978 was the first big year for venture capital when the industry raised
approximately $750 million.

Legislation made it possible for pension funds to invest in alternative assets classes such as venture
capital firms only in 1980. Shortly thereafter, 1983 was the boom year - the stock market reached new
heights. During the year, there were over 100 initial public offerings for the first time in U.S. history.
This year has become memorable also because many of today's largest and most prominent firms
were founded. However, due to the excess of IPOs and the inexperience of many venture capital fund
managers, VC returns were very low during the 1980s. The VC firms retrenched, worked hard and
created new criteria for investment. The work paid off and with the new criteria for investment the
returns began climbing back and portfolio companies started becoming successful.

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The initial success generated further success in 1990s which were the best years for the Venture
Capital Industry. The favourable economic climate in the US coupled with the advent of the Internet
boom was the engine for growth. The decade saw low interest rates and high P/E ratio compared to
historical averages. This triggered Mergers & Acquisition activities creating more opportunities for
small, venture-backed companies to exit (cash out) at high prices. The Internet became a new
medium for both personal and business communications. It created tremendous opportunities for
entrepreneurs and venture capitalists in the mid and late 1990s. The industry, in turn, experienced
extraordinary growth both in the number of firms, and in the amount of capital they have raised. It is
estimated that over 1000 venture capital firms sprang up in the United States. The 21st century,
however, is seeing declining trend in venture capital activities.

Global venture capital (GVC) is an important phenomenon that has a significant impact on global
entrepreneurship. Despite this, the understanding and analysis of GVC is very limited in academic
and practitioner research. It is estimated that US$ 800 billion was raised globally between 1998 and
2002 out of which US$ 94 billion is currently under management in Asia. Though the sums under
management is huge, very little has been studied that will enable these GVC firms to successfully
deploy these funds in emerging Asian markets. Asia is a difficult market for foreign investors, with its
diverse sets of political systems, laws and cultural conundrums. This diversity makes successful
investing in Asia a uniquely difficult proposition. Venture capital firms today are more globalised than
ever before. It has an estimated 5,162 professionals in 1,560 firms operating in Asia, the majority
being foreign firms (Asian Private Equity, 2003). Thus globalisation of Venture Capital is an emerging
field but very little study has been done in the field.

Venture Capital in India

Research and Development Cess Act, 1986 introduced in the fiscal budget for the year 1986-87, is
the precursor of the concept of venture capital as a new financial service in India. This Act imposed 5
per cent cess on all know-how import payments to create a pool of funds for, inter alia, venture capital
activities. Technology Development Fund (TDF) was set up in the year 1987 -88, through the levy of
this cess on all technology import payments. TDF was meant to provide financial assistance to
innovative and high-risk technological programs through the Industrial Development Bank of India.
This measure was followed up in November 1988, by the issue of guidelines by the (then) Controller
of Capital Issues (CCI). These stipulated the framework for the establishment and operation of
funds/companies that could avail of the fiscal benefits extended to them. However, another form of
venture capital which was unique to Indian conditions also existed. That was funding of green -field
projects by the small investor by subscribing to the Initial Public Offering (IPO) of the companies.
Companies like Jindal Vijaynagar Steel, which raised money even before they started constructing
their plants, were established through this route.
In March 1987, Industrial Development Bank of India (IDBI) had become the first to introduce Venture
Capital Fund (VCF) scheme for financing ventures seeking development of indigenous technologies /
adapta tion of foreign technology to wider domestic applications. Thereafter, Industrial Credit and
Investment Corporation of India (ICICI) started financing technology-oriented innovative companies.
ICICI in association with Unit Trust of India (UTI) formed a venture capital subsidiary called TDICI -
Technology Development and Information Company of India - with headquarters at Bangalore, for
taking up venture capital activity. Industrial Finance Corporation of India (IFCI) formed Risk Capital
and Technology Finance Corporation (RCTC), with headquarters at New Delhi. TDICI is now known
as ICICI Venture Funds Management Company Ltd. or ICICI Venture; and RCTC is now known as
IFCI Venture Capital Funds Ltd. (IVCF). Their main focus is on development and commercialisation of
viable indigenous, often, untried technologies. Almost at the same time, Credit Capital Venture
Finance Limited was started in the private sector. This has mobilised funding from global funding
agencies, with the joint sponsorship of Commonwealth Development Corporation, London (U.K.),
Credit Capital Finance Corporation, Asian Development Bank (ADB), and Bank of India, a public
sector bank in India.

Government of India, in November 1988, announced the first venture capital guidelines in the
Parliament. These guidelines provided venture financing of technology start-ups, promoted primarily
by first generation entrepreneurs. Soon thereafter in 1989, four institutions were selected by the World
Bank under its Industrial Technology Development Project to start venture capital activities in different
parts of the country. ICICI at Mumbai, Gujarat Industrial Investment Corporation (GIIC) in
Ahmedabad, Andhra Pradesh Industrial Development Corporation (APIDC) in Hyderabad, and
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Canara Bank in Bangalore were selected under this scheme. IFCI at New Delhi, and Infrastructure
Leasing and Financial Services Ltd. (IL & FS) at Mumbai were added later under the scheme. These
institutions formed separate companies for handling venture capital activity and have been following
Government of India guidelines. Venture Capital Funds promoted under the scheme and their parent
organization are tabulated below.

Parent Institution Venture Fund Promoted

ICICI TDICI, renamed as ICICI Venture Funds Management

Company or ICICI Venture
IFCI RCTC, renamed as IFCI Venture Capital Funds Ltd. (IVCF)
IL & FS Pathfinder
GIIC Gujarat Venture Capital Finance Ltd. (GVCFL), with all India coverage
APIDC APIDC Venture Capital Ltd., with coverage as Andhra Pradesh
Canara Bank Canfina - VCF, with focus on southern states

The venture capital industry has grown manifold over the last decade and a half. The number of
venture capital funds increased from 12 in 1990 to 31 in 1997, and 45 in 2000. The total corpus
increased from Rs.200 crore in 1990 to Rs.4, 000 crore in 1997, and Rs.5, 000 crore in 2000. There
has been very slowgrowth in the domestic funds, whereas 19 offshore private equity funds have
started making investment in Indian companies. Inflow of venture capital from offshore funds has
been quite substantial from 2001 onwards. This may be the effect of the implementation of the
recommendations of the Report of the Working Group on Structure of Venture Capital Funds, chaired
by K.B. Chandrasekhar, a NRI (Non-Resident Indian) from Silicon Valley, U.S.A.

State Bank of India (SBI) and Canara Bank took the lead in promoting venture financing among the
public sector banks. SBI Capital Markets, promoted by SBI is operating VCF. Later several PSU
Banks started venture financing. From 1996, there has been an increased level of activity in the
venture capital industry. More funds have been set up both by existing companies and by new ones in
the public and private sectors. There has also been an increased availability of foreign funds for
Indian venture capital investments.

World Bank has been instrumental in the development of Venture Capital industry in the country. It
provided initial support by providing funds as well as giving international exposure. Further it
contributed in developing manpower resources and networking among venture capital companies in
India to foster cohesiveness. This resulted in professionalisation of venture capital companies. The
venture capital industry started maturing and in 1992, twelve domestic VCFs formed the Indian
Venture Capital Association (IVCA). The association took vigorous steps and influenced Government
of India to streamline the guidelines for venture capital industry in the country. The Indian Venture
Capital Association (IVCA) became the nodal center for all venture activity in the country. It has built
up an impressive database. According to the IVCA, the pool of funds available for investment to its 20
members in 1997 was Rs25.6 billion. Out of this, Rs10 billion had been invested in 691 projects.

Certain venture capital funds are Industry specific i.e. they fund enterprises only in certain industries
such as pharmaceuticals, infotech or food processing whereas others may have a much wider
spectrum. Again, certain funds may have a geographic focus – like Uttar Pradesh, Maharashtra,
Kerala, etc whereas others may fund across different territories. The funds may be either close-ended
schemes (with a fixed period of maturity) or open -ended.

The Venture funds in India can be classified on the basis of:

a) Genesis

Financial Institutions Led By ICICI Ventures, RCTC, ILFS, etc.

• Private venture funds like Indus, etc.

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 • Regional funds like Warburg Pincus, JF Electra (mostly operating out of Hong Kong).
• Regional funds dedicated to India like Drap er, Walden, etc.
• Offshore funds like Barings, TCW, HSBC, etc.
• Corporate ventures like Intel.

To this list we can add Angels like Sivan Securities, Atul Choksey (ex Asian Paints) and others.
Merchant bankers and NBFCs who specialized in "bought out" deals also fund companies. Most
merchant bankers led by Enam Securities now invest in IT companies.

b) Investment Philosophy

Early stage funding is avoided by most funds apart from ICICI ventures, Draper, SIDBI and Angels.

Funding growth or mezzanine funding till pre IPO is the segment where most players operate. In this
context, most funds in India are private equity investors.

c) Size of Investment

The size of investment generally varies between less than US$1mn, US$1 -5mn, US$5-10mn, and
greater than US$10mn. As most funds are of a private equity kind, size of investments has been
increasing. IT companies generally require funds of about Rs30-40mn in an early stage which fall
outside funding limits of most funds and that is why the government is promoting schemes to fund
start ups in general, and in IT in particular.

d) Value Addition

The venture funds can have a totally "hands on" approach towards their investment like Draper or
"hands off" like Chase. ICICI Ventures falls in the limited exposure category. In general, venture funds
who fund seed or start ups have a closer interaction with the companies and advice on strategy, etc
while the private equity funds treat their exposure like any other listed investment. This is partially
justified, as they tend to invest in more mature stories.In addition to the organized sector, there are a
number of players operating in India whose activity is not monitored by the association. Add together
the infusion of funds by overseas funds, private individuals, ‘angel’ investors and a host of financial
intermediaries and the total pool of Indian Venture Capital today, stands at Rs. 50 billion, according to
industry estimates! Despite availability of funds, the primary markets in the country have remained
depressed for quite some time now. In the last two years, there have been just 74 initial public
offerings (IPOs) at the stock exchanges, leading to an investment of just Rs. 14.24 billion. That’s less
than 12% of the money raised in the previous two years. That makes the conservative estimate of
Rs36bn invested in companies through the Venture Capital/Private Equity route all the more
significant.

Forays of VCFs in India

Some of the companies that have received funding through this route include:

• Mastek, one of the oldest software houses in India

• Geometric Software, a producer of software solutions for the CAD/CAM market
• Ruksun Software, Pune -based software consultancy
• SQL Star, Hyderabad based training and software development company
• Microland, networking hardware and servi ces company based in Bangalore
• Satyam Infoway, the first private ISP in India
• Hinditron, makers of embedded software
• PowerTel Boca, distributor of telecomputing products for the Indian market
• Rediff on the Net, Indian website featuring electronic shopping, news, chat, etc
• Entevo, security and enterprise resource management software products
• Planetasia.com, Microland’s subsidiary, one of India’s leading portals
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 • Torrent Networking, pioneer of Gigabit-scaled IP routers for inter/intra nets
• Selectica, provider of interactive software selection
• Yantra, ITLInfosys’ US subsidiary, solutions for supply chain management

Though the infotech companies are among the most favored by venture capitalists, companies from
other sectors also feature equally in their portfolios. The healthcare sector with pharmaceutical,
medical appliances and biotechnology industries also get much attention in India. With the
deregulation of the telecom sector, telecommunications industries like Zip Telecom and media
companies like UTV and Television Eighteen have joined the list of favorites. So far, these trends
have been in keeping with the global course.

However, recent developments have shown that India is maturing into a more developed market
place, unconventional investments in a gamut of industries have sprung up all over the country. This
includes:

• Indus League Clothing, a company set up by eight former employees of readymade garments
giant Madura, who set up shop on their own to develop a unique virtual organization that will
license global apparel brands and sell them, without owning any manufacturing units. They
dream to build a network of 2,500 outlets in three years and to be among the top three
readymade brands.
• Shoppers Stop, Mumbai’s premier departmental store innovates with retailing and decides to
go global. This deal is facing some problems in getting regulatory approvals.
• Airfreight, the courier -company which has been growing at a rapid pace and needed funds for
heavy investments in technology, networking and aircrafts.
• Pizza Corner, a Chennai based pizza delivery company that is set to take on global giants like
Pizza Hut and Dominos Pizza with its innovative servicing strategy.
• Car designer Dilip Chhabria, who plans to turn his studio, where he remodels and overhauls
cars into fancy designer pieces of automation, into a company with a turnover of Rs1.5bnThe
Electric 3-Wheeler of Scooters India Ltd, which was displayed in Taj, Agra during Prisident
Clinton’s visit was given a face lift in this studio..

In the year 1992, when IVCA was formed, Securities and Exchange Board of India (SEBI) was
granted statutory powers with the main objective to regulate and develop the Indian securities market.
The SEBI Act empowered SEBI to inter alia regulate the venture capital funds, the logic being that
these funds are part of the overall securities market; and are a source of capital. Provision was made
that all the VCFs will have to be registered with SEBI. With the liberalization in economy and financial
reforms, several foreign equity funds started investing in India from 1996, more so from 2001.

Classification of Venture Capital Funds in India

The VCFs can be classified into domestic & offshore and private & public funds.

Domestic Funds
The majority of domestic venture capital funds created their funds under the Indian Trust Act, 1882.
The industry has either a two or three tier structure. In the two tier structure, an Asset Management
Company (AMC) is formed which also acts as a trustee to the funds. The funds are settled as close
ended funds. In the three tier structure, an asset management company and a separate Trustee
Company are formed. The policy guidelines to the AMC for making investments and disinvestments
are provided by the Board of Trustees. This facilitates launching of more funds, each with a different
objective or focus by the VC companies which normally act as the AMC. Both the structures are very
similar to the Limited Partnership Act which is the structure through which VC funds are operated in
U.S.A. and U.K as well. IDBI operated its venture capital activities through a separate division. SIDBI,
which also operated VC earlier through a separate division, has formed an asset management
company and a Trustee Company in 1999 - 2000 to operate venture capital activities.

Offshore Funds
Post liberalization, from 1991, mobility of international funds in India has steadily increased. The funds
are set up outside India in many countries like U.S.A., Hong Kong, Singapore, Mauritius etc. These
are very large funds, and make large investments. They generally invest in existing big companies.
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The fund is set up usually either with the sole contribution from one company or with contributions
channeled through the foreign investors. Most of the funds have created the fund in Mauritius for
investment exclusively in India. These offshore funds create an advisory board that makes investment
and divestment decisions. The funds are routed through Mauritius for investment in Indian companies.
This is primarily done to save taxes under a double tax treaty between India and Mauritius. The
Mauritius based companies are totally exempted from paying capital gains tax. Such investments are
also subject to Foreign Investment Promotion Board (FIPB) approval.

Comparison of the domestic funds and offshore private equity funds

Feature Domestic Funds Offshore Funds

1. Base Based in India Based usually in foreign countries

(Mauritius is an attractive base)

2. Guidelines Follow SEBI guidelines Follow SEBI guidelines,

and need to get registered and need to get registered
with SEBI with SEBI

3. Corpus size Smaller in size, up to Larger in size up to

Rs.30 crore US $30 million

4. Invested Investment primarily in Investment primarily in

companies start up small and medium existing large companies
enterprises

5. Investment Average of Rs.50 lakh to Average of Rs.8 crore

size Rs.2.5 crore per enterprise Rs.10 crore per enterprise

6. Structure Registered as a Trust under

Indian Trust Act, 1882 Registration in host country

Venture Capital Funds may be private or public. Historically, private equity/venture capital funds have
out- performed public equities and mutual funds over the long term because an active PE investor can
improve returns by developing corporate strategies with management, implementing incentive
programmes for management and employees, and identifying appropriate add on acquisitions
whereas public funds get bound by rules and regulations. PE funds, usually, do not make passive
investments. Their financial participation is significant so as to influence the company’s operations. PE
funds negotiate either a Board seat or super majority rights. This ensures that they have a significant
role in the direction of the company.

Types of Venture Financing

The venture capitalist may investment in an enterprise through equity, quasi- equity, conditional loans,
and income notes.Investment in the form of equity is the most desirable form of venture financing, as
it reflects an approach of sharing risks and rewards and does not put any pressure on the cash flow of
the company in the initial teething period. Equity contribution from the venture capitalist should be
slightly lower than that of the promoters’ equity so that promoter feels secure and carries on with
innovation and business development. The quasi-equity instruments are converted into equity at a
later date. The conditional loan is a misnomer. It really is not a loan because there is no repayment of
principal and there is no interest on such loans. In this instrument, the company pays royalty to the
venture capital undertaking that is linked to the turnover, after the unit goes into regular production.
This is based on the true concept of sharing risk and reward. Income Notes is a hybrid of simple loan
and conditional loan. The outstanding debt carries concessional rate of interest and royalty attached
to the turnover.

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Government of India Guidelines on Venture Capital Funds
In November 1988, Government of India issued guidelines on venture capital which introduced
concessions in capital gains tax for technology. These were, however, modified in 1996 with the
issuance of revised guidelines. The VC guidelines were announced with the primary objective of
protecting the interest of investors, and providing enough flexibility to fund managers to make suitable
investment decisions. Participation by very small investors was restricted. Only high net worth
individuals and institutions, both domestic and foreign, were allowed to participate with a minimum
investment of Rs.5 lakh. GOI guidelines issued in September 1995 for overseas investment in venture
capital in India restricted the setting up of VCFs by the banks or financial institutions only.

Central Board of Direct Taxes (CBDT) and other guidelines state that a venture capital fund can invest
up to 40 per cent of the paid up capital of the invested company or up to 20 per cent of the corpus of
the fund in one undertaking. SEBI regulations and the guidelines of CBDT require that at least 80 per
cent of the corpus of the venture fund should be invested in unlisted equity shares of the VC
undertakings. However, the regulations permit investment by VCFs in listed companies of sick
industrial undertakings. In the In come Tax Act 1961, a new section 10 (23FA) was introduced by the
Finance Act introduced in Union Budget (1998 – 99) in respect of investments made by VCFs. They
were exempted from dividends and long-term capital gains on unlisted equity shares. This cover ed
investments in a number of product lines / services. These included software development, IT, basic
drugs in the pharmaceutical sector, biotechnology, agriculture and allied sectors, and other areas as
notified by the Government from time to time. During 1999 - 2000, SEBI was made the nodal agency
for all VCFs. Both domestic and foreign VCFs had to get registered with SEBI to entitle them to avail
the facilities made available by different institutions. In pursuance to the recommendations of
Chandrasekhar Working Group, the guidelines issued by different agencies were harmonised. A
number of concessions were announced by Government of India thereafter (Union Budget 2000 –
01). This gave a big boost to the VC industry as any income of such VCFs or VC company was
exempted from tax under section 10 (23FB). Further, section 115U was introduced with effect from
the assessment year 2001 – 02 in order to:

• Simplify the procedures; SEBI has been designated as the nodal agency for registration and
regulation of both domestic and overseas VCFs.
• Withdraw the requirement of registration by VCFs by tax authorities.
• Apply the principle of ‘pass-through’ in tax treatment of VCFs,

The income of VF was made tax free, except when not distributed within the period that may be
prescribed in the SEBI guidelines. Income in the hands of its investors, which otherwise was taxable,
was also made tax free. Only one-time payment of tax by the VCF at the rate of 20 per cent was
required, when the fund distributes its income to the investors. The same rate was applicable to the
undistributed income as well.

The Monetary and Credit Policy announced by the Reserve Bank of India (RBI) in April 1999, to
encourage the finance for venture capital, increased the overall ceiling of investment by banks in
ordinary shares, convertible debentures of corporates, and units of mutual funds, etc., from 5 per cent
of their incremental deposits to the extent of bank’s investment in venture capital. It was also decided
to include investments in venture capital as part of priority sector lending. While, on one hand there
were relaxations in VCF’s operations, on the other investment restrictions mentioned below were
imposed.

• VCFs shall not invest more than 25 per cent of the fund in one VCU;
• VCFs shall not invest in the associated companies;
• VCFs shall make investments as enumerated below:
a. at least two-thirds of the investible funds should be invested in unlisted equity shares
or equity-linked instruments of VCUs
b. not more than one -third of the investible funds may be invested by way of :
i. subscription to initial public offer of a VCU whose shares are proposed to be
listed,
ii. debt or debt instrument of a VCU in which VCF has already made an
investment by way of equity,

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 iii. preferential allotment of equity shares of a listed company subject to lock in
period of one year,
iv. the equity shares or equity-linked instruments of a financially weak company
or a sick industrial company whose shares are listed,
v. special purpose vehicles which are created by a VCF for the purpose of
facilitating or promoting investment in accordance with these regulations.

Exit Route for Venture Capital

The most crucial stage in any venture capital investment is its exit from the enterprise. Generally, the
goal of the venture capitalist is to sell the investment in a period ranging from three to seven years at
a considerable gain. The different possible routes for exit from venture investment or disinvestments
or divestment are:

Initial Public Offer (IPO): The most preferred exit route for a venture capitalist is the IPO. The
company can go to the public through stock exchanges.

Trade Sale: In a trade sale, the venture capitalist sells his stake to a strategic buyer, which already
owns a business similar / complementary or plans to enter in to the target industry. This helps the
strategic buyer to produce a synergistic increase in its value. The promoter may or may not sell this
stake to the strategic buyer.

Promoter Buy Back: In this pattern, the promoter buys back the venture capitalist’s stake at a pre-
determined price. This is not very popular since the promoter as a first generation entrepreneur is
hard pressed for money.

Company Buy Back: In this, the company buys back the venture capitalist’s stake at a pre-determined
price. The company buy back has been recently announced.

Management Buy Out: In this, the operating management group acquires the business by buying the
equity held by the promoters. It usually involves revitalizing an operation with entrepreneurial
management acquiring a significant equity interest and has to be within SEBI guidelines.

Analysis of Venture Investments

In 2002 , there were over 70 operating offshore VC funds focusing on India as a country. It is
estimated that over 80 per cent of them are dollar funds, and the rest are rupee funds. The total
cumulative assets under management are over US $5 billion. The investments in various sectors in
2000 alone are placed at around US $1 billion. This has given tremendous boost to IT sector from
2000. The total venture capital/ private equity investments have touched $1 billion during 2003-04
from $600 million in 2002-03. VC/PE funding in the calendar year 2003 was in the $500-600 million
range, a sharp drop from $1.1 billion in 2002 and $900 million in 2001.

The Venture Intelligence India Roundup Annual report, 2004 reveals that:

• VC / PE firms invested about US$ 1.1 billion in 66 Indian companies and exited about 30
companies during 2004
• Investments in Business Process Outsourcing declined sharply compared to 2003
• ICICI Ventures emerged as the most active VC
• Companies based in South India cornered over 50% of investments
• Mumbai threatens Bangalore’s lead as top destination for PE investments
• Six venture-backed companies pulled off successful IPOs during the year
• Contract electronics manufacturer Flextronics emerged as a major investor as well as
acquirer of Indian technology companies.

10
Conclusion
Venture Financing in India is still in its infancy. There is no reliable estimates of VC funding because
what all is repo rted is not real as rules allow many VC transactions to fall outside official statistics by
making them indistinguishable from routine foreign investment. VC financing increased in the
beginning with liberalization but started falling thereafter. VC in India invest in profitable companies
rather than start-ups. VC in India invest in profitable companies rather than start-ups. Information
technology, software development, BPO, biotechnology, food and agro-processing industries,
pharmaceuticals, service enterprises, media, entertainment and healthcare have emerged as the new
stars. Indian VC investment is essentially small, far less than China and Japan. Venture fund,
generally, flows to the entrepreneur when the investor is personally familiar with him. For
entrepreneurs seeking informal investments from outside their circle of social networks, this means
that they must be prepared to provide sufficient information for the potential investor to make informed
risk evaluation. They should also seek out, where possible, potential investors with experience in the
area of their proposed new business. There is a need to professionalize the venture fund investment
for which greater transparency and trust is needed between the entrepreneur and the investor. With
greater encouragement given to professional entrepreneurship, adoption of innovative technologies
and an integration of Indian business with the global market; industry and service sector in particular
offer bright prospects for venture capital industry in th e country.

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